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VOL. 39 | NO. 37 | Friday, September 11, 2015

The end of the Fed’s up-market guarantee program

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A week ago, the European Central Bank committed to do even more of “whatever it takes,” driving European stocks up 2.5 percent. Conversely, after Friday’s strong U.S. job report, Fed tightening fears pushed American stocks down 1.5 percent.

Why has the U.S. Fed suddenly lost the desire to support asset prices?

Because the Fed works for the U.S. economy, not the emerging markets or the stock markets, by damn.

U.S. economy: U.S. GDP grew 3.7 percent in the second quarter after growing a revised 0.6 percent in the first quarter, making the half-year run rate just over 2 percent. However, when isolating Final Sales to Domestic Purchasers, the economy has averaged 4 percent-plus growth over the last 10 quarters.

In isolation, the private U.S. economy, bolstered by rising wages, real estate prices and employment levels, is definitely performing well enough to justify a rate hike.

Emerging markets: The Chinese have acknowledged a “new normal” growth rate within a 5 to 7 percent range as a consequence of their newfound scale and debt limitations. China also has committed to reforming its economy away from heavy industries toward services. China’s falling economic growth rate and their shift away from industrialization has compounded the punishment for commodity export nations.

Many of these nations, like Brazil, banking on continued high demand from China for commodities, expanded social programs and financial commitments. Furthermore, many private debt issuers in emerging markets issued U.S. dollar denominated debt.

At some point in Mr. Market’s mind, the collapse of the commodities super cycle driven by Chinese restraint and U.S. dollar strength will claim a victim like Brazil. Conditions of stress within the emerging markets do not support a rate hike.

Markets: Without QE support, the S&P 500 has fallen 4 percent during the past year as the strong U.S. dollar saps offshore earnings.

Further gains would pressure corporate revenues further, while rising domestic labor costs and interest costs compress profit margins. 10 percent-plus earnings growth estimates for 2016 rely heavily on a rebound in energy and materials earnings.

As a thought experiment, a 15 percent gain from here in the U.S. dollar would certainly anchor commodity prices, swiftly reduce earnings expectations and likely initiate a default cycle in energy.

Conditions of earnings and energy stress imposed by a rising U.S. dollar value do not support a rate hike.

Bottom Line: Markets have begun to accept a significant structural shift in U.S. Fed policy. For nearly a decade, the Fed has worked to support asset markets and boost securities values, ala the ECB. However, the Fed may now see enough strength within the domestic economy to abandon their up-market guarantee program.

Will this change be catastrophic? Probably not, but it is a significant change and therefore requires risk managers around the globe to reassess vulnerabilities which fans anxieties, and limits further gains.

Absent a pro-market policy response from the U.S., China or Europe, global corporations must prove to investors that they can produce earnings growth despite global headwinds.

The dispersion between winners and losers will grow as things de-homogenize. The sea of money pouring into index funds may soon regret foregoing selectivity.

David Waddell is president and CEO of Memphis-based Waddell & Associates.

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