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Recalibration

David R. Kotok
Thu Jun 2, 2022

“The Great Recalibration”

In a May 13 speech about the Federal Reserve’s recalibration of policy, Cleveland Fed President Loretta Mester mentioned financial stability. This issue is a key element in the Fed’s narrative. Here’s the link to the Fed’s recent financial stability report.

https://www.federalreserve.gov/publications/files/financial-stability-report-20220509.pdf

Here’s the entire panel discussion, hosted by the European Central Bank, including President Mester’s formal remarks (at 5:25) and two others, with a Q&A at the end: “Monetary policy during and after the pandemic,” https://youtube.com/watch?v=ptBv-_77HxE. Viewers will find some nuances in the Q&A session. As Loretta Mester addressed questions, she included policy options for the Fed. She mentioned scenarios after the Fed reaches a 2% policy rate (federal funds target), and she mentioned possible future sales from the Fed’s holdings of mortgage-backed securities (MBS).

Many thanks to Bill Nelson for providing the links.

 

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Cumberland Advisors Market Commentary - Recalibration by David R. Kotok

 


Here are additional data points that support the notion that we need a great recalibration from policy to markets.

 

(1) Christopher Whalen shared his view in his May 23 note:

“Truth to tell, Jamie Dimon is not responsible for seeing JPM reach $172 per share last October, and he is not responsible for the fact that the bank’s equity is nearing $100 as of Friday’s close. Financials are simply tracking the ebb and flow of liquidity into the financial markets. Share prices are falling as expectations for short-term appreciation fall and concerns about credit costs are rising in the minds of the more astute members of the audience.”

We heartily recommend reading his full research piece: “Equity Market Valuations & Quantitative Tightening,” https://www.theinstitutionalriskanalyst.com/post/equity-market-valuations-quantitative-tightening

 

(2) DataTrek shared similar thoughts about the entire stock market, which could help put the recalibration in focus. Here’s why the Great Recalibration is needed and how it is unfolding rapidly. Thank you, DataTrek. This excerpt is taken from the DataTrek Morning Briefing for May 19, 2022. We thank Jessica Rabe and Nick Colas of Datatrek for sharing this information with our readers.

“#1: Starting off, here are price returns for various US/global equity market indices from February 19th 2020 to today (May 19,2022). That (Feb 19, 2020) was the day the S&P 500 made its last new high before the Pandemic Crisis hit global stock prices, closing on that day at 3,386. Since then:

 S&P 500: +15.2 percent

 Russell 2000: +4.3 percent (1693)

 MSCI EAFE (non-US developed economies): -2.4 percent

 MSCI United Kingdom: -3.4 pct

 MSCI Japan: -1.9 pct

 MSCI France: +1.0 pct

 MSCI Emerging Markets: -5.2 percent

 MSCI China: -24.1 pct

 MSCI Taiwan: +34.5 pct

 MSCI South Korea: +7.2 pct

“The headline here is that US stocks are still higher than immediately before the pandemic while both EAFE and Emerging Markets equities are lower. Even if one adds back the trade weighted dollar’s 3.6 percent increase in value since February 2020, neither non-US equity index is beating the S&P or the Russell from immediately pre-pandemic times to now. Taiwan and South Korea have done well, to be sure, but the losses in Chinese equities have more than offset their impact on EM equities.”

“#2: Does earnings growth from 2020 to the present justify the S&P 500’s gains since February 2020? The short answer is that it does: The S&P 500 earned $161.56/share in 2018 and $163.13/share in 2019, for an average of $162.35/share. These were the highest EPS results in the index’s history and markets in early 2020 saw current year earnings shaping up to be even better. That’s why the S&P hit that record 3,386 on February 19th.”

Datatrek continues," “Over the last 4 quarters (Q2 2021 to Q1 2022), the S&P has earned $215.97/share, 34 percent more than the average of 2018 – 2019. That’s less than the index’s 15 percent gain since February 2020, but higher interest rates have pressured valuations.”

 

(3) In her speech, Loretta Mester notes the changes in the 30-year home mortgage interest rate. It was somewhere around 3% and is now over 5%.

 

(4) Jim Bianco addressed the housing market at John Mauldin’s 2022 Strategic Investment Conference. (Hat tip to Steve Blumenthal for sending out the quote. Separately, Jim Bianco, Steve Blumenthal, and John Mauldin are all participants from time to time at our annual fishing gathering. We're still trying to teach them how to fish, but they have plenty to say about economics, and their comments about finance and economics are better honed than their fishing skills. -grin-). Here’s Jim on housing:

“As of March, the typical home value was $338,000; the 12-month change on that was $58,000 or a 20.9% increase. So let me restate that for emphasis. The median home in the United States went up $58,000 last year. As was pointed out by the chief economist of Zillow, the median income in the United States, it’s $50,295. Sitting in your house, your house made you more money than you earned on your job. That has never been the case, anything close to that. Not even in 2006. Median income then was $47,000. And we peaked out at $22,000 of the average home price gain in October of 2005. Massive stimulus in the housing market.”

 


 

Whether we investors Like it or not, the great recalibration is underway. Markets have moved very fast to reprice this change. As Loretta Mester said, it was broadcast by the Fed last fall. The pattern that it will follow is indicated. The market may have already completed the recalibration response or done a great deal of it, and the rationale for what happens after this summer is explained by Loretta Mester in the Q&A section of her speech.

We don’t know, as investors, what the final recalibration will look like. We don't know what the neutral interest rate is. Fed Governor Waller suggested maybe 2 1/2% but policymakers may go above that. Truth be told, nobody knows; Neither does the Federal Reserve. We are all guessing about the neutral interest rate. And We have to distinguish between an equilibrium interest rate that allows financial stability, which enables markets to operate in the clear but does not impact the price level of asset prices like housing or stocks. And we have to recognize that the neutral real interest rate for financial market participants is quite different than the neutral real interest rate for the housing sector or the banking sector or the manufacturing sector or others. The Fed has a difficult role because it can't have different interest rates for different folks. It has to use one blunt instrument. It has to guess at the real interest rate. It has to focus on that calculation, or estimate, and it has to do it in both the long term and the short term. And at the same time, it has to have an equilibrium market-clearing financial-stability interest rate so that markets continue to function and don’t freeze up.

Accomplishing all this is a very tall order, because a central bank can set only one interest rate, and it wants the one interest rate to do all those things. Note that the minute a central bank sets two different maturity rates, it immediately sets the whole yield curve as Japan has done for years. In a steady state economy without shocks over a long period of time, such a single rate policy is possible; but in the current context of a shooting war, worldwide sanctions, an inflation shock, and a pandemic not yet over and spreading, we have sequential shocks to contend with, as we have written about in the past. To expect a single interest rate to accomplish all these purposes at one time is to expect the impossible. What Loretta Mester has done in her speech and what the other evidence introduced in this commentary also does is to make the case that a recalibration is necessary. It has to be done thoughtfully, deliberatively, and without triggering shocks to the markets or the economy from surprises. That is the task of the Federal Reserve. So far, it’s a task they are continuing to do without surprising the markets or the economy. Our expectation is that the short-term policy interest rate will work its way somewhere above 2% but below 3% by the end of this year. And the rate of inflation by the end of this year will be falling. It may not fall all the way to 2% as Governor Waller would like to see, but it will be trending lower, not higher. The measures of inflation that are important are those referenced by Loretta Mester and others — the personal consumption expenditure deflator (PCE) and other more sophisticated measures that address inflation.

 

David R. Kotok
Chairman & Chief Investment Officer
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