Goldman Doesn’t Get It On Rates
Earlier this week we came across this article in which Goldman Sachs said it now believes the Fed will raise rates only three times this year instead of four.
We like to call bull when we see it. Goldman doesn’t get it. We see no way the Fed will raise rates three times this year. In fact, we don’t expect the Fed to raise rates even once.
We believe the Fed was engaging in Emerson’s “foolish consistency” when it raised rates to 25bps on December 16th. At the time, there was low to no inflation, slumping commodities, trouble brewing in China, and plenty of equity volatility all indicating it was not necessary. But the Fed felt it had to do it, because they said they would. They do not wish to be inconsistent with a public that doesn’t understand that changing your mind as a central banker can be a good thing.
That being said, we think the Fed is now giving itself plenty of wiggle room to not raise rates and there are many new reasons why it should not:
- On January 28th, Japan lowered its short term interest rate to negative 0.1%. The European Central Bank is already at negative 0.3%. The world’s most developed economies are all negative, except the USA. If the Fed raises rates further, it will strengthen our currency, choking off growth.
- On January 29th Q4 GDP growth was reported at 0.7%. 2014 Q4 GDP growth was over 2%. 2013 Q4 GDP growth was nearly 4%. A slowing economy is not the right environment for interest rate increases.
- February 2nd, Reuters announced the percentage of S&P 500 CEOs mentioning recession concerns in their quarterly earnings calls grew by 33% from the same time period a year ago. The last time there was this increase on a year over year basis was in 2009. These CEOs are on pulse of the economy because they run the largest businesses in America; this is a strong indication that the economy is slowing.
- On February 5th, the January jobs report came in particularly weak. Only 151,000 jobs were created vs. 190,000 estimated. Sure, the Fed might be looking at unemployment, which is now at 4.9%, but labor force participation is incredibly low and so is wage growth, further pointing to a weak economy.
- The dollar keeps strengthening against world currencies, especially against China which is forcing its currency lower in a bid to export its way out of trouble. We are in a currency war with China, but our administration is not addressing the issue. Everyone is playing beggar thy neighbor with the USA, and we’re going along with it.
The Fed is in a conundrum. What should it do? If Goldman is right, the Fed will raise short term interest rates to 1% by the end of this year. As we see it, there is no upside to raising rates. One percent is not enough to do savers any real good. Yet, one percent is enough to do real harm to our economy. It will strengthen the dollar further, which will in turn put people out of work and make the next recession worse than it needs to be. Our dollar is too strong. Exports are suffering. Fifty percent of S&P 500 revenue is generated in foreign currency. Having a strong dollar greatly hurts revenue and earnings in USD terms. The world is far too globalized today to have a drastically different monetary policy than our key trading partners (China, EU, and Japan).
The advantage to raising rates is typically to keep the economy from overheating and asset bubbles forming. Yet, years of zero interest rates have not caused the economy to overheat. Asset bubbles have already formed in fixed income, especially high yield. So it’s not like the Fed is going to get ahead of that bubble by raising rates now. That bubble will deflate itself as soon as the corporate default cycle begins, which is already happening.
To summarize, we don’t think the Fed will raise rates this year. The US economy will continue to slow, along with the rest of the world, and the Fed will have to accommodate. We hope the Fed will take steps to weaken the dollar instead of making matters worse by strengthening further with rate increases. We continue to stand by our New Year’s prediction that the stock market will tank in 2016. We see the weakness since January as the appetizer before the main course.
Recommendations / Implications:
- Stay in cash. Readers can subscribe to our free Smart Hedge™ Index market timing tool on our website, which tells people whether to be long the market or in cash. The index has been in cash since December 11th. There’s no need to take market risk right now. There will be a better time for that in the future.
- Don’t expect to earn anything on fixed income. It won’t happen. Rates won’t move.
- Don’t stretch for yield. There will be more defaults to come as we enter the downward phase of the business cycle. Stretching for yield means reaching for defaults right now.
- Don’t make the mistake of thinking that a private investment in real estate is protected from the business cycle. Unscrupulous financial advisors love to recommend private REITS, for example, because they “don’t have market risk.” Nothing could be further from the truth. Just because something doesn’t trade publicly, doesn’t mean it isn’t losing value. Real estate prices have on average been flat nationwide since September and high end residential real estate is actually declining in value.
This is the right time to be cautious. We think all three major asset classes (stocks, bonds, and real estate) are going to get more attractive in price as we enter into the next recession, for which there is ample indication at the time of writing. However, as macro-level forecasts such as the timing of interest rate rises, overall direction of the economy, and direction of financial markets cannot be made with 100% certainty, we believe investors should seek investment strategies that accommodate every possible outcome. There are alternatives to long only investing that allow investors to preserve and grow their capital in declining markets while participating rising markets. Next week we will introduce a strategy designed to make money in falling markets, a solution to a blind-spot most long-only investors are missing in their portfolios. Stay tuned.