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Notes for July Investment Committee MeetingSubmitted by The Wealth Consulting Group on July 10th, 2018
Summary and Conclusion:
Asset prices fell in June driven by Central Bank actions that resulted in a decline in the quantity of dollars, net, on the Central Banks’ balance sheets. These moves by Central Banks offset the effects of a strong U.S. economy (that has yielded strong earnings), despite a rise in the 10 year Treasury bond yield from the levels that prevailed during the last half of 2017. The S&P500 index of U.S. equity market prices declined 1.4 percent during June ending the month roughly 0.4 percent above the level of yearend 2017. The equity market in June maintained the trend of steady growth in asset prices at relatively low volume and volatility that has characterized equity markets over the past several years, save the February – April period when assets were repricing to reflect the changes to relative after-tax earnings due to U.S. Federal tax legislation. The VIX increased to slightly above its low levels of early 2017 in June but still nearly 70 percent above the levels of Autumn 2017 and roughly seventy percent of the levels prevailing from February-April 2018. The yield on 10 year U.S. government bonds breached the 3.0 percent rate during May but retraced some of its rise in June falling back to the 2.8 to 2.9 percent rate. The 10 year yield ended May roughly 10 basis points higher than end April and currently stands at 2.97 percent. The higher level of the 10 year rate, relative to that of autumn 2017, is consistent with a pickup in productivity growth based on stronger investment spending last year, as well as expectations of continued strong investment due to the incentives for investment spending in the recently passed tax bull. The recent decline reflects concerns that a change in trade policies will offset the effects of deregulation and tax policies that have spurred investment and spending growth. I doubt that bond traders are pricing in a significant increase in inflation as only at best a modest increase is apparent in the data. Net sales of Treasury and Mortgage backed Securities by the Federal Reserve and some other Central Banks is also contributing to the rise in the yield on 10 year bonds. The Federal Reserve decided to raise the target range of the Federal Funds rate to a target range of 1.75 to 2.00 percent at its June 13 meeting. (The latest release on core and headline inflation based on the PCE price index registered 2.3% (headline) in May relative to May of 2017 and 2.0% on core (excluding food and energy). The Fed’s target is 2.0 percent inflation on the headline PCE price deflator. (The Fed in its May Press Release emphasized that the 2 percent objective is a symmetric one allowing for some overshoot as well as undershoot of inflation.) The dollar appreciated 0.8 percent against the major currencies -- a level 3.1 percent stronger than its January 2018 reading, but 6.4 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 (- $150 billion) and a decline in the dollar reserves held by the main international reserve holders (-$12.5 billion during the past May) and the continuation of stronger U.S. growth as well as risks of weaker than expected growth abroad.
Equity markets appear to have experienced a regime change in February. After experiencing equity prices trending up with very low volatility during the past 5 years, equity prices have demonstrated much higher volatility with perhaps a downward trend in prices.
I believe the pick-up of volatility during 2018 is due to the passage of legislation on tax reform by both houses of Congress that excludes a capital gains tax cut but produces some clear-cut losers and winners. With tax legislation resolved, at least with regards to capital gains taxes, investors will no longer have the incentive to postpone sales for tax reasons. Thus, we now have a better balance of buyers to sellers. In addition, with the Federal Reserve reducing the size of its balance sheet, 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 will most likely feature higher volatility (due in part to lower liquidity with Central Banks tightening money and credit) and a downward trend in prices. In order for equity prices to rise, firms must experience strong earnings to offset the decline in the price/earnings ratio. To date, strong earnings, produced by a strong economy, has offset the deflationary actions of the central banks. The risk to this scenario is the recent rise in oil prices and the expectation that Russia and Saudi Arabia will also raise production to offset declines in Venezuela, Libya, and most likely Iran. These events may lead Russia and Saudi Arabia to raise their levels of international reserves, offsetting the drawdown in the Federal Reserve’s balance sheet.
