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Wednesday, October 3, 2018

Readers of my weekly participation in this blog may realize that I do not believe “slack” causes inflation. That is because, in the words of Nobel Prize winner Milton Friedman, inflation “always and everywhere a monetary phenomenon.” An unemployment rate below the “natural rate” won’t cause inflation; only a monetary mistake will. The Federal Reserve’s economists are always looking for the Phillips Curve, an artifact of the fixed-exchange rate monetary policy era which ended over 40 years ago. Importantly, the Wall Street Journal noted in August that Fed Governor Jerome Powell has enlisted the support of Johns Hopkins economist (and former Fed advisor), Jon Faust. In 2016, he wrote, “At last summer’s Jackson Hole conference, Jon Faust and Eric Leeper reviewed how well the best thinkers and policymakers have historically done in assessing these factors (u* and r*). The record shows essentially no relation between inflation outcomes and inflation forecasts based on real-time assessments of labor market tightness.” This refreshing line of thinking was repeated in 2017: “Taking as given that Phillips curve reasoning is correct at some level, we have from the inception of this blog pointed to overwhelming evidence that the jobs-inflation link gives rise to only weak forces, forces that can be swamped for years at a time by myriad other factors.” As the WSJ article noted, Dr. Faust posited in 2017, “We ask this. Where is the episode in which inflation jumped from persistently too low to painfully out of control without allowing ample time for a sensible, moderate, and adequate policy response?” I believe Dr. Faust, an important advisor to Powell, is keeping things on the right track.

Tuesday, October 2, 2018
Reported fourth quarter earnings growth for S&P 500 companies is 6% year-over-year with 60% of companies reporting.

Investors received some relief from trade worries yesterday after the announcement that Canada has signed on to a new NAFTA trade pact (USMCA – United States-Mexico-Canada Agreement). This will help businesses grappling with ways to modify their operations and supply chains to respond to proposed tariffs. U.S. dairy farmers and domestic auto makers are some of the biggest winners in this deal. Canada agreed to drop its quota system which limits imports of some U.S. dairy products. What’s more, cars with 75% of their components manufactured in North America can escape tariffs. Steel and aluminum tariffs will remain in place for now. The U.S. agreed to a trade deal with South Korea last week and is now turning its attention to Europe and Japan. All of these deals will work to block China and its growing dominance as a global supplier. But the China negotiations are far more complex as they deal with core trade practices involving technology transfer and government subsidized protectionism so the trade angst is not over yet. Investors seem relieved but are still generally cautious. Still, the fourth quarter is usually the best quarter of the year. Earnings season is on tap and its forecasts are for 19% year-over-year growth in profits. Keep your eye on fundamentals.

Please follow market earnings and sales metrics on page 8 of the Global Perspectives Book.

Friday, September 28, 2018
Returns for a globally diversified strategy over the last 10 years refute the notion of a “lost decade”.

Have you noticed that many of the headlines are about pensions? Last week, the Federal Reserve announced a change to the accounting of pension funded programs for states and municipalities. They use a projected obligation method rather than an accumulated benefit approach and lo and behold the unfunded liabilities ballooned by a whopping $2.3 trillion. In the past few months, the Wall Street Journal (WSJ) has reported that the pension crisis is coming home to roost in state and local budgets. Quite simply, benefits are too generous and lifespans are too long to keep the promises made to state and local workers. Inevitably, benefits will have to be cut or taxes will have to be raised. One WSJ article reported that some big pension funds are lowering their implied rate of return to 7.0%. This makes the already grim situation worse but more realistic. Double digit market returns like the 22% market return last year lull investors into thinking double digit returns are the norm. Investors then run the risk of becoming greedy. However, 6.0%-8.0% is potentially a more reasonable long term equity market rate of return. What’s more , bond returns in a low interest rate world are even lower. Investors trying to time the market will often miss the above average years as they chase returns. Do not count your chickens before they are hatched and stay diversified. Do not put all your eggs in one basket to help build wealth with lower risk.

Please see an example of an effectively diversified portfolio on page 4 of the Global Perspectives Book.

Thursday, September 27, 2018
U.S. consumer confidence hit a five-year high but is still off pre-crisis levels.

There were no real curve balls yesterday when the Federal Reserve raised interest rates as expected. This signaled strong support for an additional hike in December, an affirmation of the robust economy. The most significant development was the elimination of the word “accommodative” in the Fed’s comments regarding its current position on rates. Initially, investors perceived this as dovish, interpreting it as an indication of a possible Fed rain delay in the hiking cycle. This interpretation was downplayed, however, during Fed Chair Jerome Powell’s slightly hawkish Q&A.
Today investors are digesting a myriad of data points as the month, quarter and most importantly, regular major league baseball season winds down.

