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Note for February Investment Committee MeetingSubmitted by The Wealth Consulting Group on February 16th, 2017
Summary and Conclusion:
Market prices have moved within a narrow range since the beginning of the year. Market participants appear to be awaiting the outcome of both tax and health care legislation. The House and Senate seem to be unable to coalesce around a health care bill, be it either a revision to or a repeal and replace to the Affordable Care Act (ACT). While Grover Norquist and Rob Portman have given optimistic prognoses for a rather quick conclusion to tax reform legislation, there remains a great deal of uncertainty about what the bill will look like. That is, equity traders seem unwilling to trade on either Portman’s or Norquist’s assessment of what tax reform will look like. The administration seems keen on a middle income tax cut and a border tax adjustment. There appears to be a desire on the part of most of the parties engaged in writing the legislation to broaden the tax base and lower the tax rates. There is less of a consensus on primarily taxing domestic production (current tax law) vs. taxing domestic expenditure (of which the border tax would be one way of implementing a consumption tax). Since the election, equity markets have moved upward on low volatility and unimpressive volume reflecting the expectation of lower capital gains tax rates (with at least the repeal of the 3.8% Affordable Care Act (ACA) investment income tax that is expected to accompany the repeal of the ACA). Thus, as the market finally climbed above the 2160-2240 level on the S&P500 in a sustainable way, sellers once again were motivated to step aside from the market in anticipation of at least a 16 percent reduction in capital gains tax rates. The result is an imbalance of buyers to sellers placing upward pressure on equity prices. This appears to be a much sounder explanation for the advance in the market than a positive reaction in anticipation of future economic policies (still ill-defined) coming from the Trump Administration and a Congress that is at least as fractured as the previous Congress and one with narrower Republican majorities in both Houses.
There is less uncertainty now regarding President Trump’s economic policy agenda than there was last month. At this point in time, the President’s focus is on national security and immigration issues. (President Trump and many Republicans believe that border security (illegal immigration) is a national security issue. His stance on legal immigration is less clear. The questions: Will he move to restrict legal immigration as a means of protecting the incomes of American workers – both laborers and professional and technical workers -- or encourage more legal immigration as a way of raising economic growth and the necessary tax revenue to support his stance of saving old age pensions, disability payments, Medicare, and Medicaid?) The President does not support the repeal of the ACA without an immediate replacement. That puts the timing of the repeal of the ACA investment income tax in limbo. (For those who are listening, President Trump’s objective is to give middle income taxpayers relief but not necessarily high income taxpayers.) President Trump has directed reductions in both financial and environmental regulations. President Trump’s focus on tax reform is a border adjustment tax and a middle income tax cut. While his advisors emphasize broadening the base and lowering the rates, I have heard these words from President Trump but not with the passion of his emphasis on the border tax. We also are not hearing much about infrastructure investment except for the Border Wall. The committee should follow the process on the ACA; markets will respond to the ACA repeal depending in a large part upon whether the ACA investment income tax is repealed. (The ACA investment income tax was repealed in the legislation that repealed the ACA last year that President Obama vetoed.) Repeal of the ACA tax is the preponderant relief to taxes on capital gains; the Ryan plan provides relief in a complex way that may well end up being removed from the tax reform plan and the Trump plan provides no relief (outside of the repeal of the ACA tax) to capital gains taxation. Thus, we might see some sellers return to the market once the ACA tax is repealed. If the market reacts badly to the failure to repeal the ACA tax, we might see even more sellers enter the market as market participants see this as a bad sign for the prospects for tax reform. A correction of the imbalance of buyers to sellers will in these cases place downward pressure on equity prices.
