- About WCG
- Our Team
- Our Services
- Account Access
Notes for May Investment Committee MeetingSubmitted by The Wealth Consulting Group on May 15th, 2018
Summary and Conclusion:
Asset prices rose in April, despite a rise in the 10 year Treasury bond yield. The S&P500 index of U.S. equity market prices rose 2.5 percent during April ending the month near the level of yearend 2017. The increase during January 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 remained at its lows of November/December -– levels well below those preceding the election and during the beginning of last year. During February and March, asset price volatility more than doubled and the trend in prices switched from steady increases to volatile declines. During April, volatility returned to historical levels, but those levels were 50 percent higher than those experienced during the last half of 2017. The yield on 10 year U.S. government bonds edged up to 2.7 percent during January, moving above the levels preceding the election. The 10 year yield climbed another 20 basis points during February and March before dropping 15 basis points at the end of March to 2.75 percent. The 10 year yield rose another 25 basis points during April before declining to 2.95 percent. The higher level of the 10 year rate 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. 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 leave the target range of the Federal Funds rate unchanged at a target range of 1.5 to 1.75 percent at its May 2 meeting. (The latest release on core and headline inflation based on the PCE price index registered 2.0% (headline) in March relative to March of 2017 and 1.9% on core. The Fed’s target is 2.0 percent. (The Fed in its 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 0.3 percent against the major currencies -- a level 9.4 percent weaker than its January 2017 reading. I attribute the weaker dollar since January 2017 to a combination of the Federal Reserve’s normalization of its balance sheet (- $120 billion) being more than offset by an accumulation of dollar reserves by the main international reserve holders (+200.1 billion during the past 12 months) and slightly stronger 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 will likely produce 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.
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.
Effect of Possible Shocks on Asset Prices
There are two 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.)
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 6 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 offset the Fed’s net sales of securities by adding a similar amount of dollars to the to the size of their international reserves. 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 in early February. I believe the possibility of monetary shocks will be with us for the next two years at least so we should expect the higher volatility (with respect to 2017) to persist. 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 officials made some progress (using the term loosely) on economic legislation. Both the House and Senate and the President signed a budget for 2018. The parties were able to pass the budget bill by increasing spending of the military (for the Republicans) and raising outlays on domestic programs (for the Democrats). 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. Both houses passed a short-term continuing resolution that postponed implementation of the ACA taxes (except for the ACA investment income tax). The net effect of the budget and tax legislation is to increase the budget deficit and place even more upward pressure on bond yields as Central Banks switch from net purchasers to net sellers of short-term paper and bonds. Congress is also planning to pass another tax bill to fix some technical glitches in their previous bill. This bill may include a provision to make the personal tax cuts permanent.
With the differential effects of the tax bill on different industries and companies, the markets will exhibit greater volume and volatility as traders re-price equities to reflect changes in after tax earnings and lower PE ratios. 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. 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 trade policy may have a negative effect on investment and growth.
After raising its policy rate on March 21, the Federal Reserve decided to leave the target for the Federal Funds rate unchanged at a range of 150 to 175 basis points at its meeting on May 2. 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 May and June. 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 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 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 March meeting, the FOMC raised its projection for U.S. GDP growth in 2017 to 2.7% from 2.5%, 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 three rate hikes during 2018. The market estimate of the probability of a rate hike on June 13th is 95 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 March 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 could be a substantial change in the voting make-up of the FOMC in 2018 relative to 2017. In addition, now that Chair Yellen has departed, the Fed is down to three Board members. Thus, the FOMC will have only 8 voters (as Marvin Goodfriend and Rick Clarida have not yet been confirmed) and for the first time in my memory the majority of the voting members will be Bank Presidents. John Williams will be taking 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 will be appointed and will be a voting member in 2018. The Fed will release a Press Release, forecast update, dot plots, and hold a press conference following the June 13th meeting. The minutes of the May meeting will be released on May 23. Chairman Powell’s 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 further significant downward movement and higher interest rates begin to slow the economy.
I recommend that wealth managers work with their clients to re-balance their portfolios (once the extreme volatility subsides) 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 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. 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. (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 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 initially appeared to me that real estate investments would be hit hard, but the most lucrative of their tax breaks remained in the final bill (although they were axed in the initial drafts). Fertilizer production rather than sausage making is probably a better description of the current U.S. legislative process..
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 65 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 decreased their international reserves a combined $18 billion during March. When combined with the Fed’s decline of $20 billion to its balance sheet and more rapid economic growth abroad, these actions contributed to a relatively stable dollar, but a decline in equity prices and an increase in volatility. (The dollar appreciated 0.3% during April against major currencies and has depreciated 9.5 % 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. At present, his focus is on trade agreements and dealing with immigration issues. 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. long-term growth as is his policy on foreign trade. It is expected that Congress will address immigration policy this year, but the immigration issues were not a part of the budget agreement. Congress and the Administration are having difficulties resolving their differences on immigration policy. So the prospects for immigration legislation appear slim 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 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.
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.
The U.S. economy grew 1.8% (Q4/Q4) during 2016. The U.S. economy grew 2.6% (Q4/Q4) during 2017. BEA’s first estimate of growth in 2018Q1 growth is 2.3% (SAAR). This level of U.S. GDP is 2.9% 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 very little 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 March 21st. The U.S. economy will likely 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 1.9 percent Mar18/Mar17. 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.
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 is estimated to grow 6.9% in 2017 and 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 $113.1 billion since March of last year and increased $8.3 billion last month contributing to a slight depreciation of the RMB with respect to the U.S. dollar. The modest increase in China’s reserves and increases (net) in the reserves of other managed exchange rate countries has allowed the dollar to appreciate since the end of December 20176. Saudi Arabian international reserves continued to decline at a steady pace and have dropped by $19.7 billion during the past year (February 18 – February 18).
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 likely 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.
The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
International and emerging market investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.
Stock investing involves risk including loss of principal.
The payment of dividends is not guaranteed. Companies may reduce or eliminate the payment of dividends at any given time.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
Government bonds and Treasury bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.
The fast price swings in commodities and currencies will result in significant volatility in an investor’s holdings.