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 2018. First, legislation on either a 2nd round of tax legislation to remove some unintended anomalies in the code or explicit health care legislation 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) in the tax bill and then postponed implementation of other ACA taxes (except the investment income tax) in the short-term continuing resolution. Second, a wave election that gives the Democratic Party majorities in both Houses, might well trigger the expectation of tax increases in 2019, and could induce an upsurge in selling. But again, the driving force behind a negative trend in equity prices during 2018 will be 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). (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, an adverse outcome to trade policy negotiations that leads to higher tariffs and interruptions of cross-border supply chains of U.S. resident firms.
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. Non-residential investment rose more than 6 percent last year – twice the rate of the previous 2 years and the Bureau of Economic Analysis estimate that it advanced 10.4 percent during 2018Q1. 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). The current controversy over trade policy with China and NAFTA 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 April and May 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. I believe the possibility of monetary shocks will be with us for 2018 at least so we should expect the higher volatility (with respect to 2017) to persist. (The Fed re-iterated its balance sheet reduction policy in the June Press Release, raising its rate of decline to $40 billion per month during July from $40 billion per month in June.) 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
Washington policy has focused on immigration and trade. Washington has made little progress on either issue, a result that partially explains the reduction in equity price volatility relative to the February-April period. (Shocks cause volatility; government actions are often the most damaging of shocks to the economy.) The Senate will stay in session longer than normal in order to pass the budgets for the individual agencies and confirm Presidential appointments to these agencies. For example, the Federal Reserve has only 3 of it authorized 7 governors confirmed. In addition to legislation authorizing spending for the individual agencies, there is again talk (from th President) of a second tax bill to make the tax cuts permanent and clean up some of the unintended consequences of the language in the original tax act.
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.).
After leaving its policy rate unchanged on May 2, the Federal Reserve decided to raise its target rate for the Federal Funds rate to a range of 175 to 200 basis points at its meeting on June 13. 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 $18 billion and that of mortgage securities by $12 billion during June and then raising this rate to $24 billion of Treasury securities by $16 billion during July. While during January 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 June period had only a relatively small dampening effect on equity prices (save February), 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 during the second half of the year. The balance sheet reduction will have more noticeable effects on asset prices when accumulated over a year, and as the FOMC plans to increase its rate of decline. These actions by the Fed may well yield a decline in asset prices for the year (or at least declines in the P/E ratios) if not offset by increases in dollars held on foreign central bank balance sheets, or by continued strong earnings growth. At the June meeting, the FOMC raised its projection for U.S. GDP growth in 2018 to 2.8% from 2.7%, but maintained its long-term projections unchanged. Speeches and interviews of FOMC members, as well as the dot plots, indicate that many FOMC members favor as many as four rate hikes during 2018. The market estimate of the probability of a rate hike on August 1st is 2.5 percent. The market projects at least one additional rate hike by the end of the year. The market estimates are consistent with the Fed Press Release statement that economic conditions warrant further gradual federal funds rate increases. The median estimate of the projections by June FOMC members (the dot plots) is 4 rate hikes this year. The dot plots at this point in time are a less useful guide to future policy as there could be a substantial change in the voting make-up of the FOMC in 2018 once the three appointed Governors of the Board have been confirmed. At this point in time, the FOMC will has only 8 voters and for the first time in my memory the majority of the voting members will be Bank Presidents. John Williams has taken over as President of the New York Fed (and Vice Chair of the FOMC) for William Dudley and a new President of the San Francisco Fed will be appointed and will be a voting member in 2018. The minutes of the June meeting will be released on July 5 and may be more newsworthy and market moving than the June 13th Press Release and News Conference as the minutes will give greater insight into the probabilities of further rate hikes, balance sheet reductions, and changes in communications strategy. The FOMC announced following its last meeting that it will be holding Press Conferences following each FOMC meeting beginning in January 2019 (thus every meeting will be live.). The FOMC will distribute a Press Release regarding their August 1st Meeting. The Minutes of the August 1st meeting will be released on August 22nd.. Chairman Powell will testify before Congress on its semi-annual monetary policy report during July. His presentations before Congress and before the Press have been well received by the markets thus far. It will be interesting to see how he handles the planned balance sheet reduction if markets experience significant downward movement and higher interest rates begin to slow the economy.