Based on statements from several of his cabinet appointees (as well as House Speaker Ryan (R, WI) and Senator Portman (R, MI) a further economic policy goal is to institute both Individual and Corporate Tax Reform. At this point in time (as opposed to January), it appears that tax reform might well come to fruition before the repeal of the ACA. (Adjustments to Environmental, Business, and Financial regulatory reform are well underway through executive actions as opposed to legislation. As I mentioned in earlier posts, achieving President Trump’s policy agenda through legislative action will be difficult.) So, as was the case with the Kemp-Roth tax reform under Ronald Reagan, the tax changes may not be effective until 2018 – the Kemp Roth tax rates did not take effect until January 1987, the year after the bill was passed (August 1986). At this point in time, there are major differences between Congressman Ryan’s (R, WI) blueprint and Mr. Trump’s tax plan. (For example, Speaker Ryan insists the tax plan will be revenue neutral; the Treasury Secretary Designate states that middle income taxpayers will experience a tax cut and affluent taxpayers will not experience an increase or decrease in taxes as a group.) Both plans eliminate the ACA 3.8 percent net investment income tax and equity markets are behaving as if the elimination of the ACA tax is a certainty. Of interest will be the response of Senate Democrats to the ACA repeal and more importantly to tax reform. Ten Democratic Senators that represent States that President Trump carried in November are up for re-election in 2018. Senator Schumer may have trouble getting some of them on board to oppose the repeal of the ACA, reduction in regulations, and lower tax rates under tax reform.
The equity markets have moved to record highs with the S&P500 moving above the critical 2160-2240 range in a sustained way. This response surprised many as Mr. Trump enters office with a high unfavorable rating. Therefore we can expect that over the next few years a large share of the population will be unhappy with this choice – especially the 52+ percent that did not select Donald Trump on their ballot. Thus, having a promising agenda may not assure the ability to implement this agenda, particularly with a very narrow majority in the Senate (but with significantly more Democratic than Republican Senate seats in play in 2018). Volatility in asset markets has been relatively muted as has been trading volume. My explanation for the rally, which I assume will continue until tax reform legislation is passed or scuttled, is the high probability that the 3.8 percent net investment income tax will be repealed. This high probability prospect means that a seller with capital gains can sell now and pay a 23.8 percent tax or sell later at a 20 percent tax (under Trump’s plan) or a 16.5 percent rate (under Speaker Ryan’s plan). That is, they can wait until the ACA investment income tax is repealed and pay at least 16 percent less in capital gains taxes. Since there are more buyers than sellers at existing prices as sellers wait for the lower capital gains tax rates, prices will continue to rise, although slowly, with restrained volatility, and with a reduced volume of transactions. At current valuations and the prospect that there will be some significant losers as well as winners in the business tax reform legislation, I would expect a selloff on relatively high volume once tax reform legislation is signed (If the ACA tax is repealed effective this year and the capital gains tax rate remains at 20 percent). I believe, net, the effect of the legislation will be negative in the short run and positive in the long run depending on the content of the legislation. There no doubt will be losers and my belief is that these losers (as well as those affluent tax payers that will enter the market to cash out capital gains at the prospective lower rates) will drag the entire market down until investors have a view of the quantitative effect of the legislation on the winners. In the short term, the combination of the border tax and restrictive immigration policies may be positive for investment, labor compensation, GDP growth, and the market. In the long term these policies will be a negative for productivity growth and GDP growth and make it more difficult for the government to maintain old age pensions and disability payments under social security as well as Medicare and Medicaid without adjustments to benefits or revenue sources.
Following the election, long-term (but not short term) interest rates (the 10 year and 30 year) rose substantially (and bond prices fallen) but have retreated somewhat this year.. I believe this outcome is based on some combination of 4 factors. First, the belief that Mr. Trump will appoint a rules-based Chairman of the Federal Reserve Board such as John Taylor in 2018. A Taylor Rule based Federal Funds rate would currently be in the neighborhood of 3 to 4 percent vs. the current rate of 62 basis points. (I also note that Fed statements, including those from Chair Yellen as well as the Minutes of the December meetings, have been more ‘Hawkish’ since the election.) Second, many market analysts believe that Trump’s fiscal policies will likely lead to a marked increase in the inflation rate. (I do not although I believe a Federal Government law that follows moves by the States to legislate a Federal Minimum wage in the $12/hour to $15/hour range would be inflationary.) Third, Trump’s fiscal policies would place upward pressure on long-term interest rates through higher inflation and higher productivity growth. (I find these last two factors a stretch since we know little about the probable outcome of his fiscal policy other than the repeal of the ACA 3.8% investment income tax and I believe repeal of the ACA 3.8% investment income tax will be strongly opposed by Senate Democrats and perhaps some from the House as well.) Fourth, more market participants now share my skepticism regarding the implementation of President Trump’s fiscal policies and are less concerned about higher inflation and less optimistic about medium term productivity growth, hence the decline in long term interest rates and the recent depreciation of the dollar.
