Does the most dramatic change in the Federal Reserve’s policy outlook indicate a change in the economy?
Prior to December 1, the Fed had widely broadcast that it intended to raise it benchmark rate 3 more times in 2019. At the December meeting, they lowered that to 2 times in 2019. In January after the horrid December stock market fall, the Fed changed once again, removing expectations of further rate increases.
The Fed has claimed to be data-dependent and the major economic data points have been indicating slowing growth for most of 2018, and more so since Q2 2018. The Fed may have realized it overtightened, having raised the Wu-Xia Federal Funds Shadow Rate (Atlanta FRB) by more than 5%. This was the fastest rate of increase in almost 40 years.
Now the Fed’s balance sheet normalization plan is being questioned and pundits are calling for an early cessation. In November 2017 the median targeted estimate for the Fed’s balance sheet was just under $3 trillion. The balance sheet peaked at $4.5 trillion and is currently a tick under $4T. At the beginning of 2008 it was $800 billion.
So, from a target Fed Funds rate of 3% and Fed balance sheet of $2.75T, to a ‘normalized’ rate of 2.25% and a Fed balance sheet of $4 trillion. The last few recessions we have seen the Fed raise rates right into economic weakness, only to cease then ease as the recession begins. With that kind of track record its no wonder people believe the Fed to either be behind the ball, or the outright cause of recessions.
The irony is that the US may have crossed the Rubicon regarding diminishing returns from cheap credit (low rates) aka velocity of money. While over the past 40 years we have lowered the cost of credit to induce consumption, each recession we must lower the rate below the previous recession lows. And while we ramp up credit expansion to boost the economy (borrowing more and spending more today) each time, we are getting less and less growth for each dollar borrowed/spent (velocity continues to decrease). And when there is low velocity, in order to create growth, exponentially larger amounts of money (credit) are required.
I have seen a few reports discussing the idea that low rates decrease future potential growth. Essentially low rates fail to attract capital, reducing investment, reducing future productivity gains which reduces overall growth.
We have seen the Fed essentially stop tightening (balance sheet runoff should continue to at least this summer) the next step will be for the Fed to ease again, indicating a recession has begun.
Selected Index Returns Year to Date/ 2nd Quarter Returns
Dow Jones Industrials -.73%/1.26% S&P 500 2.65%/3.43%
MSCI Europe -3.23%/-1.27% Small Cap (Russell 2000) 7.66%/7.75%
Emerging Mkts -7.68%/-8.66% High Yld Bonds .08%/1.0%
US Aggregate Bond -1.7%/-.17% US Treasury 20+Yr -2.66%/.07%
Commodity (S&P GSCI) 5.47%/4.09%
The second quarter ended with a sharp decline from the mid-June highs, with US stock indexes retreating about 4.5% and ex-U. S markets losing upwards of 6%. This pulled year-to-date returns back close to zero in the broad stock market indexes. The only areas doing well on a year to date basis are US small cap and the technology sector. Equity markets outside the US are in the red year to date languishing under the burden of a strengthening US Dollar and the constant threat of a tit-for-tat Trade War. Areas of the market with exposure to global trade (US large cap, emerging markets, eurozone stocks) have had marginal performances while areas perceived to be somewhat immune to concerns about a Trade War have fared better.
Additionally, the bond market has only recently seen a slight reprieve as interest rates have eased as economic data has consistently come in below expectations—still expanding, but not expanding more rapidly. Job creation, wage growth, and GDP growth all continue to expand but only at a similar pace that we have seen over the past several years. The stronger US Dollar has wreaked havoc on emerging market bond indexes have fallen by more than 12% year to date. And in the U.S., investment grade bond prices have fallen by more than 5% year to date, hit by a double whammy of higher interest rates and a widening credit spread (risk of default vs. US treasuries) has edged up.
On the bright side, per share earnings continue to grow more than 20%, with second quarter earnings expected to climb more than 20%, thanks in large part to the Tax Reform passed late in 2017. As earnings have climbed and prices remain subdued, the market Price to Earnings ratio (P/E) has fallen making the market appear relatively less expensive and sentiment as measured by the AAII (American Assoc. of Individual Investors) has fallen from near 60% bullish on January 4th to 28% on June 28th, a level equal to the May 3 reading when the February-April correction ended. The Dow is approximately 800 points higher than the May 3 intraday low.
With reduced bullishness, increasing earnings, and expanding (albeit slow) GDP growth, there is room for equities to move up. Bonds too have a chance for gains. The meme of Global Synchronized Growth which justified the November-January run in stock prices and interest rates has all but died, given Europe’s frequent economic data misses and Japan’s negative GDP print in the first quarter. This has taken pressure off interest rates and allowed the US 10-year Treasury yield to fall from a high of 3.11% on May 15 to 2.85% at quarter end. I would not be surprised to see the 10-year yield fall further in the coming weeks. Muted economic data with solid earnings growth would be beneficial to bonds and stocks respectively.
