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Note for January Investment Committee MeetingSubmitted by The Wealth Consulting Group on January 18th, 2018
Summary and Conclusion:
Asset prices rose during December. The S&P500 index of U.S. equity market prices increased by 2.6 percent. This increase continued the trend of steady growth in asset prices at relatively low volume and volatility that has characterized equity markets over the past several years. The VIX fell back to its lows of October and November – levels well below those preceding the election and during the beginning of last year. The yield on 10 year U.S. government bonds edged up to 2.4 percent, returning to the levels at the beginning of last year. Following the passage of the tax bill that included incentives for investment spending, bond traders are pricing in a gradual increase in productivity growth for the economy.
The Federal Reserve increased the Federal Funds rate by 25 basis points to a range of 1.25 to 1.5 percent at its December meeting. (The latest release on core and headline inflation based on the PCE price index registered 1.8% (headline) in November relative to November of 2016 and 1.5% on core. The Fed’s target is 2.0 percent.) The dollar depreciated 0.8 percent against the major currencies -- a level 9.5 percent weaker than its January 2 reading. I attribute the weaker dollar to a combination of the Federal Reserve’s normalization of its balance sheet (- $10 billion) being more than offset by an accumulation of dollar reserves by the main international reserve holders (+$22.8 billion during the month) and slightly stronger than expected growth abroad. The weakness in the dollar during the past year I attribute to the build-up in international reserves by foreign central banks. I believe the mild pick-up of volatility at the beginning of last month was due to the completion of draft legislation on tax reform by both houses of Congress that excludes a capital gains tax cut but produces some clear-cut losers and winners. The positive direction of the markets since the Presidential election and the continued low level of volatility stems from market participants waiting for the resolution of Health Care legislation promised by House leadership during 2018 that might well contain a removal of the ACA investment income tax. While I believe that this is a low probability event (repeal of the ACA investment income tax), I was also quite surprised that Congress removed the penalty assessed on those that did not purchase health insurance (the ACA mandate). The bond market is telling us that traders now expect an increase in non-residential investment leading to higher productivity and full employment GDP growth based on their reading of the tax bill. The expectation for inflation over the next ten years has not changed much since the election. I believe that President Trump’s de-regulation policies have had a positive effect on output (as we have seen in the energy industry), and since I expect this trend to continue, I expect that we will eventually have higher 10 year yields and lower bond prices as these regulatory policies boost productivity, economic activity, and potential output growth (although the President’s immigration policies will dampen the effect on potential output growth).
Washington policy officials made progress on economic legislation. Both the House and Senate have passed budget resolutions. Tax “reform” legislation has passed both the House and the Senate and was signed into law by the President. The bill is quite complex and creates many opportunities to create tax shelters, both intentionally and unintentionally. At this point in time, the bill neither lowers the capital gains tax rate nor addresses any of the Affordable Care Act (ACA) taxes save for repeal of the ACA mandate. Congress reached an agreement to extend the government funding legislation until mid-January. The debt limit ceiling must be addressed by April; Of primary interest to us is the fate of the ACA taxes and capital gains taxes. Thus far, proposed tax legislation addresses neither capital gains tax rates nor ACA taxes. The House is still determined to find a way to repeal the ACA taxes, even if the repeal is attached to legislation not associated with Health Care – such as the ACA Mandate in the tax legislation. Some in the Senate want to extend the wider coverage of Medicaid and there are some reports that they will pay for this and subsidies to cover those with pre-existing conditions by retaining the ACA investment income tax. (The House leadership does not want to extend the expanded Medicaid coverage.) Until the market has a clear view on capital gains taxes, markets will remain in a low volatility, low volume status, although not as low as September/October..
I believe volume and volatility will pick up as traders adjust prices down for the equity values of apparent losers in the legislation and drive up the prices of the apparent winners. We have seen a little of this, but the contents of the bill are complicated enough and some parts are subject to IRS interpretation that most investors may be hesitant to rebalance their portfolios until the bill is better understood. The repeal of the investment income taxes in the ACA is a low enough probability and the market is getting rich enough that investors may be less hesitant to transact serving to raise volume and volatility as well. Thus I still see equity markets rising slowly on relatively low volume with a relatively low VIX, at least through January. With the decline in corporate tax rates, the incentives to invest in machinery and equipment, continued reduction in regulation, and stronger growth abroad, U.S. GDP growth in 2018 should remain in the 2.5-3.0 percent range. The deregulation efforts of the Trump Administration are beginning to manifest in a recovery in business investment and a resolution of tax legislation should remove some uncertainty for the policy outlook and give a boost to investment. Uncertainties regarding Health Care legislation may act as drag on growth.