I believe that volatility will pick up during the next few months, although with unimpressive volume. Market participants, as well as Mr. Trump’s advisors, are still uncertain of the Trump agenda for the next four years. Following the election results, market participants are less certain of Federal Reserve interest rate policy in 2017 (the number of increases if any) than they were when the expectation was of a Hillary Clinton President and a Republican House of Representatives with an ideologically and policy agenda split House. (Market expectations indicate a 65% probability of a rate increase by June 14 and a 67% probability of a second increase by December 17. The Fed dot plots project 2 rate increases during 2017 by 14 of 16 FOMC members and 11 of 16 project a third rate increase. I infer from these data that currently the Fed projects 2 increases in 2017 – consistent with the market projection.) The consensus view of economic forecasters (including voting members of the FOMC) projects a bounce-back in the U.S. economy. The consensus estimate of economic growth during the second half of 2016 is in the 2.5-3.0 percent range. Recent data releases support this outcome. Chair Yellen’s statements during the Press Conference following the December 15th FOMC Meeting as well as the release of the small changes in the economic forecast and the dot plots had little effect on interest rates. The release of the February Press Release saw a muted response on interest rates as well, although many analysts viewed the statement as hawkish. The Fed placed a good deal of emphasis on meeting their inflation objective of 2% in the statement, so I did not view the press release statement as hawkish given my skepticism in an outbreak of inflation, even with 19 states raising minimum wages this year. If the Federal Government raises the national minimum wage and gives Federal employees a mid-single-digit pay raise, then we will get above the Fed’s 2 percent target. Chair Yellen will testify before Congress in February and hold a Press Conference (and release revised forecasts and dot plots) following the March FOMC meeting. A change to the commitment of lower for longer interest rates should raise medium term (1 to 5 year) interest rates.
The market will move on hints of Trump administration’s policy direction or lack thereof. The level of uncertainty regarding the Trump agenda will cause risk-averse bureaucrats to hold-back spending, will likely lead to a negative fiscal shock to the economy that should affect both fourth (2016) and first quarter (2017) government spending. The Executive branch Agencies are pushing back, seeking relief from President Trump’s hiring freeze.
The path of oil prices and the pace of development policies, especially in China, with their effects on the level of international reserves may contribute as well. China reduced its level of international reserves in December (by $330 billion during the past 12 months) which when accompanied by reduction in dollar international reserves led to an appreciation of the dollar. (Net, international reserves were flat against all major managed exchange rate countries leading to the dollar stabilizing and then depreciating by 1.5 percent since the beginning of the year.) The decision of the People’s Bank of China (PBOC) to stabilize the value of the Renminbi will likely lead to further volatility in asset markets if the outlook for economic activity in China changes. Shocks to the Chinese economy will be transmitted to asset markets through changes in dollar international reserves rather than to the goods market through changes in exchange rates. These shocks could be positive or negative. The shocks to the Chinese economy have been negative enough since September that the PBOC reduced the level of International Reserves driving equity prices back below the critical range of 2160 to 2240 on the S&P 500 before rallying following the election. With the recent appreciation of the dollar, earnings abroad will look worse in dollars and it is possible that we will also experience some negative earnings surprises, especially on companies that sell to foreign markets, as reports are released during 2017Q1.
