INVESTORS MUST KEEP ON SECOND GUESSING THE FED / THE FINANCIAL TIMES COMMENT & ANALYSIS

On Wall Street

February 13, 2015 9:30 am

Investors must keep on second guessing the Fed

Henny Sender

The easy money offered by central banks is not without dangers, writes Henny Sender

 

 

The February 6 edition of Citigroup’s high yield weekly newsletter posed a question that seemed to summarise the predicament of all fund managers, and not just those navigating the pitfalls of a volatile junk bond market: which is better — to invest in the debt of lower-rated issuers because they offer more attractive absolute yields; or, to invest in the debt of higher-quality companies but do so with leverage in order to generate acceptable returns?

In a world awash with liquidity — but a fragile, unreliable liquidity that ebbs and flows in accordance with the latest utterances from policy makers — one is tempted to ask for a third option.

 

Many hedge fund managers say fundamental analysis no longer works. Investing is all about second guessing the Federal Reserve instead. Economic data remain uneven, which makes deciding on the timing of any future interest rate rise perilous. JPMorgan expects real growth for the fourth quarter to be revised down to 2 per cent in real terms. Leading indicators like new manufacturing and factory orders also are slowing, while S&P 500 estimates of sales and earnings for 2015 look flattish, notes Michael Cembalest of JPMorgan’s private bank.

 

Both consumer spending and retail sales were down in December, underscoring the downside risks. In January, retail sales were down 0.8 per cent month on month and much softer than analysts expected.

 

Meanwhile, inflows into the bond markets have resumed, emerging market debt has bounced back and the spectre of monetary tightening seems to have receded yet again — at least at the time of writing.

 

If the economy is growing at a mere 2 per cent, surely it is time to conclude that the Fed’s medicine is not healing the real economy. At the same time, the risk taking that the Fed is encouraging by making it difficult for savers to see decent returns without reaching for yield will prove increasingly dangerous. One analyst estimates that yields should be 120 basis points higher than their current levels.

Easy money ultimately is not costless. While few analysts talk about it, low returns for savers may mean an eventual cut in pension benefits and lower demand, especially for retired workers and those contemplating retirement. The Fed’s policies are contributing to income inequality today in the US and they will do so even more tomorrow. It is big borrowers and speculators who are the biggest beneficiaries of Fed policies.

Indeed, if one assumes Fed policy is not working on the economy, suddenly much of the data begin to make sense. For example, the widespread expectation that massive asset purchases and zero rates would lead to inflation assumes that Fed policies would work, that the economy would grow strongly, wages would rise, and excess capacity would disappear. But there is still excess capacity and wages are hardly rising precisely because the real economy remains fragile.

Chief executives have more incentive to buy back their shares (often with money borrowed at low rates) or to buy other companies than to invest in their own businesses.

 

If deflation really is more of a risk than inflation — precisely because wages and therefore demand remain weak — then the real burden of debt becomes heavier and investors should expect defaults to pick up.

So far, though, recent corporate defaults have been easy to explain away as due either to the heavy leverage private equity firms put on companies that are vulnerable to recession, such as Caesars Entertainment, or companies such as retailer Radio Shack, with thousands of stores that have been marginalised by the same technological changes that have doomed other retailers.

 

If the oil price comes down because new sources of energy mean Opec can no longer operate as a cartel controlling prices, inflationary pressures subside. But if a big part of the slide is owing to far less demand because of slower, less energy-intensive growth, the information for investors contained in the price slide is very different.

And finally, if the Fed continues to be the biggest reason to take risk, when the Fed finally turns, what happens to all that risk? Central bankers are meant to encourage financial stability not to be cheerleaders for inflated asset prices.