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Note for November Investment Committee MeetingSubmitted by The Wealth Consulting Group on November 15th, 2017
Summary and Conclusion:
Asset prices rose during October. The S&P500 index of U.S. equity market prices increased by 1.9 percent. The VIX fell to its lowest levels of the year in September – well below the levels preceding the election – and remained at these low levels during October. The yield on 10 year U.S. government bonds edged up to 2.34 percent, only slightly below the level preceding the election, when Federal Reserve officials intimated that a rate hike in December is a strong possibility. (The latest release on core and headline inflation based on the PCE price index registered 1.6% (headline) in September relative to September of 2016 and 1.3% on core. (The Fed’s target is 2.0%.) The dollar appreciated 2.0 percent against the major currencies -- a level 6.2 percent weaker than its January 2 reading. I attribute the stronger dollar to a combination of the Federal Reserve’s normalization of its balance sheet (- $10 billion) and a drawdown of dollar reserves by the main international reserve holders (-$3.5 billion during the month) and slightly stronger than expected growth in the United States. The weakness in the dollar during the past year I attribute to the build-up in international reserves during the past year. I believe the lack of volatility and the modest positive direction of the markets since the Presidential election are due to market participants waiting for the resolution of Tax Reform legislation that contains a hoped-for capital gains tax cut, and perhaps the removal of the ACA investment income tax. The bond market is telling us that nothing much has changed with respect to the real economy since President Trump’s inauguration; any decline in the 10 year bond rate is due to lower expected inflation. I believe that Trump’s de-regulation policies will have a positive effect on output (as we have seen in the energy industry), so I think that we will eventually have higher 10 year yields and lower bond prices as these regulatory policies boost productivity and economic activity.
Washington policy officials have made progress on economic legislation. Both the House and Senate have passed budget resolutions. On tax reform legislation, the House Ways and Means Committee is marking up the House version in preparation for a vote in the House as early as next week; the Senate committee is expected to release its version on Thursday (November 9). It is still a bit early to trade on the information released thus far. There is strong opposition to the limitations on mortgage interest and property tax deductions by the real estate industry – a very strong lobby – in the House version. In addition, representatives from high tax states are pushing back on the removal of the state and local tax deduction in the House bill. We do not yet know much about the Senate version. Thus far the bill does not lower the capital gains tax rate nor address any of the Affordable Care Act (ACA) taxes. Speaker Ryan has been ambivalent regarding addressing ACA issues in this tax bill; President Trump would like to address some ACA issues in this bill. Both the House and Senate have indicated that they are willing to address Health Care legislation once again after they have (hopefully) passed the tax legislation. Given the push-back from lobbyists and some legislators, the final bill may be better described as tax legislation rather that tax reform legislation. Congress still must raise the debt ceiling by December 7th – an interesting choice of dates.
President Trump resolved the uncertainty regarding the leadership at the Federal Reserve by appointing Governor Powell to be the next Chairman. While he may receive some hostile questions during his confirmation hearings, tentatively scheduled for early December, I expect him to be confirmed. I expect, as do others, Governor Powell to follow the current monetary policy espoused by Chair Yellen – a gradual increase in the Federal Funds rate and a gradual reduction in the size of the Fed’s balance sheet, at least in the near term through 2008 absent a significant shock. I think Governor Powell will be less supportive of the current regulatory (Dodd-Frank) environment than Chair Yellen – especially as these regulations appear to be burdensome for small- and medium-sized financial institutions. I believe he will work to address easing the regulatory burden on small- and medium-sized financial institutions before addressing the regulatory environment for large financial institutions.
The key difference between a Yellen and Powell led Fed will be the monetary policy reaction to the first significant economic shock. Chair Yellen has a wide base of expertise to consult in making decisions on policy reaction to shocks (as did Chairman Greenspan) in addition to the staff. After all, her husband is a Nobel Laureate in economics. She relied heavily on her own judgement, even over the advice of Stan Fischer, while guiding monetary policy decisions during her tenure. Powell will rely more on the staff (and perhaps a future appointed Vice Chair who will most likely (hopefully?) be a PhD macroeconomist) rather than his own instincts. With Bill Dudley’s departure from the New York Fed (a permanent voting member), there will only be one remaining professional PhD macroeconomist remaining on the Board (assuming Chair Yellen departs) and only one that I am acquainted with among the Bank presidents (Williams, SF Federal Reserve Bank).