Economic forecasters that have updated their predictions since the election have raised their outlook for GDP growth in the Advanced Economies based on the expectation of U.S. expansionary fiscal policy. Without fiscal expansion in the United States, most forecasters see 2017 looking much like 2015 and 2016 with the exception of a recovery in Russia due to the recent rise in oil prices. The outlook for the global economy looks similar with the higher growth in the Advanced Economies offset by lower GDP growth in the Emerging Market Economies. The weakness in emerging markets derives from the expectation of higher interest rates and a strong U.S. dollar that increases the carrying cost of the level of dollar denominated debt in these countries which has expanded a great deal since the 2009 financial crisis. The U.S. Department of Commerce’s release of the Advanced estimate of 4th quarter U.S. GDP data estimated that the U.S. economy grew 1.9 percent during Q4 after increasing only 0.8 percent during 2016Q1 and 1.1 percent during Q2 , but rebounded to 3.5 percent in Q3 (Seasonally Adjusted Annual Rates). If the economy registers a significant shock (a significant shock would be the resumption of the sharp drawdown in international reserves by China, Russia and Saudi Arabia that we saw in January and early February of 2016), then the United States could very well enter a recession as trend growth is so low due to the anemic level of investment and rate of growth of productivity and we should expect a lower level of Federal Government spending.
Economic activity in the Advanced Economies is moving along its full employment growth path. Most analysts have reduced growth forecasts due to a weaker outlook for trade among the Advanced and Emerging Market economies. The U.S. economy grew 1.9% (Q4/Q4) during 2015. The economy is estimated to have advanced at a disappointing 0.8% (annual rate) pace in 2016Q1 and a weak 1.1% in 2016Q2. The estimate of 2016Q3 U.S. GDP growth in the third release was 3.5%. The advanced estimate of Q4 GDP growth was 1.9 percent, just above the estimated full employment growth rate. The Atlanta Fed’s estimate of 2017Q1 growth (GDPNOW) is 2.7%. The consensus forecast for U.S. growth in 2017 is 2.0%, pretty much in line with the last FOMC forecast of 2.1 percent; but above the full employment growth rate given recent anemic readings on productivity. Forecasters that assume a positive U.S. fiscal stimulus project U.S. growth in the 2.3 to 2.5 percent range. Barring a fiscal stimulus, I would expect U.S. growth somewhat below 2.0 percent, especially if tax reform legislation does not take effect until 2018. Note that despite the 2015 (Q4/Q4) growth rate of 2.0%, the unemployment rate continued to decline indicating that it is doubtful that the full employment growth is as high as 2%. In addition, with the 1 percent growth rate of the economy during 2016H1, the unemployment rate was steady. The combination of slow GDP growth combined with healthy gains in employment is easily explained by our convergence hypothesis. As firms shift the higher productivity manufacturing jobs abroad, new service oriented firms hire workers for lower productivity jobs at lower wages thus accelerating the convergence process. In the more sclerotic labor markets of Europe, the result of the process is more unemployment. This shift in manufacturing jobs abroad will likely slow or even reverse due to demographic and wage inflation headwinds in China – Chinese firms are shifting jobs abroad to Viet Nam, Indonesia, and other ASEAN states – and a shift in U.S. trade policies in a Trump Administration.
Wage inflation, hence U.S. goods and Services inflation is beginning to pick up. U.S. core PCE prices rose 1.7% (December16/December15). The increase in wages appears to be the pass-through of minimum wage increases. Wages are rising the fastest in the hospitality category – a category with a high percentage of minimum wage jobs – while employment growth in that sector is declining. Wages rising while demand for labor is declining is an indication of a supply side wage shock rather than a pull from aggregate demand.
The Euro Area is estimated to have grown 2.0% during 2015 and is estimated to have advanced at a 1.7% rate in 2016, despite the BREXIT vote. The Euro area as a whole has recovered from its latest recession but the migration crisis along with the political fallout from the influx of migrants lends a distinct down-side risk to this projection. Most economists expect the BREXIT vote to affect 2017 GDP growth more than 2016, so they have marked down their forecasts to the 1.3% range for 2017 (1.6% for those expecting a fiscal expansion to increase U.S. growth in 2017).
The United Kingdom grew 2.2% in 2015. The consensus estimate for U.K. growth in 2016 has been lowered to 2.0% due to the outcome of the vote to leave the European Union. Economists expect BREXIT to reduce growth in 2017 and have marked down their forecasts to 0.9%.
