The "New" Fed in the "New" Environment

If you own stocks, the last few weeks have been turbulent.  Everyone seems to have a story about why it happened and what it means for the market going forward.  I listen to some of the talking heads and hear how great it is to see volatility back in markets.  The recent dive has acted as a release valve and now we are back to a healthier market.  The captain is about to take the seat belt sign off so the rally can recommence.  The fundamentals, we are told, remain favourable for equities to reach new highs.  Party on, Garth!  

Then there seems to be the deeper thinkers who suggest that there has been a seismic shift under the markets.  Investors had been operating in an environment of slow and steady growth, low interest rates, dormant inflation and accommodative central bank policies which led to a period of extremely low volatility and a relentless bid in all markets, including  equities.  Now, this view has been rattled.  While expectations for economic growth do not seem to have been altered much even with additional US fiscal stimulus, the market seems to have suddenly become aware that we are now in an environment where central banks are reigning in liquidity, yields have jumped higher and there is growing evidence that inflation is not dead.  This “new” environment requires that portfolios need to reposition for higher inflation and need to lower their risk profiles given the expectations of increased volatility.  

Adding to all this is the question as to how the new leadership at the Fed will respond to this “new” environment. The market was well served by Yellen over her term.  Rates were kept low and any increases were well telegraphed and tempered.  Her decision to start unwinding QE was virtually ignored.  Her market-friendly actions and resulting dovish moniker were the result of her setting appropriate policy.  With inflation stubbornly low, she could err on the side of ease.  Now, with Jerome in charge, the market has to consider whether he will be more hawkish than Janet.  For him, his starting point includes firming inflation, with core measures already close to their assumed inflation target.  He also has the economy growing above potential and in an excess demand situation.  Unlike Yellen, who could afford to act slowly, it is doubtful Mr. Powell has the same latitude.  Hence, he will likely be seen as less market-friendly and viewed as more hawkish over his entire term than his predecessor.  

The market already has a number of hikes built in for the next year.  Asset market valuations will depend on whether Fed actions match this profile.  To answer whether they do or not, we are right back to our “old” environment conundrum.  You know the one where inflation remains surprisingly suppressed relative to a given output gap by technology, globalization and other factors.  Unless there is more proof that inflation is really gaining traction and accelerating, I doubt we will see a huge personality change towards more aggressive behaviour coming out of the Fed.  It may take some time before we see the “hawk” in Mr. Powell.   Party on, Wayne!