Here’s a wrap up:

  • The second quarter GDP 4.2% revision — Consumer spending, exports and business investment were standout contributors. Business investment, the key to productivity and higher trend GDP, revised up to an 8.7% annual increase. Triple.
  • Durable goods jumped 4.5% in August but this notoriously volatile report was up mostly due to a rebound in transportation orders. Single.
  • Initial jobless claims were up 12,000 last week but lower than expected and still at the lowest levels seen since the 1960’s. Single.
  • Pending home sales declined for the fourth month out of the last five. Home buyers are balking because prices have been surging and inventories are lacking. Strike.
  • Consumer sentiment soared to its highest level in 18 years and close to an all-time high as consumers are especially pleased with the availability of jobs in the labor market. Home Run.

Important manufacturing and payroll reports are on deck for next week. Overall, the economy is racking up runs batted in while some investors are waiting in line for popcorn and missing the action.

Please follow consumer confidence on page 58 of the Global Perspectives Book.

Wednesday, September 26, 2018

The latest salvo in the global trade war saw Chinese tariffs taking hold on $60 billion of U.S. exports, which followed the imposition of U.S. tariffs on $200 billion of Chinese exports.

Probably the most important new developments are Secretary of State Pompeo saying, “[W]e are going to get an outcome which forces China to behave in a way that if you want to be a power…you don’t steal intellectual property,” and a Chinese white paper asserting, “The door for trade talks is always open but negotiations must be held in an environment of mutual respect…and not under the threat of tariffs.” Not much wiggle room from either side, though for now both countries have imposed lower levies than originally threatened, i.e., the United States 10% vs. 25% and China 5‒10% vs. 25%. China clearly is still a strong story: consider that exports have picked up pace, after having doubled in almost 10 years and quadrupled over 15 years.

It is important to understand that China has been forthcoming during this dispute. According to a June 2018 International Monetary Fund report, “the Chinese authorities said they would respond to the U.S. tariffs with comprehensive measures, but they also announced new opening-up plans. These include lowering entry barriers on financial services and autos, reducing import tariffs for a wide range of consumer goods and autos, loosening sectoral restrictions on foreign investment through a shortened negative list, and seeking faster progress toward joining the WTO Government Procurement Agreement. The direct macroeconomic impact of tariffs announced to date appears limited, but could be amplified significantly through financial and investment channels, and further rounds of retaliation, raising downside risks.” It will be an interesting few months.

Tuesday, September 25, 2018
The Fed funds target rate and Treasury yields remain historically low, even though the Fed increased the target rate in December 2016.

The Federal Reserve meets tomorrow and forecasts for a rate increase are close to 100% certain. The market will be looking at the commentary and language of Fed Chair Jerome Powell for clues as to the Fed’s future actions. The word “accommodative” is important because it implies that the Fed funds rate is still below the “neutral rate,” i.e., the rate consistent with full employment, trend growth and stable prices. An economy in this state presumably doesn’t need to be either stimulated or slowed by monetary policy. As of now, Fed rates are still accommodative. If Powell discusses tariffs, trade tensions or emerging markets it could be perceived as dovish – the Fed is willing to stay accommodative longer. If Powell focuses on the labor market and inflation, investors may deem his comments hawkish and more willing to raise rates. The strength of the economy has also increased the likelihood of a December rate hike, with odds currently at 75%. The picture becomes less clear moving into 2019, but consensus is currently for two more hikes next year. While the Fed has expressed willingness to remain neutral for a time, it also wants to make sure it has some ammunition ready for the next economic downturn.

Please follow the Fed funds rate on page 34 of the Global Perspectives book.

Friday, September 21, 2018
Two scenarios of Returns

Investors have been able to set aside the trade tensions and markets have climbed to historic highs. Those investors sitting on the sidelines may be kicking themselves and thinking they missed the rally. Markets care more about profits than politics and based on earnings growth projections for Q3 (19%), Q4 (17%) and 2019 (10%) the market has room to run. The continued strength of the economic outlook has been mistakenly downplayed. If you are in the market, regular rebalancing to lock in gains by selling your high flyers and buying your now cheaper holdings is always a good idea. If you are close to retirement, you may like what you see on your 401K statement but should always plan for market downturns by being globally diversified and remember that significant downturns in the early years of your retirement can derail your withdrawal strategy, which may extend more than 30 years. That’s where a good advisor can help you devise a plan. Your withdrawals won’t just be affected by market returns. Inflation, interest rates, taxes and liquidity needs will all play into your strategy. Please see page 91 of the Global Perspectives book for an example of two retirement portfolio withdrawal scenarios with markedly different terminal values based on a market downturn in the early years.

