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Note for February Investment Committee MeetingSubmitted by The Wealth Consulting Group on February 26th, 2019
Summary and Conclusion:
Asset prices rose in January following Federal Reserve statements indicating a pause in increases in the Federal Funds rate and a more flexible policy on balance sheet reduction – reversing the more hawkish sentiment expressed at Chairman Powell’s December 19th Press Conference. In addition, participants in the U.S.-China trade negotiations expressed more optimism that an agreement would be reached by the March 1st deadline.
Following the January Federal Open Market Committee (FOMC) meeting, asset prices rose as the FOMC assessment indicated a pause in increases in the Federal Funds rate and further changes in the Fed Funds rate would be data dependent. The market now sees no rate increases during 2019. However, the Fed has maintained its balance sheet reduction at $50 billion per month, but stated that they would be reviewing its balance sheet normalization policy with an emphasis on the size of the balance sheet once normalization is completed. Asset prices began to reverse course in early February as markets digested balance sheet normalization news and a more pessimistic outlook for U.S.-China trade talks.
The S&P500 index of U.S. equity market prices rose during January ending the month roughly 8 percent above the end December level and roughly unchanged from the level of yearend 2017. During January the equity market exhibited a steady increase in asset prices at low to moderate volume, but at the lower volatility that characterized equity markets over the July – October period when asset prices were rising gradually during a period of ample liquidity. 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. During January, the trend of asset prices reversed on the changes in Fed policy and a more positive outlook on U.S.-China trade. The lower level of the 10 year rate, which has dropped below 2.7%, is consistent with the general assessment of a slowing world economy during 2019 and 2020 and a tamer inflation outlook relative to that of November. 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 2018 might push the S&P500 lower. Net sales of Treasury and Mortgage backed Securities by the Federal Reserve and some other Central Banks might also contribute to an uptick in the volatility in asset prices if foreign central banks refrain from increasing their levels of international reserves as a move from net purchases to net sales would reduce liquidity in the market.
The Federal Reserve decided to leave the target range of the Federal Funds rate unchanged at a target range of 2.25 to 2.50 percent at its January 30th 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 depreciated 1.6% during January against the major currencies reflecting the change in monetary policy -- a level 3.7 percent stronger than its January 2018 reading, but 5.2 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 (- $470 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 February at the same rate as during January. The Fed, according to Chairman Powell, is in the process of reviewing the program. John Williams stated 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, 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 2019 and most likely for 2020 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 January Press Release, maintaining its rate of decline to $50 billion per month during the January-March quarter. U.S. dollar appreciation and RMB/dollar depreciation should act as a signal of downward pressure on U.S. equity P/E ratios. (The rise in equity prices during January was accompanied by U.S. dollar depreciation and RMB/dollar appreciation.)
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). The Legislative and Executive leaders are in the process of deciding 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 tax policies so I don’t believe any tax legislation will gain traction until 2021. Congress should vote on the revised NAFTA soon and it should pass. Some discussions should take place regarding infrastructure and immigration. 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. 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.).
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..
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.
As the calendar announces the beginning of a new year, economists start to revise their forecasts of the year ahead and take a more serious look at 2020. Our baseline economic forecast is characterized for a weaker outlook for 2019 and 2020 although the estimate of 2018 remains unchanged. Downside risks to the forecast have risen. These risks include an escalation of trade tensions leading to significantly slower growth in China, the high levels of public and private debt, a no-deal, hard BREXIT, and the risk of worsening financial tensions in Italy and Turkey that could spread to other excessively indebted countries. 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 moderated with the rebound 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.
Global economic growth during 2018 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 estimate continued strong world economic growth of 3.7% during 2018. Analysts project global growth to slow to 3.5% in 2019 (down from their forecast at this time last year) and to pick up to a slightly stronger growth rate of 3.6% in 2020. GDP growth in the United States is projected to be lower in 2019; 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 moved above its full employment growth path as the United States, Japan and the European economies finally experienced a meaningful recovery from the great recession. Most analysts have projected a gradual decline in growth in the advanced economies from 2018 to 2020, consistent with a return of economic growth closer to potential. Relative to the beginning of 2018, 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.
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 (because of the shutdown) 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 2019 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.) The Bureau of Economic Analysis will report its current estimate of 2018Q4 U.S. GDP on February 28th.
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 2.4% rate in 2017. 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 1.8% for 2018, 1.6 % for 2019, and 1.7% for 2020.
The estimate for U.K. growth in 2017 is 1.8% and 1.4% for 2018. Analysts project U.K. growth of 1.5% in 2019 due to the negative effect of the outcome of the negotiations to leave the European Union. Economists estimate a negative effect of BREXIT on U.K. growth to dissipate a bit in 2020, and project 2020 growth at 1.6%.
Looking at the Advanced Economies as a whole, they are estimated to have grown 2.4% in 2017 and 2.3% in 2018 and are projected to advance 2.0% in 2019, and 1.7% during 2020, 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, but is expected to pick up significantly this year and next. 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 2017 of 6.9%. China’s economy is estimated to grow 6.6% in 2018 and projected to grow 6.2% in 2019 and 6.2% in 2020. China’s economic activity was boosted by policies designed to make the Party look good during the 2017 Party Congress. China’s international reserves decreased by $97 billion last year and increased $11 billion during January, contributing to a depreciation of the RMB with respect to the U.S. dollar during 2018 and a slight appreciation in January. 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 $1.9 billion during the past year . The bright spot in the Emerging Market outlook is India. India is estimated to have grown 6.7% in 2017, 7.3% in 2018, and is projected to grow 7.5% in 2019 and 7.7% in 2020.
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 decrease production to offset the declines in demand due to slower global growth. 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 less dire than communicated in the media. I believe that U.S. growth will remain above its potential rate, due to the response of investment to deregulation policies and hopefully will continue with a removal of uncertainty around trade and immigration 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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