Looking at the Advanced Economies as a whole, they are estimated to have grown 2.1% in 2015 and 1.6% during 2016 and 1.7% during 2017. With a U.S. fiscal stimulus, Advanced Economies will likely grow 1.9 percent during 2017.
The Emerging Market Countries growth has been slowing down, but is expected to pick up a bit in 2017. Brazil and Russia are in recession but are expected to recover during 2017, although Brazil’s recovery is expected to be weak. Brazil is struggling from poor policies and a political crisis due to corruption (in Petrobras no less); Russia is slowing down due to sanctions and low commodity prices, but should be helped by the rise in oil prices. China’s economy is slowing from its 7.3% pace of 2014, but there is little consensus on how much they have or will likely slow down (as well as little belief in the validity of their published numbers). The data currently circulated for China estimate growth in 2015 of 6.9% and in 2016 of 6.7%. China’s economy is projected to grow 6.5% in 2017. The negative shocks that both China and Russia have sent to international financial markets appeared to have eased considerably in late February last year. China drew down international reserves by roughly $90 billion during December 2015 and another $100 billion in January but their reserves position stabilized in February through August. (This contraction of dollar money supply weighed heavily on the prices of primary commodities and equities in January and caused an appreciation of the U.S. dollar but the stabilization of international reserves in China (and elsewhere – Brazil and Russia) contributed to the dollar depreciation and the commodity prices rebound since January.) China’s international reserves declined by $24 billion in September, $45 billion in October, and declined a further $70 billion in November, contributing to both dollar appreciation and the decline in equity prices before the election. China’s reserve decline in December ($12.5 billion) was offset by increases in reserves in other managed exchange rate countries so the dollar has depreciated since the end of December. Saudi Arabian international reserves continued to decline at a steady pace and have dropped by $67 billion during the past year (December16 – December 15).
In addition to U.S. and China monetary policy actions, oil prices will also move with news of OPEC and non-OPEC producers production decisions. Oil prices will end up where the Saudi’s are comfortable with the combination of price and Saudi output levels. The Saudis signaled to other producers at the recent (December 2016) OPEC meeting that they are comfortable with the current higher oil prices, as well as with cutting production. While higher oil prices that signal higher aggregate demand are on balance good for equity markets (because of the higher aggregate demand), higher oil prices due to cuts in production reduce aggregate demand and reduce profits, raise long term interest rates and are therefore negative for both bond and equity prices.
The consensus forecast of economic growth in the Advanced Economies appears promising, as most forecasters project an acceleration of growth in the United States in 2017. I remain skeptical that growth will rise above its potential rate, which is somewhere between 1.5 and 2 percent. The United States expansion is getting ‘mature’, so U.S. growth should advance close to potential barring a pro-growth fiscal policy action. Therefore, I would expect growth during 2017 to be closer to 1.5% than the Fed’s projection of 2.1%. In addition, I don’t expect the election outcome (the combination of Presidential and Congressional) to be positive for U.S. economic growth in the short run (2017). In the medium-term (2018 and beyond), growth should improve as long as the Fed increases interest rates – which it will with a Trump appointment of John Taylor or one of a similar bent in 2018 – and the legislature passes comprehensive tax reform which should stimulate investment and productivity growth. (In the short run, capital adjustment costs will likely depress growth, even if the tax plan takes effect in 2017.) The weak investment on machinery and equipment, both past and current, dictates continued low productivity growth – consistent with our convergence thesis, and with our view of the way that low policy interest rates affect inflation and savings and investment. Without higher productivity growth, it will be difficult to reach above 2% GDP growth absent an unanticipated large growth in the labor force.
