Zeller Kern’s Investment Monitor

Is the Fed Behind the Curve?

September 26, 2019

By Steve Zeller                           

As we make our way through the final month of the third quarter of 2019, economic conditions are getting a little precarious. The third quarter will be completed at the end of September, and another earnings season will be under way. That being said, it is likely that Q3 earnings could be pretty ugly, in our view. Why? Because the rate of growth for corporate earnings and revenue has been slowing since Q4 of last year, and continue to do so. FedEx came out last week, with a disappointing earnings report, as they reported revenues slipped to $17.1 billion for their fiscal first quarter, while net profit fell to $2.84 a share from $3.10 a share a year earlier. “Our performance continues to be negatively impacted by a weakening global macro environment driven by increasing trade tensions and policy uncertainty,” stated CEO Fred Smith.

Earnings for the S&P 500 for Q2 of this year, slowed down to an approximate year-over-year growth rate of 1.6%. All of the data that our firm follows and tracks, indicates that growth is slowing both domestically and globally, and has been doing so for quite some time. Earnings for the third quarter of last year (Earnings of companies represented by the S&P 500), reached a historical all-time high. With earnings growth continuing to slow into the completion of Q3 of this year, the year-over-year earnings comparisons will likely be a disaster. This does not make for a healthy environment for U.S. stock prices, or the market in general.

Recently, the market had rebounded back up to its all-time highs, but really its relevance is limited if the market corrects itself and erases the gains it had previously achieved. The announcement by Fed Chairman Powell, last week, of a .25% Fed Funds rate cut, was less than what the market was hoping for. So, if macro-economic growth is slowing more than they realize, it may prove that the Fed is behind the curve, once again, and it may put the market into a panic mode in the near future. Another factor that may have a negative impact on stock prices are the waning hopes for a miraculous trade deal with China, which would come to us as a big surprise if that were to happen in October. Thirdly, the question of whether a “Brexit” will happen remains, and still poses to usher in market volatility.

But in the meantime, we continue to track the macro economic data, and the data doesn’t look too encouraging.


The ISM Manufacturing Index continues to decline with its August number coming in at 49.1, further giving indication of continued contraction. Furthermore, if you look at other ISM Indexes, such as Export Orders, shows it is contracting. The Durable Inventory to Sales measurement is rising, which isn’t a good thing. This is reflected especially in the auto sectors as inventories continue to build to record highs. According to a September 5th article on Wolfstreet.com, orders for heavy trucks that haul part of the economy’s goods across the country, plunged by 80.1%, year-over-year, in August. This was the 10th month in a row of year-over-year declines, and the second month in a row of 80%-plus declines, with orders in July having plunged 81.2% to about 9,800. This level has not been seen since 2010.



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Economic trends have been slowing since Q4 of last year. As a result, we have since been favorable towards Federal Treasury Bonds, Utilities, Gold, and REITS, and have been avoiding risky credit, junk bonds, and high beta growth equity asset classes, aswell as Small Cap Equities, for the most part. If you look at the 1-year performance numbers as of the market close on Friday, the Morningstar U.S. Utilities Index is up 19.44%, The REIT Index is up 14.05%, the Morningstar U.S. Government Long Bond Index is up 16.63%, the Morningstar U.S. Government Intermediate Bond Index is up 8.55%, and the SPDR Gold Shares Index (GLD) is up 23.80%. In comparison, the Morningstar Broad Stock Market Index is up 4.46% for 1 year, The Morningstar Small Cap Index is down -5.59%, the Morningstar U.S. Large Cap Growth Index is up 6.30%, the Morningstar U.S. Energy Index is down -15.11%.

The point is, when we enter a cycle in which earnings, revenue, and overall growth are slowing, certain assets do better than others, and it may be advantageous to avoid assets that present a lot of risk under these conditions.

Even though oil spiked up last week due to geopolitical risks, and Treasury yields spiked up the prior week, we expect the price of oil to make its way back down, barring any kind of escalation of conflict, and we expect Treasury yields to trend back down, further appreciating Treasury bonds. If the economic trends continue to slow and Chairman Powell remains behind the curve in reducing short term rates, he may find himself in a situation of having to more aggressively reduce short term rates, and possibly even starting QE back up again.

We are nowhere near being able to predict that a recession will occur, in the months ahead, but the ECRI Weekly Leading Index, is a tool to help determine the likelihood of one happening. The index, as seen below, continues to tread in negative territory, which is a sign of weakening conditions. Even though wage growth has expanded, it might actually be a bad thing, because if they are doing so into weakening earnings, it historically leads to an increase in lay-offs. Rising wages and a declining growth in earnings puts a squeeze on corporations. It also may put a squeeze on Capital Expenditures (CAPEX) and share buy-backs.