A Chairman Powell will more likely follow his own instincts (rather than the staff’s input) on regulatory policy. His instincts at the margin are for less regulation rather than more. Monetary policy has yielded better results when the Chair has been a professional PhD macroeconomist. Regulatory policy has fared better under Chairmen whose backgrounds have been in financial markets. (Recall that Volcker lost all of his battles on regulatory policy during the 1980s.) We should get a better view of Governor Powell’s view of his role as Chairman during his confirmation testimony currently scheduled for early December.
Once Chair Yellen departs, the Fed will be down to three Board members. Thus, the FOMC will have only 8 voters and for the first time in my memory the majority of the voting members will be Bank Presidents.
The President and House and Senate leadership agreed to a continuing resolution on the budget and a suspension of the debt ceiling through December 7. The T-bill market rallied to remove the uncertainty premium in the October contract but inserted an uncertainty premium in the December contract raising the yield and lowering the price.
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. 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. Until the market has a clear view on capital gains taxes, markets will remain in their current low volatility, low volume status.
I still believe the most likely outcome is that sellers will be reluctant to enter the market until there is a resolution of the legislation relative to the capital gains tax rate – the investment income tax in the Affordable Care Act (ACA) and the capital gains tax rate in the personal income tax legislation that is expected to be part of tax reform legislation. (See Becky Quick’s interview with Warren Buffet on CNBC’s Squawk Box on October 4th for confirmation of this hypothesis.) Thus I still see equity markets rising slowly on little volume with a relatively low VIX, at least through November and most likely through December as well. Even with the uncertainty to the policy outlook, 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 health care and tax legislation (legislation or no legislation) should remove uncertainty for the policy outlook and give a boost to investment.
The Federal Reserve left the Federal Funds rate unchanged at 100 to 125 basis points on November 1. The Fed statement indicated that the Fed would continue the process of reducing the size of the balance sheet in November by reducing its holdings of Treasury securities by $6 billion and that of mortgage securities by $4 billion. The Minutes of the meeting, to be released on November 22nd, should give further guidance on the size of this so-called balance sheet normalization going forward. 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. At the September meeting, the FOMC raised its projection for U.S. GDP growth in 2017 to 2.4% from 2.2%, but maintained its long-term projections unchanged. While the median of FOMC members’ projections of the Fed Funds rate at yearend is 1.4 percent, the dot plots indicate that 4 members project a yearend rate of 1.15 percent – the current target rate. I doubt that the FOMC will raise rates with 4 dissents. Recent data on inflation has come in weaker than the FOMC’s September 20 projection putting at risk the prospect of an additional rate increase this year. However, speeches and interviews of FOMC members have indicated that many still favor a December rate hike. Hence, the market has raised its estimate of the probability of a December rate hike to 91.5% from last month’s estimate of 77.9%. If the markets estimate of the probability of a rate hike remains in the 90%+ range, I believe the FOMC will raise the Fed Funds rate in December.
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 and lower capital gains tax rates in tax reform legislation. House members have indicated that they plan to introduce legislation to repeal the ACA taxes on a bill unrelated to health care reform. My explanation for the rally in equity markets, which I assume will continue until tax reform legislation is passed or scuttled, is the perceived high probability that the 3.8 percent net investment income tax will be repealed either in tax reform legislation or an unrelated bill. This perceived 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 current legislation). 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 and implemented. (If the ACA tax is repealed effective 2018, I would anticipate a selloff in January 2018). I believe, net, the effect of the tax reform 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. That said, if firms believe that tax reform legislation will pass this year effective in 2018, we should begin to see firms postponing dividend payments and bonuses until 2018. We don’t yet see any evidence of this behavior, although Warren Buffet implied in his interview with Becky Quick that he may be contemplating such actions.
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 at pre-election levels.. I believe this outcome is 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 raises the Federal Funds rate..