If the Trump Administration’s economic policies provide incentives for private investment and legal immigration, then economic growth should begin to improve in 2018 and beyond. However, the uncertainty over the content of tax reform legislation and trade policy could give us more of a negative bump in 2017 than is contained in the consensus of forecasts of the U.S. economy. While tax reform should be bullish for economic growth and equity prices in the medium term, the uncertainty of the effects of complex legislation often results in short-term slower growth due to capital adjustment costs and declines in equity prices in sectors most negatively affected by the legislation. With a lower rate of potential output growth, it is more likely that a significant shock will push the economy into a recession. One such shock that has pushed the U.S. economy into a recession – late 1980, late 2000, and late 2008 – is a slowdown in government spending during the change in administrations due to the uncertainty of agency budgets and the absence of leadership at the top tier of the executive branch agencies. Another such shock occurs when firms and individuals defer income given the prospect of lower taxes the following tax year(s). I see no evidence of firms deferring profits, dividend payments, or individuals postponing income into 2018 as yet. We should pay attention to this possible development. (At this point it does not make sense for firms to defer dividend payments to 2018 until tax legislation on tax reform and the ACA are passed.) To the extent that markets price in higher productivity growth from Trump’s policy agenda, the higher outlook for productivity growth should reinforce the increase in long-term bond prices once the FOMC begins to raise short-term rates. The other Advanced Economies face headwinds similar to those experienced by the U.S. economy from 2010 to 2014, so growth above potential in these areas seems a bit of a ‘rosy’ scenario as well.
Drivers of the Recent Bull Market:
Globalization and the aggressive development policies of the large emerging market economies have been the key drivers of the post financial crisis bull market. The key forces that spurred globalization are the improvements in transportation and communication that enhanced international trade and capital mobility. Russia, India, China, and South Africa re-connected with the world economy and along with Brazil embraced aggressive development policies. These development policies aimed to increase income per capita by raising productivity growth. Economies increase productivity growth through investment. Thus these investment growth policies embraced in countries with large populations increased the demand for capital, hence the price of capital, placing downward pressure on interest rates. The addition of these countries with large populations essentially doubled the world labor force, placing downward pressure on wages, worldwide, because of capital mobility. These policies resulted in emerging market economies growing faster than the advanced economies – an outcome called the new normal by Mohammed El Erien and structural stagnation by Larry Summers. (I called this phenomenon convergence.) With the exception of India, these aggressive development policies have slowed which will likely result in a slowdown in convergence and a reduction in the risk of deflation. (However, Federal Government policies toward constraining Federal Government workers wages and salaries could heighten deflation risk while possible minimum wage legislation – probably a bargain to move tax reform legislation – will likely lead to higher inflation.)
U.S. macroeconomic policy focused on preventing deflation on goods and services prices. The key to preventing deflation on goods and services prices is preventing declines in nominal wages. With nominal wages rising, albeit slowly, and globalization driving up the price of capital relative to the price of labor, equity prices rose significantly because equity prices reflect the value of the firms underlying assets as well as the discounted present value of future earnings.
When it appeared that the bull market had pretty much run its course toward the end of 2012, the U.S. capital gains tax rate on affluent households (holders of a disproportionate share of equity value – I have seen estimates of 80%) rose 59% from 15% to 23.8%. This rate increase removed a large share of equity holders out of the sell side of the market and led to a 30% plus increase in equity prices in 2013 and contributed to a further 24% increase during 2014, before flat-lining during 2015 and through the first half of this year. This 54% increase in equity prices is in sharp contrast to subdued price performance of other assets such as oil, metals, and even gold. If the equity price was driven by Fed (and international dollar) monetary policy, all asset prices would be marching up in lock-step like the dollar money supply driven asset price increases of the first half of 2008 and decreases during 2008H2. With the prospect of the removal of the 3.8% ACA investment income tax, investors will remain detached from the sell side of the market, putting upside pressure on equity prices, until tax reform legislation is completed.
