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When Janet Yellen took her post as Fed Chair, many assumed she would be a clone of her dovish predecessor Ben Bernanke, occasionally referred to as "Helicopter Ben" for remarking approvingly in 2002 on the concept of a "helicopter drop" of money to fight deflation. For the first year of her service beginning in February 2014, Yellen was exactly what the markets expected and wanted her to be - Bernanke 2.0. However, the markets now appear less certain of how to regard the Yellen Fed. The S&P 500 has entered choppy waters, generating a loss over the course of Yellen's second year. More on that in a minute.
So what's driving this change in the market environment? Valuations? More macro risks? Energy? Geopolitical concerns? Elections? Perhaps a combination, but I think something much more basic is at work. Animal spirits have shifted – from risk seeking to risk aversion. With the Fed out of the market manipulation game, market participants no longer perceive a wave of liquidity propping up prices, which means investors are forced to look at the fundamentals. Unfortunately, the fundamentals that drive stock returns (valuations, profit margins, earnings) don't look so strong right now. While "animal spirits" sounds like a term that might pertain to a cult affiliation, the term was initially coined by renowned economist John Maynard Keynes. He used the phrase in his famous 1936 book The General Theory of Employment, Interest and Money to describe the role of confidence in both positive and negative emotional feedback loops. Keynes states these animal spirits drive market participants to action based on optimism or pessimism, not based on mathematical economic expectations or probabilities. Sound familiar?
Related to monetary policy, one factor fueling animal spirits is excess liquidity (reserves) held by financial institutions. The higher these balances go, the greater the potential for liquidity to flow across the capital markets, acting as a tailwind. The charts below illustrate how closely monetary policy, liquidity and asset prices are linked.
Farewell Bernanke Put, Hello Yellen Covered Call
Ben Bernanke inherited a wonderful gift from Alan Greenspan when he took over as Fed Chair. The Fed's ability to stoke those animal spirits through low interest rates, buying US treasuries (quantitative easing) and a pledge to keep it that way for a long time kept those animal spirits happy. Investors adapted to exceptionally easy monetary policy. What happened next was very simple: asset prices inflated. If the fundamentals ever suggested prices were too high, market participants could look the other way and rest assured that the Fed had placed a put under the market. In other words, through easy Fed policy, investors were long a put option that would kick in and rise in value if markets got out of control and experienced meaningful pain.
The situation is different today. The Fed wants to normalize policy and is starting to get the courage to follow through, even if only slightly. The job market has recovered and consumer balance sheets have largely been repaired. Even inflation and wage growth expectations are starting to show signs of life. But whenever the Fed tries to tighten policy, the markets riot or some macro risk – one that was likely small enough to brush off in an environment of easing monetary policy – causes the Fed to get nervous and back off. However, once the macro risks go away, the Fed has indicated it plans and wants to raise rates. So, good news may not be as sweet going forward and rate hikes might place a ceiling on upside for the markets.
Investors no longer own the Bernanke Put, but the Yellen Covered Call. A covered call is when an investor is long an underlying asset, but writes (sells) call options on that same asset. The call writer (seller) receives some income for doing so, but their upside is capped if the asset rises above the strike price of the option as they are now on the hook to the option buyer. In our current situation, investors are long stocks, but upcoming Fed tightening of monetary policy acts as a sold call option capping further upside. This isn't horrible news, because call writers at least earn a return – just a modest one.
The Fed is clearly looking to the markets (both equity and rate markets) as it makes decisions about interest rates. This doesn't mean fundamentals are ignored, but the markets are in control over the pace of Fed tightening. Hopefully markets won't need to test whether the Bernanke Put retains any potency anytime soon. If it does come to that central banks only have radical options remaining in their arsenals. Lately, concerns over sluggish global growth, high government debt ratios and constrained fiscal budgets have revived the notion among some pundits that central banks should do even more. Perhaps "helicopter money" is what central banks will ultimately have to resort to if negative interest rates don't do the trick.
What Does This Mean for Investors?
Oxford's Current Thinking & Portfolio Implications
The above commentary represent the opinions of the authors as of 3.30.16 and are subject to change at any time due to market or economic conditions or other factors.Print