Equity prices have risen during the past year due to an increase in earnings and an increase in the Price/Earnings (P/E) ratio. Strong U.S. and foreign economic growth as well as the corporate tax cuts should boost earnings. The P/E ratio rose in part last year because the excess liquidity caused by an increase in U.S. dollar international reserves at foreign central banks raised the price of equities relative to U.S. dollars – that is, the U.S. dollar declined in value relative to other assets. With the Fed, through its balance sheet normalization program, increasing the rate at which it reduces the size of its balance sheet, the price of other assets relative to the dollar should decline unless the reduction of the supply of dollars is offset by the increase in foreign central banks accumulation of U.S. dollar international reserves. During 2017Q4 foreign central banks offset the effect of the Fed’s balance sheet normalization. As the Fed increases the rate of decline, foreign central banks will need to acquire more international reserves to prevent an appreciation of the dollar with respect to other assets. Thus, balance sheet normalization should act to depress the P/E ratio, at least during the second half of 2018.
The Federal Reserve raised the Federal Funds rate by 25 basis points to a range of 125 to 150 basis points on December 13. The Fed statement indicated that the Fed would continue the process of reducing the size of the balance sheet in December by reducing its holdings of Treasury securities by $6 billion and that of mortgage securities by $4 billion. The Minutes of the meeting, released on November 22nd, stated that the FOMC plans to remove statements regarding balance sheet normalization in their Press Release unless they change policy. Going forward, the Fed will begin reducing the balance sheet by $20 billion -- $12 billion Treasuries and $8 billion in Mortgage securities – beginning in January. At this point in time, the size of the decline in reserves is smaller than the normal monthly movements of U.S. dollar international reserves held on foreign countries Central Bank balance sheets. While these relatively small reductions in the U.S. Federal Reserve Balance sheet should have only a relatively small dampening effect on equity prices, and toward a stronger dollar and weaker bond prices, these effects may well be offset or amplified by movements in the U.S. dollar international reserves of foreign Central Banks. The balance sheet reduction will have more noticeable effect on asset prices when accumulated over a year, and as the FOMC plans to increase its rate of decline. At the December meeting, the FOMC raised its projection for U.S. GDP growth in 2017 to 2.5% from 2.4%, but maintained its long-term projections unchanged. Recent data on inflation has come in stronger than the FOMC’s September 20 projection. Speeches and interviews of FOMC members, as well as the dot plots, indicate that many FOMC members favor as many as three rate hikes next year. The market estimates a near zero probability of a rate hike on January 31. Market estimates of a rate hike on March 21st is 62 percent., and the market projects at least one additional rate hike by the end of the year The median estimate of the projections by December FOMC members (the dot plots) is 3 rate hikes this year. The dot plots at this point in time are a less useful guide to future policy as there will be a substantial change in the voting make-up of the FOMC in 2018 relative to 2017. In addition, once Chair Yellen departs, the Fed will be down to three Board members. Thus, the FOMC will have only 8 voters (if Goodfriend has not yet been confirmed) and for the first time in my memory the majority of the voting members will be Bank Presidents. The Fed will release a Press Release following the January 31 meeting. The FOMC will hold a press conference on March 21st (Chairman Powell’s first press conference) and release revised economic projections and updated dot plots following that meeting. We should get further insights into Chairman Powell’s views during the Federal Reserve’s monetary policy testimony to Co0ngress in February and perhaps some insights from the minutes of the January 31st meeting as he will oversee the editing of the minutes rather than Chair Yellen.
I recommend that wealth managers work with their clients to re-balance their portfolios now that the tax bill has passed and we have better knowledge of what is in the bill.
