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Note for January Investment Committee MeetingSubmitted by The Wealth Consulting Group on January 15th, 2019
Summary and Conclusion:
Asset prices declined in December as a drawdown in the supply of dollars on Central Bank balance sheets, primarily in the United States, offset the strong earnings that reflected continued solid economic growth and the corporate tax cut. Following December Federal Open Market Committee (FOMC) meeting, asset prices fell as the FOMC assessment indicated a strong economy with little inflation and the prospect of between one and two 25 basis point rate hikes for 2019. The FOMC statement also stated that the Fed will continue to reduce the Fed’s balance sheet by $50 billion per month – a rate of decline that Chairman Powell stated in his Press Conference was on automatic pilot. (I believe that as was the case during 2018Q4, a $50 billion reduction in the Fed’s balance sheet is too large of a reduction to be mitigated by changes in international reserves by foreign central banks and may well provide too strong of a headwind to accommodate increases in asset prices – particularly equities.) In an interview on CNBC later in December, John Williams, President of the New York Federal Reserve Bank, emphasized that decisions regarding movements in the Federal Funds rate will be data dependent and should no longer be considered on a predetermined path of further tightening. Furthermore, and more important in my view regarding the future path of equity prices, Williams stated that the path of balance sheet normalization is “not inflexible.” With analysts, including the FOMC, beginning to lower their forecasts for economic growth both in the United States and abroad and projecting that the Fed will be data dependent regarding Fed Funds rate moves in 2019, the market is now projecting no Fed Funds rate hikes in 2019 and the 10 year rate fell back near 2.7%.
The S&P500 index of U.S. equity market prices fell during December ending the month roughly 6 percent below the end November level and roughly 7 percent below the level of yearend 2017. During December the equity market continued the trend of steady decline in asset prices at moderate volume, but at the higher volatility that characterized equity markets over the February – April period when asset prices were repricing to reflect the changes to relative after-tax earnings due to U.S. Federal tax legislation. During December, the equity markets appeared to respond to a changing international trade environment and the risk of a slowdown in foreign economic activity. The VIX was relatively high during the month, responding to news on U.S. trade with China. The lower level of the 10 year rate, relative to that of November, is consistent with a slowdown in economic activity as well as a tamer inflation outlook. Concerns regarding a change in trade policy that might reduce investment and offset the recent pickup in productivity growth derived from stronger investment spending in 2017 and thus far in 2018 might also have been weighing on the market. Net sales of Treasury and Mortgage backed Securities by the Federal Reserve and some other Central Banks is also contributing to the volatility in asset prices as the move from net purchases to net sales has reduced liquidity in the market.
The Federal Reserve decided to raise the target range of the Federal Funds rate to a target range of 2.25 to 2.50 percent at its December 19th meeting. (The latest release on core and headline inflation based on the PCE price index registered 1.8% (headline) in November 2018 relative to November of 2017 and 1.9% on core (excluding food and energy). The Fed’s target is 2.0 percent inflation on the headline PCE price deflator. The dollar appreciated very slightly (roughly flat) against the major currencies during December -- a level nearly 5.3 percent stronger than its January 2018 reading, but 3.5 percent weaker than in January 2017. I attribute the stronger dollar since January 2018 to a combination of the Federal Reserve’s normalization of its balance sheet (- $420 billion) that has more than offset the increases in international reserves of foreign central banks as well as the continuation of strong U.S. growth and the risk of weaker than expected growth abroad.
Headwinds on Asset Prices
With the Federal Reserve reducing the size of its balance sheet, China reducing its dollar holdings of international reserves, and other banks (the ECB, Japan, etc.) planning to reduce the size of their balance sheets as well, these actions will reduce the quantity of dollars relative to other assets, increasing the price of dollars relative to other assets, thus lowering the price of assets in dollars. Thus for 2018, equity markets have been characterized by higher volatility (due in part to lower liquidity with Central Banks tightening money and credit) and a downward trend in the price/earnings ratio. In order for equity prices to rise, firms must experience strong earnings to offset the decline in the price/earnings ratio. Through the first three quarters of 2018, at least in the United States, strong earnings, produced by a strong economy, has offset much of the deflationary actions of the central banks. The recent decline in oil prices and the decision by OPEC to cut production has removed the risk of an increase in holdings of international reserves by the major oil producers (Russia, Saudi Arabia, etc.).