I believe that volatility will pick up once we see more specificity in the content of the tax reform legislation and a better idea of the likelihood and the timing of tax legislation passing. Market participants are now more certain of Federal Reserve interest rate policy in 2017 (a 91.5 percent probability of an additional rate increase in December). The Fed dot plots project 1 additional rate increase during 2017 by 12 of 16 FOMC members – 11 of 15 if we discount Stan Fischer’s vote. The Fed left the Fed Funds rate unchanged at 1.15% at its November 1 meeting. The Fed will release the minutes of the November 1 FOMC Meeting on November 22. These minutes should include additional information regarding the timing and size of its plans for balance sheet normalization.
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. When he returns from his trip to Asia, his focus will be on tax reform 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. President Trump has directed reductions in both financial and environmental regulations. We are hearing little regarding infrastructure investment except for the privatization of Air Traffic Control. 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 contentious issues regarding the Budget and the increase in the Debt ceiling have been pretty much ignored by the financial press. With the poisonous political atmosphere in Washington, smooth reconciliation of both issues is not assured, even though the resolution deadline has been moved back 2 months. A rocky resolution could give markets the jitters – especially bond and credit markets. Thus, December and January could be vulnerable months for the bond and equity markets, especially if market participants know more about the content and the probability of passage of tax reform.
Foreign exchange markets have also remained relatively stable. The key managed exchange rate countries lowered their international reserves a combined $3.5 billion last month. When combined with the Fed’s decline of $10 billion to its balance sheet, these actions contributed to the appreciation of the dollar. (The dollar appreciated 2.6% last month against major currencies and has depreciated 6.2 % since the beginning of the year.)
The path of oil prices and the pace of development policies, especially in China, have contributed to a recovery in 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, but their reserves are still $50 billion lower than in October 2016. 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. Even without the previously assumed fiscal expansion in the United States, most forecasters see 2017 looking stronger than in 2015 and 2016. Growth in Japan is projected to be higher, Russia is expected to recover due to the rise in oil prices and the recession in Brazil is projected to end. 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 Euro Area and Japan. 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 along its full employment growth path. 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 advanced estimate of 2017Q3 growth is 3.0%. The Atlanta Fed’s estimate of 2017Q4 growth (GDPNOW) is 3.3%. U.S. GDP growth during 2017H2 will be positively by perhaps 0.1 percentage point due to the effects of Hurricanes Harvey and Irma. This negative effect in Q3 (lost wages and spending) will be offset by the positive effect in Q4 (repair and reconstruction).
The consensus forecast for U.S. growth in 2017 is 2.2%, a bit below the last FOMC forecast of 2.4%, but above the full employment growth rate given recent anemic readings on productivity. (The Fed has gradually reduced its estimate of full employment growth to 1.8 percent.) I would expect U.S. growth of 2.2 percent during 2017 as the economy receives a boost from deregulation and the hurricanes – especially in the energy sector and construction – which is already manifesting in higher investment. This higher investment should give a boost to productivity and once the uncertainty regarding health care and tax legislation is removed should result in an even higher outcome – around 2.5 percent – for 2018.
Wage inflation, hence U.S. goods and services inflation, declined during the past two months. U.S. core PCE prices rose 1.3% (Sep17/Sep16). 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 but the migration crisis along with the political fallout from the influx of migrants 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%..
Looking at the Advanced Economies as a whole, they are estimated to have grown 1.7% in 2016 and are projected to advance 2.2% during 2017. With a U.S. fiscal stimulus, Advanced Economies are expected to grow 2.0 percent during 2018. Without U.S. fiscal stimulus, Advanced Economies are projected to grow 1.8 percent in 2018.
The Emerging Market Countries growth has been slowing down, but is expected to pick up a bit in 2017. Brazil and Russia have been 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 2016 of 6.7%. China’s economy is projected to grow 6.8% in 2017 and 6.5% in 2018. China’s international reserves declined by $50 billion since October of last year but increased just $1 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 small increases (net) in the reserves of other managed exchange rate countries has allowed the dollar to depreciate since the end of December. Saudi Arabian international reserves continued to decline at a steady pace and have dropped by $60 billion during the past year (October17 – October16).
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. 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. Thus far, U.S. shale production is offsetting much of the effects of OPEC cuts in production.
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 has offset some of the positive effects of investment to productivity growth.).
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. 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 the low rate of potential output growth, it is more likely that a significant shock will push the economy into a recession. One 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 as the FOMC continues 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.
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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