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 is an imbalance of buyers to sellers placing upward pressure on equity prices.
The hope for a repeal of the ACA investment income tax in 2018 has pretty much eroded (but not disappeared); there was no reduction in capital gains tax rates in either the tax reform legislation or the continuing resolution. Since Speaker Ryan announced that he will not seek re-election, it is unlikely that any more significant legislation will be introduced this year. To the extent that repeal of the ACA taxes is no longer credible, volatility and volume has picked up and allowed for an adjustment of prices among winners and losers in the tax reform legislation, as well as an adjustment to P/E ratios due to the Fed’s balance sheet normalization. The price adjustment among winners and losers from the tax reform legislation should be completed for the most part as firms have made their quarterly tax payments and firms and markets should at this time understand the consequences of the tax bill.
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 retreated and bond prices rallied somewhat during 2017. Ten year Treasury yields have risen in 2018 and stand nearly 60 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 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 $3.9 billion during May. When combined with the Fed’s decline of $30 billion to its balance sheet and increased uncertainty regarding more rapid economic growth abroad, these actions contributed to an appreciation of the dollar and a rise in interest rates. An exceptional quarter of earnings reports yielded only a mild increase in equity prices. (The dollar appreciated 0.8% during June against major currencies and has depreciated 6.8 % since the beginning of 2017.)
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 re-negotiating NAFTA and resolving trade disagreements with China. Neither effort appears to be 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.
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 their management of international reserves should affect economic growth in 2018 and 2019. With the expansionary U.S. fiscal policy (and I guess overlooking the expected contractionary monetary policy) most analysts expect a further pickup in world economic growth during 2018 and continued strong growth in 2019. Forecasters see Global economic growth in 2018 and 2019 at 3.9 percent vs. estimated growth of 3.2 percent in 2016 and 3.8 percent in 2017. GDP growth in the United States and Japan are projected to be higher; 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 1.5 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 2018 due to stronger data for trade among the Advanced and Emerging Market economies. Relative to last month, analysts view greater uncertainty to the foreign outlook due to a stronger dollar, higher oil prices, political uncertainties (especially in Italy), and a deteriorating trade policy climate, but have not changed their base case forecasts..
The U.S. economy grew 1.8% (Q4/Q4) during 2016. The U.S. economy grew 2.6% (Q4/Q4) during 2017. BEA’s second estimate of growth in 2018Q1 growth is 2.0% (SAAR). This level of U.S. GDP is 2.8% above the level of GDP in 2017Q1. The Atlanta Fed’s estimate of 2018Q2 growth (GDPNOW) is 4.1%. The GDPNOW estimate is based on incomplete data reflecting activity in 2018Q2. The consensus forecast for U.S. growth in 2018 is 2.9% and for 2019 is 2.7%,, 0.25 percentage point s above the FOMC’s projection on June 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 2.0 percent May18/May17. 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 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 and have raised the estimate of growth to 2.3% for 2017, and the growth outlook to 2.4% for 2018, and 2.0 % for 2019.
The estimate for U.K. growth in 2016 is 1.6% and 2017 of 1.8% 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 1.6%, 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 2.5% in 2018, and 2.2% during 2019.
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. 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 was estimated to grow 6.9% in 2017 and projected to grow 6.6% in 2018 and 6.4% 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 $7.5 billion since April of last year and decreased $17.9 billion last month contributing to a slight depreciation of the RMB with respect to the U.S. dollar. The modest decline 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 Saudi to build reserves $13.3 billion last month and by $7.5 billion during the past year (April18 – April17).
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. 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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