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Wednesday, October 17, 2018

Special Guest Blogger: Tim Kearney, PhD

It looks like Federal Reserve Governor Jay Powell committed a basic communication error that threw a shock into U.S. financial markets. At the Jackson Hole Symposium Powell seemed to downplay the ability of the Fed to discern in real time the “neutral” Fed funds rate (r*), i.e., the level of interest rates which neither inhibits growth nor stimulates inflation. He called for a risk management approach to monetary policy, rather than a rules-based approach; but his subsequent statement noted that the Fed could hike up to 50 basis points (bp) over neutral. While the comment raised uncertainty about his belief in neutral, his comment holds some hope as to intent: the Fed might go 50 bp above the current estimate of neutral, or it might be raising its estimate of the appropriate neutral rate. That is, higher growth might prompt a higher neutral rate than is necessary at present, suggesting that the Fed may remain accommodative for some time. It is a sentiment that I think the equity market would relish — once digested.

Since Jackson Hole, there has been pushback against the view that we cannot measure the neutral rate in real time, and neutral remains a useful concept. President Williams of the NY Fed and President Evans of the Chicago Fed both made comments implying that the Fed will not cut short its hiking cycle. Williams emphasized the existence of a neutral rate in the Wall Street Journal, noting “…our path today is getting us back to normal interest rates or neutral interest rates relatively quickly, over the next year or so.” Evans was rather hawkish, telling Reuters the Federal Open Market Committee “…could move to a slightly restrictive policy stance and, you know, probably pause at that point and see how things are going…” citing a target range above three percent. My view is that higher growth will lead to higher nominal rates, but the growth will come first. That sequencing is to the benefit of growth and risk assets over time.

Don't forget to register for the GP Quarterly Market Outlook Webinar!

Tuesday, October 16, 2018

On October 4, 2018, coincidentally or not, there were two stories describing China’s provocative policies toward the United States and the world. These were not sensational stories. One was from the Vice President of the United States given at the Hudson Institute and the other was the front cover and feature story of Bloomberg’s Businessweek Both of these read more like a highly confidential U.S. intelligence brief than something for public consumption. I highly recommend taking time to read both of them carefully. The news that keeps coming under the title “trade war” in the popular press and media has nothing to do with trade at all. I offer no opinion on this except to say that China is a very important part of the global supply chain and any disruption in this would have adverse consequences to global markets.

The Big Hack: How China Used a Tiny Chip to Infiltrate U.S. Companies” - Bloomberg Businessweek 10/4/2018

The attack by Chinese spies reached almost 30 U.S. companies, including Amazon and Apple, by compromising America’s technology supply chain, according to extensive interviews with government and corporate sources.

"Remarks by Vice President Pence on the Administration’s Policy Toward China" - The Hudson Institute 10/4/2018

Beijing now requires many American businesses to hand over their trade secrets as the cost of doing business in China. It also coordinates and sponsors the acquisition of American firms to gain ownership of their creations. Worst of all, Chinese security agencies have masterminded the wholesale theft of American technology –- including cutting-edge military blueprints. And using that stolen technology, the Chinese Communist Party is turning plowshares into swords on a massive scale.

Please see the Global Perspectives Quarterly Market Outlook and don't forget to register for the GP Quarterly Market Outlook Webinar!

Thursday, October 11, 2018
U.S. Financial Conditions Index

The markets got walloped Wednesday on a Fed that has been raising interest rates at the fastest pace in over a decade, and with expectations for more to come. In fact, the Federal Reserve has raised rates seven times since President Trump was elected. The Fed seems well within their mandate since unemployment is at a 49-year low, economic growth has jumped to 4.2%, corporate earnings are at all-time highs, and financial conditions are relatively easy (see chart). The Fed is arguably trying to keep in-line with an economy that is booming and to tamp down on excesses before they get too extreme. Yesterday’s “tech wreck” is a sure signal that things were trending toward extremes, and if anything the Fed likely will be proven correct with its “shot across the bow”.