The Driver-less Market:
Recent macroeconomic (and political) developments are changing the bull market’s calculus and help explain the key features of the 2015-16 market – periodic volatility with no direction. The pick-up in economic activity in the Advanced Economies and the slowdown in the Emerging Market Economies stems from a change in policy in the Emerging Markets – primarily in China and Brazil – and a change of emphasis in Russia. (Thus these policy changes signal the end of El Erien’s new normal -- which was neither new nor normal. El Erien has recently commented on its demise. His former colleagues call it the new neutral.) As China attempts to shift its growth strategy away from investment and exports to consumption and services, China will experience a lower build-up in their capital stock, a slower increase in its capital/labor ratio, lower productivity growth, and lower growth of potential output. Therefore, the convergence between China and the Advanced Economies will likely slow, the Advanced Economies will retire capital at a slower rate, allowing them to grow at a faster rate than they experienced during the past ten years. However, China’s productivity growth will still outpace that of the advanced economies, so as long as China manages its exchange rate at a constant or depreciated level, its exchange rate policy will send deflationary shocks to the Advanced Economies that, along with their change in development polices, will act as a tightening of monetary policy that will reduce asset prices to include those of equities and bonds. The recent depreciation of the RMB sends a warning concerning the risk of this deflationary shock. [The RMB has depreciated 10% since July 2015.]
In both China and Russia, political exigencies have taken priority over economic development. In China, the move from export led growth to domestic consumption and services has turned into an excuse for a political purge and a consolidation of power under Mr. Xi. The purge indicates a change in the “rules of the game” in China, increasing uncertainty, and discouraging investment – especially by foreign capital. (In contrast to popular belief, capital flight is most often instigated by domestic residents rather than by “so-called” foreign hot money.) In Russia, perceived threats, in Russia’s view, to its spheres of influence has shifted priorities away from development toward actions in Eastern Europe and the Middle East that have led to sanctions which have hurt economic development (Russia is currently in recession) and trade. With China’s investment and industrial output slowing, the demand for commodities (particularly coal and oil) declined sharply and the prices of commodities tanked. The fall in commodity prices sharply reduced income from oil exports in Russia and in other large oil exporting countries such as Saudi Arabia. This lower oil income led oil exporters such as Saudi Arabia and Russia to draw down their international reserves in order to support their currencies (Saudi Arabia is on a tightly fixed exchange rate; Russia adopted a managed float which mitigated the effect of lower commodity prices on its international reserves.). This drawdown of international reserves reduced the supply of dollars, leading to an appreciation of the dollar, downward pressure on U.S. export earnings in dollars, and downward pressure on U.S. equity prices, contributing to the difficulty that the U.S. equity market is encountering as it tries to cross that 59% threshold. [U.S. equity prices-- based on the S&P500 index -- have bounced around the lower end of the estimated 59% threshold during the past few months, but have had difficulty sustaining that level. With the election of Donald Trump and the expectation of a repeal of the 3.8% ACA investment income tax, equity prices have risen above the 2160 to 2240 band and should remain above that range until the capital gains tax issue is resolved.] With the stabilization of China’s foreign currency reserves, commodity prices have rebounded, putting less pressure on the Saudi Arabian and Russian economies. Russia responded to this pressure by floating its currency and is on the path to positive GDP growth by 2017. Saudi Arabia is responding to lower oil revenues by devising economic policies that offer a quite radical change from those of previous regimes.
Uncertainty regarding both when the Federal Reserve’s Open Market Committee (FOMC) will raise the Federal Fund’s Rate and what the effect of its action will have on the economy and on equity markets is still a major factor effecting volatility in asset markets. In December, the market placed a high probability on a 25 basis point increase and Fed moved rates as expected. Going forward, the market and investors will focus on the pace and the increments of rate increases. Most FOMC members (at least in the December Projection Materials) project two 25 basis point moves during 2017. The market is projecting two increases as well. To the extent Fed Speak contradicts this view, volatility will return to markets.
I believe the market (at least market analysts) is still expecting higher medium-term
growth in the United States and in other Advanced Economies than will manifest because of a lack of appreciation of the role that globalization via convergence among advanced and emerging market economies plays in the lack of investment and slowdown in productivity growth in the United States and other Advanced Economies. Weak investment and low productivity growth strengthen the case for “convergence” to be the primary cause of the slow growth in potential output. Since the evolution of China’s economy is an important element in this calculus, the success (or lack thereof) of China’s switch from export led growth to a service driven consumer society will affect the potential growth of the Advanced Economies including that of the United States. Counterintuitive to some, deceleration in growth and development in China and Brazil will likely lead to more investment and growth in the Advanced Economies.