Thursday, September 20, 2018

Today’s initial jobless claims of 201,000 takes us back to the sixties to find a number so groovy. In addition, the latest economic data points indicate a robust economy that is totally right on. A rebound in the regional Philly Fed index to 22.9 in August was higher than consensus. Existing home sales held steady at 5.34 million annual rate with a welcome bump up in lean inventories. Leading indicators came in at .4, supporting forecasts of a 3% + economy for the first time since 2005. In addition, the moderation of the U.S. dollar is helping to alleviate some of the emerging market angst and long-term yields are moving up for the right reason – growth. Investors are digging it and the market is at all-time highs. However, markets rarely move in a straight line. The trade tariffs, U.S. debt and deficits, emerging market debt, and mid-term elections are just a few of the potential threats to the current vibe. Diversification across asset classes including bonds and a proactive plan to deal with market and economic cycles is always cool. Please read the Global Perspectives Mid-Year outlook for an in-depth look at what is driving markets.

Wednesday, September 19, 2018
Core and headline inflation remain subdued with the Fed’s preferred measure of inflation, Core PCE, remaining slightly below target.

August was a good month on the U.S. inflation front. While I do not like to write an “elevator report,” in this case most cars are heading to lower floors. In a flurry last week, the full run of price measures was down on a year-over-year (YoY) basis. The “headline” Consumer Price Index for All Urban Consumers (CPI) rose 2.7% YoY in August, compared to 2.9% in July. Core CPI, which excludes food and energy prices, rose 2.2% YoY in August, down from 2.4% in July. If you are more goods oriented, the headline Producer Price Index (PPI) rose 2.8% YoY for August, compared to 3.3% in July. Core PPI — excluding food, energy and trade — in August rose 2.9% YoY, slightly up from 2.8% in July. Export prices were up 3.6% Yoy in August, down by 0.7% from July. Import prices — bolstered by a 5% rise in the U.S. dollar in six months — fell to 3.7% in August, down by 1.2% from July.

There was one modest uptick within all the inflation data: real average hourly earnings rose 2.9% YoY in August, compared to 2.7% in July. That is a long way from the January 2015 peak of 2.4%, but a pleasant surprise. Expect to see more wage increases as the labor market tightens. If the Phillips curve is a labor market output rather than an inflation rate input, then the entire concept of slack or NAIRU (the non-accelerating-inflation rate of unemployment) will not hold. A rise in productivity is required to move real wages higher.

This aligns with economic theory, which holds that employee compensation is not a cost-push phenomenon. As a general consideration, it is a truism that slack — especially the unemployment rate — does not drive inflation; inflation is “always and everywhere a monetary phenomenon,” to quote Milton Friedman. Unemployment below the “natural rate” does not cause causes inflation; rather, there will be inflation if and only if there has been a monetary policy mistake. With the Federal Reserve tightening policy, it is possible that inflation will remain in its current trend for longer than market participants, and possibly the Fed, expect.

Please check out page 60 of the Global Perspectives book for more on inflation - consumer price index.
 

Tuesday, September 18, 2018
Over 90% of the world’s consumers reside outside the U.S., making global trade imperative for growth. The global growth slowdown corresponds with an overall slowdown in trade..

Another round of trade tariffs on $200 billion of Chinese imports has been announced and will take effect on 9/24. The planned 10% tariff is less than the 25% initially proposed but it will move up to 25% by the end of the year. Retaliatory measures by China are expected. The Chinese trade issue has been hanging over the market for quite some time and the market has become adept at shrugging it off. While some industries and companies are feeling the impact, the overall implications to the global economy have been minimal. Bilateral trade between the U.S. and China accounts for a mere 2.5% of total global exports. In addition, the strength of the dollar versus the Chinese Yuan has helped buffer the additional cost of Chinese imports to the consumer. The uncertainty is certainly a negative for businesses and planning. But the robust U.S. economy and record high corporate earnings continue to provide markets with the gas to move higher. Please follow global imports and exports on page 47 of the Global Perspectives Book

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