The other interesting thing that occurred last week was the failing of the “REPO” market. What happened is the cash available to banks and financial counter parties for their short-term funding needs all but dried up and interest rates in U.S. money markets shot up to as high as 10% for some overnight loans. It was more than four times the Fed Fund’s rate. This resulted in the Fed having to make an emergency injection of more than $125 billion over a two-day period, which is the first emergency intervention they have had to make in more than a decade.

In a repo transaction, the borrower will sell certain securities that they have in their possession, along with an agreement to buy them back the next day. Where it got tricky is that the following day, the borrower repurchasing the collateral from the lender for slightly more than it had previously sold it for, compensating the lender for the risk by paying interest. That interest shot up overnight, and the Fed had to intervene.


The exact cause for the chaos in the Repo market remains open for debate, but the two probable primary reasons are, first, corporations had to withdraw funds from money market accounts to pay for quarterly tax bills. Second, on the same day the banks and investors who bought $78 billion in U.S. Treasury notes and bonds sold by the Fed last week, had to settle their trades. The media has been blaming this seasonal phenomenon (meaning, this commonly happens at this time of the year) for the crisis. But, if that is the case, why did everything lock up and cause the Fed to make an emergency intervention?

One view is that there were already conditions within the system related to primary dealers hoarding treasuries, creating a tightening in liquidity in the system. We are not experts in this area, but of what we have been following, tells us that something is going on that we don’t know about, which causes us to ask, “Why are primary dealers and banks sitting on cash and treasuries, and not wanting to engage?”

Why? We don’t know, but one thing I learned about the bond market and bond traders, over the years, is that they seem to know what is going on, or what is ahead more than the stock market does and stock traders do.

So, these conditions, along with other factors, caused the $2.2 trillion repurchase agreement (Repo) market to lock up.

This could be a one-off occurrence, but it does lead us to mention the ongoing liquidity problem we have globally with U.S. dollars. There are a number of reasons why there is a global liquidity problem for U.S. dollars, but there basically isn’t enough dollars to go around, which can cause capital markets to lock up. These conditions will likely become more frequent in the future. Most assets are denominated in U.S. dollars, including traditional assets, derivatives, etc. If the demand for dollars suddenly increases, illiquidity spikes.

From our viewpoint, there is a lot of risk in the capital markets in the coming months. Perhaps there will be a miraculous trade deal, and stocks will go higher, but we think that is currently unlikely - But anything is possible. Aside from that, a lot of negative trends could prove for turbulent times in the coming months. Markets run in cycles, and there are times that taking on risk is attractive and times where it isn’t.

Market Sentiment

This week the primary focus will be GDP. While this is typically big report expectations are for it to be unchanged from previous estimates. None of the metrics released over the past several months have indicated any reason to believe that the report will deviate from the expectations.

On Thursday there is the Kansas City Federal Manufacturing Index to be released which is expected to show an uptick from the previous report. Also, the pending Home Sales Iindex should come in better-than-expected due to the lower interest rates that have prevailed over the past several months.

This sets the tone for an incredibly dull week with market participants searching from one news story to the next, hoping to find something to play off of. The reality is that there will likely not be much to stimulate the markets.

Typically, after the FOMC meeting, you will see several of the fed presidents working their way around the street doing speeches and talking to media to reemphasize the outcome of the meeting.

The only day this week that someone is not speaking from the Federal Reserve is on Tuesday.  Every other day, multiple speakers will be delivering rhetoric to reaffirm the meeting of last week.

Looking Back on Last Week

Last week had plenty of news to impact it, but the movement was minimal as the irregular pattern continued. S&P 500 was down 0.5% the NASDAQ down 0.7 Dow Jones down 1.0% and the Russell 2000 down 1.2% for the week. Meanwhile, all of the indices are up greater than 15% year to date.

Last week crude oil was in focus after two refineries in Saudi Arabia were attacked on Saturday which was estimated to impact roughly 5% of total global output, but the Saudis were quick to respond the same they would have production back by the end of the month. While this is optimistic, prices did tail off of their peak values on Monday.

On Tuesday, the attention shifted to the fed funds as the repurchase rate jumped for the second consecutive day indicating some liquidity stress among primary dealers.

However, the Fed’s action brought the markets back into control while it is likely they will have continued operations into this week.

FOMC meeting on Wednesday had no surprises as the Fed statement called for a 25 basis point drop in the Fed funds and cut the range on excess reserves lower by 30 points to 1.8%. While the FOMC voted 7 to 3 in favor of the decision some members were voting for 50 basis points while others were fine leaving rates unchanged.

The dot plot suggests that there is not likely to be any more cuts this year and as chairman Powell stated they would be dated dependent going forward.

There was some slight movement in the trade front as the Trump administration granted temporary tariff exemptions for some products imported from China. The decision was made after trade officials from the two countries conducted low-level talks ahead of the next round of negotiations planned for October.

Best Wishes,

Zeller Kern Investment Committee