Responding to client requests, Kolanovic and Bram Kaplan analyzed the reaction of the equity market to Fed Chair Powell’s speeches and unexpectedly found that they "resulted in equity market declines this year." Unexpectedly, because this is a material change from the popular "FOMC drift" observed over the past decade, in which stocks levitated before and just after the Fed press conference.
For his analysis, Kolanovic divided speeches into 2 categories: FOMC Press Conferences and Other Speeches. The average performance and hit rate for S&P 500 declines was as follows
- FOMC Press Conferences – average negative return -44bps, 3 out of 3 negative
- Testimonies and Other Speeches – average negative return -40bps, 5 out of 9 negative
And while Kolanovic acknowledges that it is not possible to attribute the market impact of each speech with certainty, "simple math indicates that ~$1.5 trillion of US equity market value was lost this year following these speeches."
So what does the market's reaction to Powell's speech convey?
To answer that question, Kolanovic first gives a simple definition of what is a "market", which he defines as a "wisdom of the crowd" system (likely the most sophisticated one in existence).
It is made up of a broad range of participants with skin in the game, and it incorporates natural selection. Participants who are wrong in their forecast lose assets, i.e. input weight, and those that are correct see their input weight increase.With that in mind, the question is the following: why was the market reaction on Fed speeches negative this year?
To Kolanovic, the most likely answer is that the equity market’s assessment of the economy and various risks is not aligned with that of the Fed, and "specifically, the equity market likely implies that the Fed is underestimating various risks, and hence is increasing the implied probability of the Fed committing a policy error in the future."
And since the higher probability of a policy error translates into lower equity prices on the news, Powell's speeches which hint that the Fed is indeed on the verge of policy error, are increasingly greeted with a market selloff.
Taking this one step further, the next logical question is where does the market disagree with the Fed? To JPM, several places where markets may be diverging from the Fed are the following, paraphrased from recent Fed comments:
- “Equity valuations are at the high end” – this statement may not be accurate as forward looking estimated P/E of the equity market this year averaged 16.4, which is exactly the average P/E over the last 25 years (and slightly above the historical median of 15.8, i.e. at 60th %ile). Trailing P/E multiples, which are significantly higher, are currently less relevant in our view given that earnings re-based on tax reform this year (i.e., the new rather than old tax rate is relevant for future profits). By repeatedly stating that valuations are high, the Fed may be causing equity markets to re-price the risk of a policy error higher.
- “Multiple rate hikes are needed/appropriate” – equity markets see tightening of financial conditions and increased risks in 2018 compared to 2017: the USD is higher, market liquidity is lower, volatility (e.g. VIX) is higher, oil prices are higher, and political risks around trade wars, EM and Europe are all significantly greater. From an equity market perspective, these developments would not warrant higher interest rates. Higher interest rates would likely create further headwinds for consumer, housing, business financing and lending, and leverage of various trading strategies - thus increasing the potential risk of a policy error and a recession.
In other words, the new microstructure of financial markets would be brutal, violent and instantaneous, and not leave enough time for the Fed to react.
With these three considerations in mind, Powell may want to be especially careful what words he picks for his future public statements, because if he stretches the rubber band between what the Fed believes and what the market believes the Fed should believe, the outcome - for markets - could be dire.