The positive direction of the markets from the Presidential election through 2017 accompanied by the low level of volatility stems from market participants waiting for the resolution of Health Care and Tax Reform legislation promised by House leadership during 2018. The positive trend in prices from 2009 through 2017 was driven by the expansion of Central Bank balance sheets – primarily that of the U.S. Federal Reserve. As the Federal Reserve expanded the supply of dollars relative to that of other assets, the price of dollars declined relative to that of other assets. Thus, the price of assets rose when priced in dollars. The positive effect on prices of the imbalance of buyers to sellers was supported by the increase in the supply of dollars by foreign Central Banks – especially the People’s Bank of China. This increase in the supply of dollars lowered the price of dollars relative to other assets, thus increasing the price of assets denominated in dollars. This positive shock to asset prices is now being offset in part by the Fed’s balance sheet normalization policy.
Effect of Possible Shocks on Asset Prices
There are three events that could lead to more selling of equities during 2019. We witnessed some of these shocks in December. First, an adverse outcome to trade policy negotiations that leads to higher tariffs and interruptions of cross-border supply chains of U.S. resident firms. While negotiations with Canada and Mexico appear to have reached a settlement, communications with China have not been positive, with a significant effect on both China’s and the United States’ asset markets. Second, the Federal Reserve increases or just maintains its rate of reduction of its balance sheet (Quantitative tightening). The Fed stated that it will continue its balance sheet normalization during January at the same rate as during December and according to Chairman Powell, the program will remain on auto-pilot through 2019. John Williams countered the Chairman by stating that the balance sheet normalization policy is not inflexible. The reduction in the size of the U.S. Federal Reserve’s balance sheet to the extent that the Fed’s reductions are not offset by purchases of dollars by foreign central banks as was the case in January 2018, should provide a sharp headwind to increases in equity prices as the growth in earnings are projected to slow reflecting slower economic growth in the United States and abroad as well as the absence of the one-time growth in earnings effect of the corporate tax cut.. (Recall that the upward trend in equity prices from 2012 through 2017 was interrupted for a few months by the People’s Bank of China reducing sharply the quantity of dollars on its balance sheet.) Third, the slowdown in growth abroad leads to a sharper slowdown in U.S. growth than is now anticipated.
The Bond Market
The bond market had been telling us through 2018Q3 that traders expect an increase in non-residential investment leading to higher productivity and full employment GDP growth based on their reading of the tax bill. Non-residential investment rose more than 6 percent during 2017 – twice the rate of the previous 2 years and the Bureau of Economic Analysis estimate that it is advancing at a 6.8 percent rate during 2018. The expectation for inflation over the next ten years has not changed much since the election. With the 10 year yield dropping below 2.7%, the bond market is telling me that it fears either that trade policy issues will inhibit investment or that we will experience a recession sometime during the next few years.
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 (despite the recent decline) and lower bond prices as these regulatory policies boost productivity, economic activity, and potential output growth (although the President’s immigration and trade policies will dampen the effect on potential output growth). The current controversy over trade policy with China could lead firms to re-assess their investment decisions, could cause a reduction in the rate of growth of productivity, and place downward pressure on the ten-year rate.
