I have to make this point and make it emphatically – central banks continue to matter and maybe now more than ever. Those of us that have been cautious on the markets have rightly said, time and again, in this two-month bounce-back that prices have begun to reflect a whole lot of potential good news – from a successful resolution to the trade file, to Chinese stimulus to a Brexit solution.
Since early January, Fed official after Fed official has come out and told investors “we hear you." Back in December when U.S. Federal Reserve chairman Jerome Powell tightened into the market maelstrom, threatening two more hikes and the continued selling of Treasuries, the sharp slide that quickly ensued was the message from Mr. Market to the Fed to the effect of “buddy, you are tone deaf.”
But then the Fed backed off. Mr. Powell didn’t wait years only to end up apologizing in a book like Ben Bernanke did – he wasted no time in easing up. And so we have to acknowledge that even if the markets have priced in some good news on various fronts (and did so perhaps prematurely) there is a reality that has to be accepted, which is that this market rebound has occurred amid a very poor set of incoming economic data and a wave of downgrades to the earnings outlook.
But even with the profits backdrop challenged, the interest rate that investors use to discount future cash flow streams has come down as well, and this is a very powerful positive influence on equity values, pure and simple. The markets believed in December that the Fed was on the precipice of making a huge policy error – and the central bank pulled back. End of story.
From my lens, the Fed has already overtightened and recession risks for this year are elevated and on the rise. Only history will be the arbiter of whether the downturn already got priced in during the setback in last year’s fourth quarter; I wouldn’t necessarily rule out a retest of those lows. But what is important is that the Fed is not going to allow any further steep correction beyond that, if it can. Mr. Powell has shown his hand in terms of when he feels the need to put investors’ minds at ease – and it is at the December lows. The Fed responded to those lows by doing a 180-degree shift in tone, and rest assured it is not going to be just the tone that changes in the next corrective market phase, but rates themselves.
So if there is one conviction I have, it is that front-end rates and bond yields of all maturities on the curve will be melting before our eyes in the next 12 to 24 months. This obviously spells decent returns in the fixed-income market (bond prices and yields move inversely), but it should also be a solid underpinning for high-quality, blue-chip, non-cyclical dividend-paying stocks. North American financials are the first to come to mind, and this is from the resident bear.
David Rosenberg is chief economist with Gluskin Sheff + Associates Inc. and author of the daily economic newsletter Breakfast with Dave.
David Rosenberg