The difficult aspect for investors is that their returns, which were not stellar year to date, just took another hit. Through the third quarter, performance of a diversified portfolio of stocks and bonds was up a dreary 1.7%. However, thus far in the fourth quarter through today:

  • S&P 500 large cap stock performance is -4.5%
  • S&P 600 small cap stock performance is -7%
  • Emerging Market equity performance is -8%
  • U.S. corporate bonds performance -1.5%
  • U.S. treasury 20 year + long bond performance is -2.75%

Wait a minute. Investors are so concerned about rising rates and their impact on bonds, but even long U.S. Treasury bonds are a hedge compared to equity performance. Yes: building a globally diversified portfolio of stocks and bonds can smooth out the volatility impact that investors’ experience. That is why we advocate to “stick to the plan” that you implemented during sounder times considering that market corrections happen – normally – two to three times per year.

In our quarterly outlook “The Economic Boom 10 Years after the 2008 Credit Crisis” we pointed out our concern about rising rates and the economy in sections:

  • “Economic Growth with a High Degree of Difficulty” reviewing the speed of the Fed rate increases and the resilience and strength of the economy despite the rate increases;
  • “Investors Pessimistic About Equities” reviewing that despite markets rising, especially in technology, inflows have been in to bonds over equities this year;
  • “Dollar Dread and Interest Rate Anxiety”, Rising rates have the ability to disrupt markets. Rising rates impact financial assets by lifting the implicit discount rate and puts downward pressure on earnings multiples.

Market corrections are normal and we last saw one in February 2018. Rates are rising because the economy is so good. This is not a Fed Policy mistake; we are just getting back to normal, and that is disruptive to markets. “Stick to the Plan and Don’t Fight the Fed."

Tuesday, October 9, 2018
The shale oil and gas revolution has made energy cheaper for U.S. manufacturers and spawned many high paying jobs. The recent drop in oil prices has caused the energy sector to cut back.

Oil prices are starting to attract the spotlight and whispers of $100 a barrel are being heard. Oil is an intricate dance between supply and demand with some speculation and positioning thrown into the mosh pit. Uncertainty regarding the Iranian sanctions to take effect in November and how much of their supply will be replaced by Saudi Arabia and Russia tops the list of supply concerns. Initially, OPEC and Russia seemed reluctant to boost production, but are now assuring markets that they will step in. Meanwhile, U.S. production is on track for record highs of 11 million barrels a day but has hit a few speed bumps with pipelines and skilled workers. We believe technology and CAPEX will be a game changer for the U.S. oil industry. On the demand side, higher economic growth is resulting in higher demand. But the recent rise in the dollar has made oil, which is usually priced in dollars, more expensive for international markets, threatening to dampen demand. In addition, here in the U.S., higher oil prices could cause consumers to pull back on spending although that is not yet the case. The trade war with China could also enter into the mix as a demand downer. Finally, oil futures contracts are constantly being traded by speculators and hedgers to bet on or lock in prices and can often shift prices. Wow, who said disco is dead? This is a complicated dance but at the end of the night, there is still a global oversupply of oil and natural gas which will limit the upside in the price of oil and $100 a barrel is not likely. The Global Perspectives forecast for oil in 2018 is about $70 a barrel.

Please follow U.S. rig counts on page 76 of the Global Perspectives book.

Friday, October 5, 2018
Total payrolls, including all non-farm employment, have inched steadily upward with private job creation leading the way.

Investors scrambled to figure out the non-farms payroll report released this morning for the month of September and whether it would move the needle on the Federal Reserve rate hikes. The headline number of 134,000 jobs added was a miss and the lowest number in a year, but Hurricane Florence may have been a factor and the upward revisions of the previous two months were up 87,000. Therefore, job growth is still quite healthy. The unemployment rate ticked down to 3.7%, the lowest rate in almost 50 years. The more comprehensive U6 rate which includes people marginally attached to the workforce rose up to 7.5%. Growth in the average hourly earnings remained around 2.8%. Wage inflation is not yet an issue - the labor market is tight but there are still 96 million U.S. civilians not in the workforce. Overall, this was a strong report and an affirmation of the robust economy. There is certainly nothing in this report that would give reason for the Fed to pause. In addition, the ADP private payrolls report was a blowout and the latest ISM non-manufacturing measure of the services sector was the highest reading on record.

Please watch the payrolls reports on page 63 of the Global Perspectives Book.

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.

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