Investors Need to Focus on the Signal, Don't be Distracted by the Noise

The markets are an incredible aggregator of information.   However, because of a tsunami of information, sometimes investors have difficulty in distinguishing the signal from noise. 

Let us try to help. Here we look at three cases in which it seems many investors may be confusing the noise for the signal. 

First, the Chicago Federal Reserve President Evans, a voting member this year of the FOMC, spoke yesterday.  Evans is often placed on the dovish side of the Fed.  While recognizing signs of strong growth in the US, he urged patience on raising rates.  He warned that the Fed's inflation target might not be reached until 2018.

Evans indicated he was one of the two Fed officials who does not expect the Fed to raise rates this year, according to the last month's dot-plot.   He went further, claiming that it would be a "catastrophe" to raise rates.   

This is not the signal for investors.  The clearest signal came from the FOMC statement and Yellen's press conference.  The signal was not totally obscured by in the minutes that were published yesterday.  That signal is that provided the labor market continues to improve,  a rate hike near the middle of the year remains the most likely scenario, even if price pressures are not closer to the Fed's target.  We note that the last tightening cycle began with the core PCE deflator near current levels.  There was not a formal target at the time, but it is still an instructive example. 

No one at the Federal Reserve, including to two hawkish dissents from the December meeting, favor an immediate hike.  The Fed is showing patience.  It is also showing patience in the sense that it will its balance sheet remains at historic levels.  The Fed argues that the accommodation of its asset purchases, which it never called QE, lies with the stock of holdings, not the incremental flow (purchases).   That it will likely raise rates before it reduces the size of its balance sheet is also a sign of the Fed's patience. 

A second issue that investors risk confusing noise for the signal, is over Greece's membership in the European monetary union.    Some reports had claimed that the German government is prepared to see Greece leave.  Although these reports were denied, many investors suspect there is more than a kernel of truth here.  With the anti-EU party on the rise in Germany, the coalition government cannot afford to make new concessions to Greece.

That is noise.  The signal is that since at least November 2012, Germany and other creditors have held out the possibility of "further measures and assistance" for Greece provided it completed its austerity program, which included achieving a primary budget surplus.  The "measures and assistance" are understood to be lowering the debt servicing costs.  This will take place not through debt forgiveness or a haircut to the public sector creditors, but through lowering the interest rates and extending the maturities on the multilateral and bilateral debt. 

The noise is that officials are weary of Greece, and a Grexit is a likely scenario.  The signal is that the vast majority of Greeks want to stay in EMU, and there is no mechanism in the controlling treaties that allow a country to be ejected. 

A third confusing issue relates to the dollar.  The US earnings seasons kicks-off in earnest next Monday with Aloca.  Many investors are concerned that the rise in the dollar will hurt US corporate earnings.   Indeed, many multinationals will likely attribute some part of whatever disappointments they announce to the exchange rate.  To help separate the signal from the noise, we suggest investors (and the media) adopt former President Reagan's stance to arms negotiations:  Trust but verify.

The dollar's rise did not happen out of the clear blue.  It was not a surprise.  Corporate treasurers were well aware the Fed was tapering and that the ECB and BOJ were engaged in further easing.  Most foreign exchange specialists had forecast a stronger dollar.  A stronger US dollar environment often has weighed heavily on emerging markets.    This is not a surprise.  Moreover, corporate treasurers have numerous financial tools, and the ability to construct natural hedges, to manage their currency risks.  On top of that, they get favorable accounting treatment for properly hedging their currency risks.  

That said, expectation for Q4 earnings have been continuously revised lower since September, when the consensus called for a 9.6% increase.  The most recent surveys suggest earnings growth of around 1.2%.  Macro-economic considerations, like weak demand in Europe and Japan, are a headwind to the US corporate earnings.  It is interesting to note how two companies in the same industry with roughly the same percentage of international sales can report two markedly different currency impacts.  Journalists and equity analysts would do everyone a service by pushing back against assertions about the dollar-impact and question the corporate hedging strategies.