Monetary policy decisions are also affecting the ten year yield and are contributing to the sharp increase in volatility as the reduction in the size of the Fed’s balance sheet will affect the equity markets price-earnings (P/E) ratio as well. The Fed not only has discontinued purchasing Treasury bonds and Mortgage backed securities but has become net sellers of these securities as well. This exogenous increase in supply and decline in demand for bonds as well as an expected increase in supply due to increased deficits from the tax bill and the apparent increased spending from the 2-year budget agreement will put downward pressure on bond prices and increase yields. To the extent that the Federal Reserve’s balance sheet normalization reduces the Fed’s balance sheet by more than foreign central banks increase U.S. dollar international reserves, the supply of money as an asset will decline relative to the supply of other assets lowering the price of assets (P/E ratios) relative to the price of money. (It appears that foreign Central Banks failed to offset the Fed’s net sales of securities during October and November so the dollar appreciated and interest rates rose throughout the yield curve.) That is, this is the opposite effect that Quantitative Easing had on asset prices during the past decade. Along with the desire to re-price equities in line with the differential effects on industries and firms induced by the changes in taxes, shocks to dollar money supply that affect the price of assets relative to money have induced the sharp increase in volatility during February-April, and again in November. I believe the possibility of monetary shocks will be with us for the rest of 2018 and most likely for 2019 as well. We should expect the higher volatility (with respect to 2017) to persist. (The Fed re-iterated its balance sheet reduction policy in the September Press Release, raising its rate of decline to $50 billion per month during the October-December quarter from $40 billion per month during July-September.) U.S. dollar appreciation and RMB/dollar depreciation should act as a signal of downward pressure on U.S. equity P/E ratios.
Recent Policy Actions in Washington
One of the positive outcomes of the mid-term elections was the outcome resulted in a split Legislative branch (Republican Senate and Democratic House). Washington activity will focus on allocating the leadership positions in the House and Senate including the Committee leaders and members. Once the leadership positions are resolved, then the Legislative and Executive leaders can decide what issues they might wish to address. Among these issues are infrastructure investment, trade, tax policy, and immigration. Republicans and Democrats are quite far apart on ways to address these issues so it is quite possible that no significant legislation will pass during the 2019 and 2020 Congress. Inaction in Washington is usually good for asset prices.
Of immediate concern is immigration policy. A disagreement over the construction of a border wall has placed the Federal government in partial shutdown. In addition, the Senate must ratify the revisions to NAFTA. There is also a March deadline to resolve trade issues with China. The President and Congress must also resolve their differences in the proposed increase in Federal employee pay. Neither proposal on government pay appears to risk a significant inflation shock. However, twenty states will raise the minimum wage this year. As the state minimum wages approach the $15 to $20 per hour, these levels may begin to affect the wages of Federal employees and pose a significant inflation shock.
The deregulation efforts of the Trump Administration are continuing and are beginning to manifest in a recovery in business investment and the resolution of tax legislation should remove some uncertainty for the policy outlook and give a boost to investment. Uncertainties regarding trade policy may have a negative effect on investment and growth, as may the consequences of the resolution of the negotiations on tariffs. (Tariffs are a tax that re-allocates resources from the private to the public sector and so is a negative for investment, productivity, and growth.).
Monetary Policy: The Return of the Greenspan Put?
The Fed raised its target rate for the Federal Funds rate to a range of 225 to 250 basis points at its meeting on December 19th. The Fed also released a statement indicating that the Fed would continue the process of reducing the size of the balance sheet by reducing its holdings of Treasury securities by $30 billion and that of mortgage securities by $20 billion during January. While during January 2018 the decline in the Fed’s balance sheet was smaller than the monthly movements of U.S. dollar international reserves held on foreign countries Central Bank balance sheets (and equity prices rose sharply), the February decline in the Fed’s balance sheet was augmented by declines (net) in U.S. dollar international reserves on foreign central bank balance sheets resulting in sharp declines in equity prices and an increase in volatility. While these relatively small reductions in the U.S. Federal Reserve Balance sheet during the January to September period had only a relatively small dampening effect on equity prices (save February when actions by the People’s Bank of China drove equity prices sharply lower), and toward a stronger dollar and weaker bond prices, these effects may well be less likely to be offset by movements in the U.S. dollar international reserves of foreign Central Banks as the sales of securities increase. China sharply reduced its holdings of dollar international reserves during December leading to a sharp reduction in U.S. equity prices. These actions by the Fed (and China) yielded a decline in asset prices for the year. At the December meeting, the FOMC lowered its projection for U.S. GDP growth in 2018 to 3.0% from 3.1%, but raised its long-term projection of U.S. GDP growth to 1.9% from 1.8%. Speeches and interviews of FOMC members, as well as the dot plots, indicate that many FOMC members favor as many as two rate hikes during 2019. The market estimate of the probability of a rate hike on January 30th is zero percent. The hike in December means the Fed will have increased the Fed Funds rate by 100 basis points during 2018. The market projects at most one additional rate hike during 2019. The current market estimate implies a 73.4% probability that there will be no rate hike during 2019. If the 10 year rate remains near 2.7%, I would concur with that estimate. Statements by FOMC members indicate that further decisions on the path of the Fed Funds rate will be data determined rather than by a pre-determined path of gradual tightening. The median estimate of the projections by December FOMC members (the dot plots) is 2 rate hikes this year. The FOMC commented in the minutes of the November Meeting that they indeed would study current communications policy in the hopes of developing a more effective strategy.