The political focus on inequality and the possibility of concomitant (outsized) increases in minimum wages will work their way through the U.S. economy’s wage structure and will most likely produce higher inflation than expected over the next several years. The wage increases published to date in the various labor market reports reflect this increase as opposed to the so-called Phillips Curve effect on wages as we reach full employment. Accelerating inflation should place up-sized pressure on long-term interest rates and allow the Federal Reserve to justify a rise in short-term rates despite stagnant growth. [Although the profession has not clearly shown whether higher inflation causes higher interest rates or higher policy interest rates cause higher inflation, John Cochrane (University of Chicago) is circulating a paper claiming the latter, a view that I share and explained in my presentation on April 16th.] Higher wages, stagnant growth, and an appreciated exchange rate (at least in real (price-adjusted) terms) will likely depress earnings and put downward pressure on bond prices and on equity prices.
Implications of Economic Volatility for Client’s Portfolios
Given the possibility of a heightened level of uncertainty in markets (i.e. the volatility in global equity markets) and the effects of possible shocks (passage of U.S. tax reform, China’s development and exchange rate policy, the FOMC rate decision and its forward guidance, and the risk of a negative or positive oil shock in the Middle East) the investment committee should investigate strategies to mitigate the risk of a significan drop in equity prices is such strategies are appropriate for the firm’s clients. This recommendation is based on the logical effect of a known shock that has already occurred and the shock’s effects have manifested as predicted over the past three years. At least, if appropriate, your customers should be prepared to re-weight toward equities – buy on the dip -- if such a decline in equity markets occurs.
The convergence among Advanced and Emerging Market economies, as well as impending U.S. tax reform, implies a significant restructuring of the U.S. and other Advanced Economies. In addition, tax reform legislation –especially one that includes a border tax and a broadening of the tax base – will induce substantial restructuring, changes in relative prices of assets, and movement in equity prices. Tax reform has in the past sent all asset prices lower initially so your clients should be prepared to buy on the dip. It would be wise to review clients’ portfolios to mitigate holding shares of companies that might fare poorly or perhaps disappear (Penn Central Railroad in the 1970s) due to this restructuring despite performing well in the pre-globalized world. High wage, low technology firms with production facilities in the United States and other Advanced Economies will not fare well in this environment, even if they have done well in the past as well as firms and industries that benefit inordinately from tax preferences (clean energy, oil and gas drilling, etc.).
The FOMC’s Interest Rate Decision:
The FOMC increased the Fed Funds rate 25 basis points at the December meeting to its current, effective rate of 65 basis points, as expected. The market does not see the FOMC reaching their terminal Fed Funds Rate of 3.0% (revised) any time soon. The Fed left rates unchanged at the February 1 meeting. Both the markets and the dot plots project two rate increases during 2017. There is a reasonable chance that the Fed will moderate its lower for longer stance during its Monetary Policy Testimony to Congress in February or during the Press Conference March 15th. Should they back away from this lower for longer stance, we should expect an adjustment upward of medium term rates. The latest jobs reports (165 thousand increases in payrolls, on average, over the past four months), an estimated 2.7% U.S. GDP growth in 2016H2, and the latest data on core PCE prices (1.7% rise over the past 12 months) support a continued normalization of rates. The market will most likely react to FOMC member chatter on their views on the pace and magnitude of increases in rates. Currently, the market is projecting one increase in rates by June (65 percent probability) and another by December (66 percent probability). The FOMC member dot plots also imply two rate increases during 2017. The FOMC will update its dot plots and economic projections at the March 15 Meeting Press Conference.
William L. Helkie
William Helkie is not affiliated with LPL Financial.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
International and emerging market investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.
Stock investing involves risk including loss of principal.
The payment of dividends is not guaranteed. Companies may reduce or eliminate the payment of dividends at any given time.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
The fast price swings in commodities and currencies will result in significant volatility in an investor’s holdings.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
No strategy assures success or protects against loss.