Recent Asset Market Behavior
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% ACA investment income tax that had been expected to accompany a repeal or reform of the ACA). Thus, as the market finally climbed above the 2160-2240 level on the S&P500 in a sustainable way following the results of the Presidential election, 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. (See Becky Quick’s interview with Warren Buffet on CNBC’s Squawk Box on October 4th for confirmation of this hypothesis.)
There is still some hope for a repeal of the ACA investment income tax in 2018; there was no reduction in capital gains tax rates in tax reform legislation. House leaders have indicated that they plan to introduce legislation to address Medicaid and Medicare issues this year and a repeal of the ACA taxes may well be addressed in this legislation. To the extent that repeal of the ACA taxes is no longer credible, volatility and volume should pick up and allow for an adjustment of prices among winners and losers in the tax reform legislation. The price adjustment among winners and losers may well be slower than many would assume due to both the complicated nature of the legislation, the lack of knowledge of what actually is in the law, and the uncertainty of how the IRS will interpret certain sections of the law. It appears to me that real estate investments will be hit hard, but there is not enough specificity in the legislation to know this at any reasonable level of confidence.
Following the election, long-term (but not short term) interest rates (the 10 year and 30 year) rose substantially (and bond prices fell) but rates have retreated and bond prices rallied somewhat this year, and 10 year Treasury yields stand near pre-election levels. I believe this outcome was based on the belief of faster growth under a Trump administration based on deregulation, increased investment, higher productivity growth and higher inflation. As difficulties with executing the Trump agenda became apparent, investors’ expectations of higher growth and inflation cooled, and long-term interest rates declined. I believe 10 year rates will increase as the economy responds favorably to President Trump’s de-regulation policies, and the Federal Reserve begins balance sheet normalization and continues to raise the Federal Funds rate..
Foreign exchange markets have also remained relatively stable. The key managed exchange rate countries increased their international reserves a combined $22.8 billion last month. When combined with the Fed’s decline of $10 billion to its balance sheet and more rapid economic growth abroad, these actions contributed to the depreciation of the dollar. (The dollar depreciated 0.8% last month against major currencies and has depreciated 9.5 % since the beginning of the year.)
The President’s (and Congress’s) Policy Agenda
At this point in time, the President’s focus is on national security, immigration issues, and changes in staffing in order to implement his agenda and communicate his message to the electorate. At present, his focus is on designing an infrastructure program, passing a budget or extending the continuing resolution, and raising the debt limit,. He appears to be taking a more aggressive stance on deporting those residents with no or expired immigration documents. The Administration also has restricted H-1 visas presently given to skilled tech workers and demanding preferences to U.S. workers (presumably citizens rather than permanent resident visa holders). Thus at this point in time, it appears that the Administration will move to restrict legal immigration as a means of protecting the incomes of American workers – both laborers and professional and technical workers -- rather than encourage more legal immigration as a way of raising economic growth and providing the necessary tax revenue to support Mr. Trump’s stance of saving old age pensions, disability payments, Medicare, and Medicaid. The Attorney General used such an argument to defend the Administration’s decision to end the DACA program. At the margin, his immigration policy is a negative on U.S. growth. It is expected that Congress will address immigration policy this year. President Trump has directed reductions in both financial and environmental regulations. Commerce Secretary Wilbur Ross has been working to revise U.S. trade policy and the Administration is in the process of re-negotiating NAFTA. The re-negotiating of NAFTA is not going well. The President is also working to reduce the size of the Federal Government through attrition by not filling vacant positions – both political appointee and professional positions.
The path of oil prices and the pace of economic policies abroad, especially in China, have contributed to a recovery in both advanced and emerging market countries and a reduction in the U.S. merchandise trade balance. China maintained its level of international reserves since the beginning of the year. The decision of the People’s Bank of China (PBOC) to allow more flexibility in the value of the Renminbi has contributed to the relative stability of asset markets by maintaining stability in its level of international reserves. Even without the previously assumed fiscal expansion in the United States, most forecasters see Global economic growth in 2017 and 2018 looking stronger than in 2015 and 2016. Growth in Japan is projected to be higher, Russia has recovered due to the rise in oil prices and the recession in Brazil has ended, although economic growth is still pretty weak. The outlook for the global economy in 2018 looks equally bright as higher growth in the U.S. offsets small declines in growth in the U.K., Japan, and China. Low dollar interest rates and a depreciated dollar has reduced the risk of financial crises and gives a slight boost to emerging market economies.