Recent Asset Market Behavior
Since the election through January 2018, equity markets 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 was an imbalance of buyers to sellers placing upward pressure on equity prices.
Following the Presidential election, long-term (but not short term) interest rates (the 10 year and 30 year) rose substantially (and bond prices fell) but rates retreated and bond prices rallied somewhat during 2017. Ten year Treasury yields rose through 2018 until falling to 2.7% at the end of December and stand roughly 30 basis points above pre-election levels. I believe this outcome was based in part on the belief of faster growth under a Trump administration based on deregulation, increased investment, higher productivity growth and higher inflation. Following a year of strong investment and the passage of the tax bill, I believe 10 year rates will continue to increase barring a recession as the economy responds favorably to President Trump’s de-regulation policies, and the Federal Reserve continues balance sheet normalization and increases in the Federal Funds rate..
Foreign exchange markets have been characterized by an appreciating dollar. The key managed exchange rate countries increased their international reserves a combined $18.4 billion during November. When combined with the Fed’s decline of $50 billion to its balance sheet and increased uncertainty regarding more rapid economic growth abroad, these actions contributed to an appreciation of the dollar and initially a rise in interest rates. An exceptional quarter of earnings reports were not enough to prevent a sharp fall in equity prices. (The dollar was flat during December against major currencies and has appreciated 5.3% since the beginning of 2018.)
The President’s (and Congress’s) Policy Agenda
At this point in time, the President’s focus is on national security, international trade, and immigration issues. He appears to be taking a more aggressive stance on deporting those residents with no or expired immigration documents. He has also tightened the requirements for legal immigrants which has slowed the process and reduced the number of legal immigrants. 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. long-term growth as is his policy on foreign trade. Congress has attempted to address immigration policy this year, but the members of Congress are too far apart on the core issues to craft a bill that will pass. Immigration issues were not a part of the budget agreement. Congress and the Administration are having difficulties resolving their differences on immigration policy. 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 resolving trade disagreements with China. Progress on negotiations with China as well as relations in general with China are not going well. The President is also working to reduce the size of the Federal Government through attrition by not filling vacant positions and restricting pay increases.
Our baseline economic forecast remains the same as last month. Downside risks to the forecast have risen. However, in those countries where some evidence of a slowdown has been reported, our baseline projection includes a slowdown in these regions -- United States, China, and the Euro Area. Financial conditions have worsened with the decline in equity prices. U.S. monetary policy, ex post, may be viewed as too restrictive given the uncertainties regarding full employment growth, productivity, and inflation. (U.S. inflation outcomes have continued to surprise the Fed analysts to the downside.) Tighter U.S. monetary policy, ex post, could negatively affect emerging markets as well as the United States. In addition, the uncertainty regarding the outcome of the BREXIT agreement (or the lack thereof) could have a significantly negative effect on Europe.
Economic growth during 2017 was stronger than most analysts projected at the beginning of last year. The path of oil prices, the depreciation of the dollar, the pace of economic policies abroad, and stronger growth in the advanced economies drove this pickup in economic growth. The value of the dollar, oil prices, and foreign countries economic policies – especially countries’ management of international reserves -- should affect economic growth in 2019 and 2020. With the expansionary U.S. fiscal policy (and I guess overlooking the expected contractionary monetary policy) most analysts expect continued strong world economic growth of 3.7% during 2018 and continued strong growth at that rate in 2019. GDP growth in the United States is projected to be higher in 2018; Russia has recovered due to the rise in oil prices; the recession in Brazil has ended; and economic growth is expected to pick-up an additional 1.0 percentage point per year from its 1.0 percent rate in 2017. At this point in time, risks are reasonably balanced for U.S. growth in 2018, but the risks appear biased to the downside for U.S. growth in 2019 and world growth in 2018 and 2019.
