When it comes to markets the Federal Reserve is not just the main game in town, it’s the only game, according to Mazars’ chief economist George Lagarias, who says that investors should not focus too heavily on Donald Trump’s tweets.
As the only central bank with a powerful enough impact to move the global economy, the US Federal Reserve is one of the biggest influences on market direction.
This has been seen during the post-financial crisis environment as lower rates and unprecedented quantitative easing have sent stock markets higher.
More recently, however, the Fed’s independence has been called into question as US president Donald Trump has criticised chair Jay Powell on social media platform Twitter.
While Trump isn’t the first US president to try to influence the Fed, he has been perhaps the most brazen and unapologetic.
Indeed, his attempts prompted the surviving former Fed chairs to write to the Wall Street Journal arguing in defence of the central bank’s independence.
“History, both here [in the US] and abroad, has shown repeatedly, however, that an economy is strongest and functions best when the central bank acts independently of short-term political pressures and relies solely on sound economic principles and data,” noted former Fed chairs Paul Volcker, Alan Greenspan, Ben Bernanke and Janet Yellen.
“Examples abound of political leaders calling for the central bank to implement a monetary policy that provides a short-term boost to the economy around election time. 
“But research has shown that monetary policy based on the political – rather than economic – needs of the moment lead to worse economic performance in the long run, including inflation and slower growth.”
As such, Lagarias (pictured), chief economist at consultancy Mazars, said that investors who fail to heed the lessons of history “will lose their shirts” when it comes to the Fed.
If Trump says, “I want the Fed to lower rates, etc.,” and the Fed says “Well, this is a mid-cycle adjustment. So, don’t expect a full rate hike this year,” you go with the Fed, Lagarias pointed out.
He added that the Fed supersedes even “market sentiment,” the prevailing belief and attitude of investors about anticipated price movements.
“Stanley Druckenmiller, the billionaire hedge fund manager, famously urged investors to ignore any sorts of signals for nine months because it’s all noise,” the economist said. “Only signals lasting more than nine months are meaningful.”
Mazars’ Lagarias said news is amplified – “good news into better news, and bad news into worse news” – because about 80 per cent of the US market is now driven by algorithms, the economist explained.
Moreover, when it comes to the Fed, investors expect too much.
“Traders expect the Fed to cut taxes more than it does. So, their anticipation drives the S&P 500 even higher,” he added. “And then when the Fed unavoidably lets them down, as It did just days ago, they sell off.
“As the Fed announces a future rate cut, the expectation of traders is two or three times that cut. You can never keep up with traders’ expectations.
“If the Fed says zero interest rate cuts, they’re going to demand three, and if it says QE [quantitative easing], they’re going to demand more QE.”
An investment process that would protect from volatility, Lagarias argued, is one based on a “true long-term horizon, which is two to three years.
Investment committees should learn to “stop looking at the next quarter, ignore the next week and the next month,” he said. “If they don’t, they ended up chasing their own tails.”
How an investor decides to “follow the Fed” will very much depend on his or her risk profile, Lagarias said, before making suggestions for three risk profiles: balanced, conservative, and aggressive.
“If I’m an investor with a balanced risk profile,” he said, “what I would do is never go underweight equities right now because the Fed is in loosening mode.”
He cautioned, however, that given the global pressures – e.g., trade wars, slow growth, Brexit – he’d be very careful going overweight equities as well.
“This is not necessarily because equities are going to underperform – in fact, in the US they’re soaring – but look at other places. The EU, for example, where German manufacturers are tanking, or European banks.”
Investors should strive to identify pockets of strength, he said.
“For example, technology continues to be a pocket of strength. In a high-debt world, they have no debt,” he explained.
Lagarias said he was not too worried about equity risk, but rather the global risks playing out.
“These risks include trade wars, China, the EU – which is in a poor shape – and of course, as a UK investor, I worry about the consequences of Brexit, especially on my mid- and small-cap holdings; or the opportunity cost of not investing in stronger currencies.”
The Mazars chief economist added that he’d probably be slightly underweight the UK, slightly overweight the US, more or less equal-weight Japan. He’d be neutral on the EU, where “it’s very difficult to go underweight because the valuations are just too good”.
“I’d be underweight UK, especially for small- and mid-caps, as long as the uncertainty around Brexit continues,” he said.
This uncertainty can be seen in the below chart, which shows UK equity underperformance compared with the developed markets-focused, market cap-weighted MSCI World index.
FTSE All Share vs MSCI World since the Brexit referendum
Source: FE Analytics
The increased geopolitical risk now facing markets means that Lagarias is reviewing risk levels across portfolios.
“If I’m a conservative investor, I will probably upgrade my risk level. In other words, to a risk I’d assign a 50 per cent probability as a balanced-risk investor, I’d now give a 60 or 70 per cent chance of happening,” he said, adding that he’d adjust his model accordingly.
“This does not mean buying bonds, as some might think, because bonds are now much too expensive,” he said.
He said, a high yield that used to get 8, 9, or even 10 per cent, now gives about 4.5 or 5 per cent, adding that bonds are just too expensive right now.
“So, I’d steer clear of bonds, nor would I go too aggressive on equities. Rather, I’d find defensive equities, good quality companies. I’d also make sure I have buffers with cash and various alternatives like gold.
“And, finally, if I’m an aggressive investor, I will do the exact opposite exercise. I’ll say, ‘I don’t care about the economy tanking; it’s all about the Fed.’ I will downgrade my risk level.”
Having reviewed these various scenarios, the economist said he personally believed in being a balanced-risk investor, noting: “I have been more conservative in the past, but like everybody else, I’ve learned not to fight the Fed.”
However, despite placing the Fed at the centre of the investment universe, Lagarias said, that it is not the only factor when making allocation decisions.
“I do not buy into the theory that the Fed is the panacea for everything,” he concluded. “I do believe in a modicum of economic and financial fundamentals.”