Economic activity in the Advanced Economies is moving above its full employment growth path as Japan and the European economies finally are experiencing a meaningful recovery from the great recession. Most analysts have raised estimates of growth in 2017 due to stronger data for trade among the Advanced and Emerging Market economies.
The U.S. economy grew 1.8% (Q4/Q4) during 2016. U.S. GDP grew at a 2.1% (SAAR) rate in 2017H1. The BEA’s third estimate of 2017Q3 growth is 3.3%. The Atlanta Fed’s estimate of 2017Q4 growth (GDPNOW) is 2.8%. U.S. GDP growth during 2017, given an estimated 2.8% rate in Q4 will be 2.5% -- a rate that matches the FOMC’s estimate in the December 13th projection materials. The consensus forecast for U.S. growth in 2018 is 2.5%,, consistent with the FOMC’s projection on December 13th. The U.S. economy should grow faster than potential this year due to continued deregulation, the tax cut, and strong growth abroad. (The Fed has gradually reduced its estimate of full employment growth to 1.8 percent.)
Wage inflation, hence U.S. goods and services inflation, increased slightly during the past two months. U.S. core PCE prices rose 1.5% (Novt17/Nov16). The increase in wages appears to be the pass-through of minimum wage increases as wages have shown their sharpest increases at the beginning of the year, when the increases take effect, and among the lower income quintiles. There are also indications of a tight labor market in the construction industry which has been explained in part as a reaction to the Administration’s immigration policies. Many technical jobs are remaining unfilled as employers are unwilling to offer a high enough wage to attract qualified candidates.
The Euro Area is estimated to have grown at a 1.8% rate in 2016, despite the BREXIT vote. The Euro area as a whole has recovered from its latest recession. The migration crisis along with the political fallout from the influx of migrants has had less of an effect on economic activity than most economists had projected, but it is still a hot-button political issue across the continent. Thus, immigration lends a distinct down-side risk to the outlook going forward. Most economists have reduced the negative effect of BREXIT on Euro area growth and have raised the growth outlook to the 2.2% range for 2017 and 2.0% for 2018.
The consensus estimate for U.K. growth in 2016 has been lowered to 1.8% due to the outcome of the vote to leave the European Union. Economists assume a negative effect of BREXIT on U.K. growth in 2017 and 2018, and project 2017 growth at 1.6%, and the 2018 outlook to 1.0%. I would expect the estimate for 2017 GDP growth to be raised as we received the final quarter’s data.
Looking at the Advanced Economies as a whole, they are estimated to have grown 1.6% in 2016 and are projected to advance 2.1% during 2017.
Emerging Market economies growth picked up a bit in 2017. Brazil and Russia have both recovered from recession during 2017, although Brazil’s recovery has been weak. Brazil is struggling from poor policies and a political crisis due to corruption (in Petrobras no less); Russia slowed down due to sanctions and low commodity prices, but has been helped by the rise in oil and other commodity prices in 2017. 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 2016 of 6.7%. China’s economy is projected to grow 6.8% in 2017 and 6.3% in 2018. China’s economic activity was boosted by policies designed to make the Party look good during the 2017 Party Congress. China’s international reserves increased by $16 billion since November of last year and increased $10 billion last month contributing to a slight appreciation of the RMB with respect to the U.S. dollar. The increase in China’s reserves and increases (net) in the reserves of other managed exchange rate countries has allowed the dollar to depreciate since the end of December 2016. Saudi Arabian international reserves continued to decline at a steady pace and have dropped by $55.6 billion during the past year (November17 – November16).
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 OPEC meeting that they are comfortable with the current higher oil prices, as well as with cutting production. Thus, OPEC agreed to extend their production cuts through the end of 2018. With tax reform and deregulation, oil production in the United States will partially offset OPEC’s production cuts. 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 2018. I believe that U.S. growth will rise above its potential rate, due to the response of investment to deregulation policies and hopefully will continue with a removal of uncertainty around tax and health care policy. (U.S. full employment growth is still somewhere between 1.5 and 2 percent as demographics, as well as projected immigration policies, has offset some of the positive effects of investment to productivity growth.)
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.
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