What is the monetary environment to start the new year?
The proprietary approach taken by Economic Index Associates (EIA) classifies monetary conditions into one of three environments: restrictive, indeterminate or expansive. This classification is based on changes in Federal Reserve policy interest rates. Our 25+ years of research confirms that shifts in Fed policy rates signal the Fed’s views on current and future monetary and economic conditions. More importantly, the research shows a strong affiliation between these policy shifts and subsequent security market returns.
At the end of November 2020, the EIA model reclassified the monetary environment from indeterminate to expansive, thus, we begin 2021 with Fed policy classified as expansive. The November reclassification was based on recent changes in Fed policy rates, which signaled the Fed was delaying its move toward higher rates. Specifically, since mid-2019, the Fed’s fundamental policy stance has remained expansive (informally, an easy money posture). In contrast, the Fed’s actions in the short-term, fixed-income market show that the Fed has alternated between an easy money posture and leaning toward a more stringent posture. In other words, the Fed is signaling it plans to maintain a generally accommodative broad policy. In the short-term market however, the Fed has alternated between applying actions intended to soak-up excess liquidity and a policy of maintaining abundant liquidity.
We believe that the Fed’s current easy money policy is only a temporary measure intended to ameliorate the impact of Covid until vaccinations become widespread. The next change in environment (expected later this year) will likely be a shift to an indeterminate policy followed shortly thereafter by a shift to a restrictive policy. Our expectation is that the Fed will proceed with caution by moving to an indeterminate policy before applying a more constraining restrictive policy.
Our years of research have taught us that the “direction” of movements in Fed policy rates is much more important to security markets than the “level” of rates. Thus, any non-transitory movement in policy rates, no matter how small, serves as a rebalance signal for the EIA model. Thus, the Fed’s seemingly innocuous policy shifts over the prior few months have had significant ramifications for the IFED portfolios; with index rebalances in September and December 2020 even though rates adjusted only slightly.
The table below shows summary data for the EIA monetary environment classification.
As shown above, from May to December 2020, the federal funds rate ranged from a low of 0.05% to a high of 0.10%, yet this period witnessed two shifts in the monetary environment: from “expansive” to “indeterminate” at August end 2020 and from “indeterminate” back to “expansive” at November end 2020. These shifts resulted in rebalances for the IFED portfolios in September 2020 and December 2020, respectively.
Our research shows that the characteristics of firms that outperform in an expansive environment are fundamentally different from those that outperform in an indeterminate or restrictive environment. For example, relative to indeterminate monetary environments, expansive environments have been more favorable for firms with greater growth potential, which corresponds with the December reallocation toward technology firms and firms with greater price multiples and ROEs.
Overall Market Commentary
In response to the subtle change in monetary policy, the IFED-L portfolio shifted substantially in early December. The largest positions prior to the rebalance were in Citigroup, Goldman Sachs, Wells Fargo and Morgan Stanley. Post-change, the largest positions are in Apple, Wells Fargo, Adobe and Johnson and Johnson. Additionally, our top ten holdings now include General Electric and Booking Holdings, large industrial and travel firms, respectively. The portfolio went from overweight positions in financials and utilities to overweight positions in information technology, health care and consumer discretionary.
The proprietary IFED model relies on twelve firm-specific metrics to select stocks that are likely to outperform in the newly established monetary environment. The model is a stock selection strategy and does not target specific sectors. While the combined influence of the twelve firm-specific metrics drove the December rebalance, we believe that fundamental valuation principles underly the change. Specifically, the Fed has signaled that it will maintain an easy money policy to begin 2021, thus, supplying the money needed to allow firms with growth prospects to take optimal advantage of their growth potential.
An old English proverb states that, “money makes the mare go.” At the start of 2021, the IFED portfolios are positioned in firms that are financially and operationally situated to take advantage of the excess liquidity existing in the market. If the Fed chooses to start soaking up some of this liquidity later in the year, as we anticipate it will, the IFED portfolios will rebalance accordingly.