Three Level Chess: What Next For The Financial Markets?
“Fragility is the quality of things that are vulnerable to volatility” – Nassim Nicholas Taleb
2018 has been a transition year: The Federal Reserve’s quantitative easing program, which dampened volatility in the financial markets, is now a disruptive “policy normalization” program. The consequential rising interest rates are exacerbating the impact of two other disruptive variables - geopolitics and changes in profit growth. These three variables together – Federal Reserve policy normalization, geopolitics, and corporate profit growth – are dynamic, interactive, and influential on the financial markets.
Geopolitical variables have taken on increased influence in 2018. In particular, trade barriers such as tariffs are in reality a tax on consumption. Improved national security and employment may be the stated goal, yet the immediate impact is negative on consumer behavior as prices rise. For 2019, we will be looking for resolution to the trade negotiations and a reversal toward a more cooperative global trade environment. To the extent negative disruptive trade actions escalate, we would expect diminished economic growth prospects for the United States. To the extent there is resolution, the negative consequences may be transitory.
The Federal Reserve initiated its monetary policy normalization program in September 2014. Over the past year to December 5, 2018, the Federal Reserve has reduced its balance sheet to approximately $4.0 trillion. This has included a $212 billion reduction in U.S. Treasury securities on its balance sheet to $2.2 trillion and a $114 billion reduction in mortgage-backed securities to $1.7 trillion. Currently, the Federal Reserve is rolling a maximum of $30 billion off its Treasury securities holdings balance sheet monthly and $20 billion off its mortgage-backed securities portfolio. In order to fine tune the fed funds rate, the Federal Reserve is using other tools, such as the rate of interest paid on bank excess reserve balances, its overnight reverse repurchase agreement facility, and interest-bearing term deposits for banks. Prior to the financial crisis, the Federal Reserve could primarily use its open market operations (OMOs), a framework based on two key features – reserve requirements and reserve scarcity, to effectively implement monetary policy in pursuit of maximum employment, stable prices, and moderate long-term interest rates. Finally, a complicating factor for the Federal Reserve is raising rates enough in order to have sufficient capacity to lower them should another economic crisis ensue, while at the same time not raising rates to a tipping point that causes an economic downturn.
Corporate profit growth has had a stellar year thus far with the third quarter preliminary 2018 numbers increasing 10.3% year over year as reported by the United States Bureau of Economic Analysis. However, recent global business surveys provided by IHS Markit for November 2018 show falling global trade flows. This, in conjunction with concerns about the impact on supply chains due to any tariffs, could negatively impact economic growth in 2019 as companies adjust to a changing landscape.
2018 has transitioned toward greater volatility in the financial markets. As 2019 enters, we see both opportunity and risks in that volatility. Companies that we view favorably have three key attributes: productive leadership, financial flexibility and a strong ecosystem. 2019 could well test corporate endurance.