Federal Reserve Monetary Policy Review: September, 2021
The Federal Reserve Signals an Indecisive Posture
Economic Index Associates (EIA) relies on the IFED model, which is a proprietary approach, to classify monetary conditions into one of three environments: restrictive, indeterminate or expansive. This classification is based on changes in Federal Reserve policy rates. Over 30 years of our 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 August 2021, the IFED model identified a shift in Fed monetary policy from expansive to indeterminate. The indeterminant environment is based on conflicting signals contained in Fed policy rates. Specifically, 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 has begun 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 preliminary actions to soak up some of the excess liquidity existing in the short-term market. The indeterminate nature of the Fed’s posture is supported by recent changes in the weekly federal funds rate as illustrated in the figure below.
Note, the Fed typically moves policy rates with conviction after signaling a policy shift. Thus, one would have expected the federal funds rate to continue its upward projection after the rate increase in early June. Instead, the rate remained fixed at 0.10% throughout most of June and July before vacillating in August. The lack of a directional trend in short-term policy rates reflects the Fed’s indecisive posture and supports the IFED classification of the monetary environment as indeterminate.
The Fed’s indeterminate posture suggests the Fed is in a holding pattern with monetary policy until more clarity is established regarding government spending, Covid variants and foreign policy. EIA believes that maintaining a value-based portfolio in such an environment is appropriate. The Fed has typically been more prone to tighten policy early in a presidential term to get the “bad medicine” out of the way prior to the next election, thus, we expect the Fed to begin tightening in earnest once more certainty is established regarding the issues noted previously. However, we expect the tighter policy to be delayed well into next year due to lingering concerns about the economy, the budget reconciliation process and Covid.
The EIA strategy relies on adjusting portfolio composition to take maximum advantage of the newly established monetary environment. Fed policy is viewed by astute market researchers, including the EIA team, to be forward looking, hence, the EIA strategy is a dynamic, proactive strategy, which contrasts with many strategies that are backward looking. The following section provides a summary of the major holdings in the IFED Large-Cap US Equity Index (IFED-L) and presents justification for those holdings.
What is the new composition of IFED-L? Why is it optimal?
The tables below identify IFED-L’s largest holdings, its sector composition and several value-based metrics before and after the index rebalance on September 10, 2021.
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 from those that outperform in an expansive or restrictive environment. Since the IFED model identified a shift from an expansive to an indeterminate environment, the portfolio composition shifted accordingly. The portfolio composition shifted to firms with higher dividend yields, more attractive valuations and lower operational slack. These metrics align with the high allocation to financial firms as financials currently have relatively strong payouts and attractive valuations.
Overall Market Commentary
The IFED-L portfolio composition shifted substantially on September 10th. After the rebalance, the portfolio is comprised of 70 stocks. The largest holdings prior to the rebalance were Snap, and Lowes, whereas post-rebalance, the largest positions are in General Motors and Berkshire Hathaway. Additionally, five of the top twelve holdings in the new portfolio are financial firms and none of the top twelve are in the information technology sector.
In addition to separately managed accounts that track the IFED-L, the index is tracked by two Exchange Traded Notes (ETNs) listed on the New York Stock Exchange:
ETRACS IFED Invest with the Fed TR Index ETN (Ticker: IFED)
ETRACS 2x Leveraged IFED Invest with the Fed TR Index ETN (Ticker: FEDL)
With the rebalance, we believe the portfolio is positioned to capitalize on the uncertainty reflected by an indeterminate monetary environment as the holdings are concentrated in mature firms that offer financial stability. The new portfolio is composed of firms with more conservative valuations, as price/sales and price/book are lower while the dividend yield is higher as compared to the previous portfolio. In addition, market risk, as measured by beta, has also declined substantially. Finally, the new portfolio is composed, on average, of much larger firms, reflecting the fact that smaller firms have historically outperformed larger firms in expansive monetary policy periods, but not in indeterminate periods.
The proprietary IFED model applies a unique combination of top down and bottom-up analysis, as monetary policy determines the investment environment and stocks are selected with characteristics that best align with that environment. While sectors are not targeted in the model, stocks in certain sectors have common financial characteristics that are conducive to outperformance in each environment. As Fed policy became less accommodative, the September rebalance produced a larger allocation to utilities, energy and financials, whereas smaller weights are now allocated to consumer discretionary, materials and communication services.
In summary, the IFED-L has a large active share (the percentage of stock holdings that differ from the S&P 500) because our methodology selects and weights component stocks by their IFED score. As the rolling alpha and cumulative returns of the IFED-L (shown in the charts below) attest, this bodes well for long-term investors seeking to compound their returns over many years. We are often asked why the most popular (glamour) stocks (e.g., FAANGM) are generally omitted from the IFED-L. To this our response remains, our strategy is a long-term, rules-based approach that targets companies that are attractively valued for the prevailing monetary/ economic environment. Glamour stocks are typically priced for perfection without regard to the current environment. In general, the IFED strategy is designed to outperform over time based on capturing underlying market patterns that our research confirms are systematically integrated into long-term security returns.