Confident that another stellar year for U.S. stocks was coming to a close, investors were jolted from their complacency when the Federal Reserve delivered an unexpected and rather unpleasant reminder at last week’s FOMC meeting that the fight to rein in inflation remains far from finished. Indeed, the proverbial “last mile” to get inflation back to the Fed’s 2% target has most certainly stalled. Sticky (or dare I say “persistent”) services inflation seems to be the major culprit in many developed market economies. For example, services inflation for November in the U.K. came in at a sizzling 5.0%/annum (ONS release here), not far off U.S. services CPI for November of 4.6%/annum (BLS release here).
Here’s my take on recent central bank decisions and the challenges they face:
The Fed: The first thing I’m not sure I understand is why the Federal Reserve reduced the Fed Funds rate at all last week, unless Jay Powell & co sense the seemingly “on-fire” U.S. economy is under more stress than economic data currently suggests. Although the Fed delivered as expected in terms of a policy rate reduction, risk markets completely fell apart mid-week because the dot plot in the Fed’s revised Economic Projections (here) show only two reductions in the Fed Funds rate next year. I completely agree with the Fed’s deliberate approach as far as cautious monetary policy easing in 2025 until inflation is more convincingly heading towards its target. A dose of reality for investors is a good thing every now and then to wash out excesses that have been building in risk markets, even if the downturn proves only to be temporary.
The ECB: The Eurozone has one thing going for it that the U.S. and U.K. do not – inflation appears to be back at target. However, unlike the U.S., the Eurozone economy is experiencing weak economic growth and is also facing political stress in its two largest economies. This backdrop has driven the ECB to pursue its “unofficial” objective of trying to stoke growth by continuing to ease monetary policy, which is exactly what Ms Lagarde said following the ECB meeting week before last.
The Bank of England: The BoE is perhaps in the most troubled of central banks. Unlike the ECB, the BoE must deal with a slowing U.K. economy and stubbornly high (services) inflation, bringing that dreadful term “stagflation” back to the forefront. The Bank of England kept its policy rates on hold last week, a logical decision given its sole mandate to contain inflation. However, this does little to inspire the sideways-trending UK economy, with growth further damaged by Labour’s tax increases that will serve as a fiscal drag.
The Bank of Japan: The BoJ, not surprisingly, did nothing at its Monetary Policy meeting last week (BoJ Statement on Monetary Policy is here). Inflation in Japan is not bad compared to other G7 economies, although certainly historically high when looking back 30 years or so. But the legacy of decades of an economy teetering on the edge of deflation makes each and every monetary tightening decision a tough one for the Japanese central bank. The BoJ seems more concerned about economic growth.
Investors were rattled by the FOMC decision and lingering concerns about sticky inflation.
And about that government shutdown….
Here we go again. Towards the end of the week, the “slam-dunk” stop-gap budget that was expected to sail through Congress with bipartisan support was derailed by President-elect Trump, who insisted his party not pass the budget until some revisions were made, including raising or eliminating the debt ceiling for two or more years. Congressional Republicans largely fell in line initially, creating 24 hours or so of uncertainty around a potential government shutdown. Fortunately, a budget was eventually passed without some of the provisions that Mr Trump had requested, including lifting the debt ceiling. What did we learn from this? Certainly one thing is clear to me now – the more fiscally conservative and cost-conscience rump of the Republican party will not bow to every whim of Mr Trump or his muppet Elon Musk. That’s a good thing for America’s fiscal health. The U.S. certainly needs to get its fiscal house in order before it is too late, and the requisite steps to reduce the deficit are actually rather simple – increase taxes and / or reduce expenses.
I have written extensively about the budget in the past (for example, “US deficits / debts soar; should you care?”). Mr Trump has sold his soul on cutting taxes for nearly everyone, which is out-of-line with reducing the deficit. Reducing expenses, the role of the new DOGE, is admirable and hopefully achievable. However, readers should understand that the discretionary portion of the budget is rather miniscule. If you set aside entitlement programs like social security and Medicare, factor in the current debt service cost of the massive U.S. debt, and assume that reductions in defence spend might be difficult in the troubled global environment, it leaves a rather small amount of the budget that can be “adjusted”. With Republicans in charge of the Executive Branch but only narrowly in charge of the Legislative (i.e. Congress) Branch, the constant hateful, spiteful and destructive rhetoric across – and within – both parties will likely mean that decision-making will continue to be fractious and difficult. As much as politicians and investors talk about taking steps to reduce the budget, I suspect that annual deficits and U.S. debt will continue to increase.
I suppose the only hope for Americans who are genuinely concerned about saddling their children and future generations with debt is that investors begin to punish the U.S. through rejection of the U.S. Dollar and U.S. Treasuries, since the country’s government so far seems incapable of addressing the spiralling debt. Having said this, there is no viable alternative at the moment to the greenback or the US Treasury market. Strap yourself in because the next couple of years will be rocky, and don’t bet too much on a “three-peat” that U.S. stocks will deliver another 20%+ year of gains.
MARKETS LAST WEEK
A highly volatile week in markets ended on a positive tone, with a good session on Friday pulling stocks and bonds off their mid-week lows. The sell-off in stocks which was occurring all week accelerated following the FOMC decision. US Treasury yields also rose sharply across the curve, with the short end screaming “higher for longer” and the intermediate and long end signalling the potential inflationary policies of the incoming Trump administration. The actions by central banks and the sell-off in US Treasuries caused the US Dollar to rise to a 20-month high vis-à-vis the Euro, and a six-month high vis-à-vis the Yen.
The tables below show the updated performance of the various indices and asset classes tracked by EMC.
MY TRADES LAST WEEK
All of my short-dated covered calls (GOOG, AMZN, MSFT, LULU, BRK.B, NVDA, CRWD) were bought back at pennies or expired worthless on Friday, some solace perhaps to the hammering I took on my long positions on Thursday. I added a scrap to a defence company name I like, LDOS (Leidos), since it has been bouncing around and is back down to the level where I initially invested. I also added to NVO (Novo Nordisk) at its lows on Friday morning, after the stock got absolutely hammered due to less-than-spectacular results of one of the company’s anti-obesity drugs. I also took the opportunity on Friday to unload one of the out-of-the-money late-March calls I own on LLY, which popped on the misfortune of its peer NVO. Overall, I remain well long equities with “insurance” in the form of a series of SPY puts in case investors come to their senses in the new year, which perhaps is starting to happen.
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