Last Thursday afternoon, while many of us were getting focused on the three day weekend ahead, the Federal Reserve was dutifully issuing its H.4.1 statistical release. As we have seen from the past few releases, the Fed’s balance sheet has stopped growing, and in fact, has been shrinking slightly. Please consider the chart below:

(Click on image to enlarge)

Source: Bloomberg

This strikes me as the greatest contradiction in the current market narrative. One of the most common themes that we hear from a wide range of financial experts is that the Fed is actively pumping money into the financial system. That was certainly true from March through May as the Federal Reserve’s balance sheet exploded by about 70%.To put matters into perspective, note the rise in the September – November period. Equity markets reacted well to the 10%+ balance sheet increase that occurred as the Fed responded to a crisis in the repo market. They rebounded from the sideways movement that we saw as the Fed slowly reduced its balance sheet throughout last summer. 

I find it hard to believe that equity markets can sustain a meaningful advance without further stimulus from the Federal Reserve or Congress. The economic picture is fuzzy, at best, yet major indices are either flirting with or breaking through their previous high watermarks.Price/earnings and similar valuation measures are well beyond their pre-COVID levels as both reported and estimated earnings shrank in response to the crisis. One can justify these higher valuations as a reasonable response to the unprecedented liquidity injections that went to fixed income markets and directly to millions of taxpayers. The questions for investors are how much stimulus is required to keep propelling markets higher, and can they sustain these valuations if those injections fail to meet current expectations.

The month of July should prove to be a month of tests for equity investors. Among them are:

• Taxes are due on July 15th. Taxpayers who expect a refund tend to file early; those who expect to owe file late. Markets rose in 2019, meaning that there are likely to be investors with capital and trading gains upon which taxes are owed. One would have to expect that at least some of those successful investors would need to liquidate some of their investments to pay taxes. Normally this occurs on April 15th, and tax-related outflows are somewhat offset by IRA investors racing to beat that same deadline.  This time, we will not see a similar offset. There are some who believe that the tax deadline is a catalyst for the “sell in May” behavior that we see in many years. We will need to assess how this year’s unusual tax timing affects investors.
• Earnings season begins in mid-July. Pepsi (PEP) and JP Morgan (JPM) have been amongst the stocks that kick off a few crucial weeks of major company earnings releases. All the FAANG names and most other market capitalization leaders will be reporting earnings before the end of July. It is hard to recall an earnings season in which there was less corporate guidance and less clarity about future economic conditions. Much will hinge upon the tone that managements set in their conference calls – specifically, will they offer sufficient rationale to justify current stock prices?
• There is a fiscal cliff at the end of the month. The $600 supplemental unemployment benefits expire at the end of July. The prospects for its extension and for another round of individual stimulus checks is murky, as the House and Senate have differing views about the necessity and types of stimulus that they view necessary. While there appears to be a broad consensus that some form of fiscal stimulus would be desirable, electoral politics could make this a difficult negotiation. Some degree of fiscal support seems baked into stock values, and it also appears that the Fed is reticent to act without knowing what Congress has in store. A period of extended bickering could have broad ramifications for consumer behavior and equity market dynamics.
• As COVID-19 cases continue to accelerate, will they create a dampening effect on the economic rebound that we have begun to experience, either by reopening rollbacks or as individuals return to risk-averse tendencies?

Returning to the present, one needs to consider whether their Federal Reserve’s actions are more rhetorical than active. Their balance sheet clearly indicates that they are holding steady rather than continuing to provide stimulus, at least for the short-term. Remember also that the Fed has never directly intervened in equity markets and has no mandate to even consider equity markets unless they threaten the stability of the banking system or the economy at large. While I am certainly of the opinion that the “Fed Put” (the level of distress that would cause the Fed to resume intervention in the credit markets) remains firmly in place, investors need to question the “strike price” of that implied put. I suspect that the strike is no higher than the 2800 level on the S&P 500, and I also suspect that is further out of the money than many investors would expect. 

As of now, investors remain sanguine and path of least resistance in the equity markets remains higher – at least in the short-term and especially in the leading Nasdaq 100 (NDX) names. The coming weeks should test the markets and are likely to determine whether investors are properly assessing economic and corporate conditions and the risks to their outlook. The savvy ones will be taking a hard look at their portfolios and assess how the likely outcomes to each of the markets’ challenges will affect their potential risks and returns.

For further reference:

Federal Reserve Release H.4.1

The Federal Reserve is Still Not as Accommodating as Many Think

The Fed Is No Longer As Accommodating As Many Think