Federal Reserve Monetary Policy Review: September, 2020
What is the new monetary environment?
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 beginning of September 2020, the EIA model classified the monetary environment as indeterminate. This classification is based on recent changes in Fed policy rates, which present conflicting signals. In particular, since mid-2019, the Fed’s fundamental policy stance has remained expansive (informally, an easy money posture). In contrast, recent changes in the short-term, fixed-income market indicate the Fed is leaning toward increased monetary stringency (i.e., a tighter posture). In other words, the Fed is signaling it plans to maintain a generally accommodative broad policy; however, it has initiated actions to soak up some of the excess liquidity existing in the short-term market.
One lesson that our years of research has taught us is that the “direction” of movements in Fed policy rates is much more important to security markets than the “level” of rates. Thus, the recent movement in policy rates, which have gone virtually unnoticed by most market pundits, has caught the attention of the EIA model. Our research indicates that even minor Fed policy shifts are ignored at the investor’s peril. Thus, the Fed’s seemingly innocuous policy shift over the prior few months has had substantial ramifications for the IFED portfolio components; the portfolio witnessed significant turnover in the September 2020 rebalance.
The table below illustrates the recent change in Fed policy rates. Note, the EIA model relies on established trends in key policy rates to avoid inadvertently identifying a transitory change in interest rates as a shift in Fed policy.
As shown above, since April 2020, several monetary indicators have established recognizable trends. The federal funds rate, which is one of the Fed’s key policy rates, has moved from 5 basis points in April to 9 basis points in September. To most, this rate change would be considered inconsequential, but remember our key lesson from above, that is, the direction of rate changes is the crucial consideration. We expect this trend in rates to continue and strengthen after the election in November. Our research establishes that the Fed tends to take a pause in its actions prior to an election to avoid being accused of swaying the election. This pattern is particularly prevalent when the policy is leaning toward monetary stringency. However, after an election, Fed policy tends to ramp up, especially when the Fed is planning to apply a more stringent policy. The idea is to get the “bad medicine” out of the way before the next election cycle.
The graph below shows considerable downward movement in the credit spread since April (from about 3.2% to 2.6%) and upward movement in expected inflation (from about 1.5% to 1.9%). Thus, the policy shift identified by the EIA model is confirmed by recognizable trends in key market indicators. The EIA strategy relies on adjusting portfolio composition to position the portfolio to take maximum advantage of the newly established monetary environment. Since Fed policy is viewed by many, including the EIA team, to be forward looking, the EIA strategy is a dynamic, proactive strategy, which contrasts with many strategies that arrive late to the party. The following section provides a summary of the major holdings in the IFED large cap index (IFED-L) and presents justification for those holdings.
What is the new composition of IFED-L?
The tables below illustrate the largest holdings, sector composition and stock characteristics of IFED-L before and after the index rebalance on September 9, 2020.
Why is it optimal?
The proprietary IFED model relies on twelve firm-specific metrics to select stocks that are likely to outperform in the upcoming monetary environment. The model is a stock selection strategy and does not target specific sectors.
Our research shows that the characteristics of firms that outperform in an indeterminate environment are fundamentally different than those that outperform in an expansive or restrictive environment. For example, relative to expansive monetary environments, indeterminate environments have been more favorable for firms considered "out of favor," which is supported by the recent reallocation toward firms with lower price multiples and higher dividend yields. This explains why the current portfolio over weights firms from the financial sector, as firms in this sector currently align with an out-of-favor status.
Overall Market Commentary
In response to the subtle change in monetary policy, the IFED-L portfolio shifted substantially in early September. The largest positions prior to the rebalance were in Apple, Adobe and NVIDIA – technology firms. Post-change, the largest positions are in Citigroup, Goldman Sachs and Wells Fargo. Additionally, our top ten holdings now include General Motors and Dominion Energy. The portfolio went from an overweight in information technology and an underweight in utilities to an overweight in financials and utilities and an underweight in information technology. While the combined influence of the twelve firm-specific metrics drove this rebalance, we believe that fundamental valuation principles are underlying this change. Specifically, throughout most of 2020, the Fed infused immense amounts of liquidity into the financial markets, causing many pundits to claim that “valuations don’t matter.” In the final quarter of 2020, our model signals that the Fed has become less accommodative, and thus, valuations will again matter – that is, “valuations don’t matter – until they do.” Reflective of this is the fact that our portfolio PE and dividend yield have gone from 16.1 and 1.21% to 13.0 and 1.50%, respectively.
The father of value investing, Benjamin Graham is quoted as saying “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” In this election season, we believe that our portfolio is well-positioned to benefit from the move from the voting machine to the weighing machine.