Economic activity in the Advanced Economies is moving above its full employment growth path as the United States, Japan and the European economies finally are experiencing a meaningful recovery from the great recession. Most analysts have raised estimates of growth in the Advanced Economies in 2018 due to stronger data for trade among the Advanced and Emerging Market economies. Relative to the beginning of the year, analysts view greater uncertainty to the foreign outlook due to a stronger dollar, higher oil prices, political uncertainties in Italy, the difficulties in the BREXIT negotiations, and a deteriorating trade policy climate, but have not changed their base case forecasts..
The U.S. economy grew 1.9% (Q4/Q4) during 2016. The U.S. economy grew 2.5% (Q4/Q4) during 2017.). BEA’s (third) estimate of growth in 2018Q3 is 3.4%. This level of U.S. GDP in 2018Q3 is 3.0% above the level of GDP in 2017Q3. The Atlanta Fed’s estimate of 2018Q4 growth (GDPNOW) is 2.7%. The GDPNOW estimate is based on incomplete data reflecting activity in 2018Q4. The consensus forecast for U.S. growth in 2018 is 2.9% and for 2019 is 2.5%, 0.1 percentage points below the FOMC’s projection on December 19th for 2018 and 0.2 percentage points above the FOMC projection for 2019. The U.S. economy should grow faster than potential in 2018 due to continued deregulation, the tax cut, and strong growth abroad. (The Fed has gradually reduced its estimate of full employment growth to 1.9 percent.)
Wage inflation, hence U.S. goods and services price inflation, declined slightly during the past two months reflected in monthly data on the core PCE prices and BLS data on wages and labor costs. U.S. core PCE prices rose 1.9 percent Nov18/Nov17. 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 and should do so again this 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 remain unfilled as employers are unwilling to offer a high enough wage to attract qualified candidates. Labor unrest among teachers indicates upward pressure on public sector wages. Outsized wage increases in the public sector are always a harbinger of future inflation. A further indication of a tight labor market is that job openings are currently greater than the number of unemployed.
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, but have lowered growth forecasts going forward due to persistent political and financial problems among the Southern cones countries, particularly Italy, and have lowered the estimate of growth from 2.4% for 2017, to a growth outlook of 2.0% for 2018, and 1.9 % for 2019.
The estimate for U.K. growth in 2016 is 1.8% and 2017 of 1.7% due to the weaker negative effect of the outcome of the vote to leave the European Union. Economists estimate a negative effect of BREXIT on U.K. growth in 2018, and project 2018 growth at 1.4%, and the 2019 outlook at 1.5%.
Looking at the Advanced Economies as a whole, they are estimated to have grown 1.7% in 2016 and 2.3% in 2017 and are projected to advance 2.4% in 2018, and 2.1% during 2019, largely reflecting lower estimates of full employment output growth.
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 relatively weak thus far. 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 and 2018. China’s economy is slowing from its 7.3% pace of 2014, but there is little consensus on how much they have or will 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 estimated to grow 6.9% in 2017 and projected to grow 6.6% in 2018 and 6.2% in 2019. 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 $31 billion since June of last year and increased $1.5 billion during June, contributing to a depreciation of the RMB with respect to the U.S. dollar. The modest change in China’s reserves and the small increase (net) in the reserves of other managed exchange rate countries has allowed the dollar to appreciate since the end of December 2017. Saudi Arabian international reserves reversed their decline of recent years as the increase in oil prices allowed the Saudis to build reserves by $14 billion during the past year (Octl18 – Oct17).
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 (with the assent of Russia) that it is time for OPEC to increase production to offset the declines in Libya, Venezuela, and Iran. Given the recent weakness in oil prices, the Saudis may well cancel their planned production increase. With tax reform and deregulation, oil production in the United States has partially offset OPEC’s production cuts. OPEC will increase its production in order to regain its market share. 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.
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