In my January Outlook I mentioned how the rise in ex-US stock markets followed closely the decline in the US Dollar. The Dollar bottomed in late February and has gained dramatically since April. This has been a weight around European and emerging market share prices and has been at the core of the emerging market debt problems mentioned above. Fortunately, the Dollar’s climb has lost momentum and appears ready to pull back, likely offering a reprieve to shares priced in currencies other than the US Dollar. It may also aid in US company earnings. So, while global economic and market conditions have changed since January, hindering prices of most assets, I believe we will see an echo of the 2016-2018 conditions that supported financial asset prices globally. A declining dollar, muted investor bullishness, slowing global growth all should conspire to allow stock, bond and even precious metal prices to rise over the coming weeks, at least until investor bullishness gets well above average and the expectation of new lows for the US Dollar become entrenched again.
As second quarter earnings begin in earnest in mid-July, expectations are for approximately 20% climb in earnings. A large portion is estimated to be due to tax reform passed late in 2017. With market prices subdued and earnings climbing, the market’s valuation (Price to Earnings ratio) is looking more attractive. While not cheap by any metric, this should give investors a reason to put money to work. In the first quarter, analysts underestimated profits and had raised estimates all the way into the start of earnings season. This is very rare. The chart below shows us that generally analysts’ estimates decline going into earnings season. Estimates start off high and then get lowered multiple times usually. Second quarter of 2018 is setting up to be another rare event where we see again earnings estimates being raised into reporting season.
The downside to the effect tax reform is having on earnings will be seen in 2019. When comparisons to 2018 and 2019 quarterly earnings start to come out (in late 2018) the impact of lower taxes on the change in earnings will be gone. In 2019 we will only see the change in earnings without the impact of tax reform. Earnings growth will likely come down to the upper single digits. How investors feel about this dramatic slowing in 2019 will dictate the path of stock prices.
Quantitative Tightening (QT) will dominate the headlines towards the end of the year. Over the past 9 years central banks have pumped more than $12 trillion in liquidity into financial markets. The US Fed stopped adding liquidity and has begun to let its balance sheet shrink, removing liquidity from financial markets. During 2017 and 2018 the European Central bank and Bank of Japan more than made up for the US absence. Europe and Japan are scheduled to reduce and eventually cease all new liquidity injections during 2019. Combined with the Fed’s liquidity reductions, global financial markets will see a net reduction in liquidity. This will have an impact on markets. It is argued whether this will cause bond prices to fall (rates to rise) or it will have an impact on equity markets. I believe it is likely this will impact both areas and the likelihood of falling bond and stock prices at the same time is significant.
US Dollar liquidity is another topic just starting to show up in the press. The rise in 2018 of the US Dollar after a long decline has taken many market participants by surprise. The “short US Dollar” and “short Treasury” trades were the most popular at the beginning of the year and have been upended. It is often that once ‘everyone’ knows something, like that the US Dollar will continue to weaken, its about the time that area reverses and goes against how most are positioned. The mystery really was given rising interest rates in the US and a stronger economy, why was the US Dollar weak to begin with? Now the causes of a stronger Dollar are the weakness in Eurozone and Emerging market growth. But which came first, the stronger Dollar or the weaker economies?
Below we can see the relationship of the US Dollar (UUP) and the TED Spread which is the difference in short term rates in the US and Europe. The recent spike in funding costs (rates) parallels the rise in the Dollar index. The rapid Dollar rise in 2014 was partly responsible for the Earnings Recession we saw in 2015. There’s about 6 months to a year lag from when the Dollar strengthens to its impact on earnings.
Ironically, part of the Tax Reform passed is a cause of poor Dollar liquidity (higher short-term rates result) and the strengthening Dollar. The ability for US firms to repatriate earnings from abroad at a lower tax rate is causing Dollars to move from Eurozone back to the US. Additionally, the $1 trillion plus budget deficit the US will run in 2018 and on into the future is also soaking up liquidity. Repatriation, US deficits, and Fed tightening are all pushing the US Dollar up, and will likely see the Dollar stronger in 2019, which may impact US earnings in 2019.
Finally, there is China. China is the largest consumer of raw materials. Besides US PMI, the China Credit Impulse impacts base metals and other raw materials that other emerging market economies export. When China is creating more, new credit we can see a rise in prices and in the growth of raw material exporting countries and a rise in US PMI with about a 12-month lag. The chart below indicates that beyond the first half of 2018 the impact from the past China impulse will be fading. This fade is happening at the same time global Central banks will be withdrawing liquidity and the US Dollar likely strengthening. This scenario doesn’t bode well for risk assets in 2019.
Stocks rose a fraction of a percent, gold fell 1%, and the bond index fell 1% in April, continuing the very choppy sideways price movement we’ve experienced this year. The month ended just below middle of the price range we’ve seen since the market top on January 26th.
Over the past few weeks, earnings have been spectacular, growing over 20% on an annual basis. Unfortunately, stock prices have not reacted well to this great news. Earnings season appears to have a ‘sell the news’ feel to it. This could support the notion that stocks were priced to perfection going into reporting season. The decline in prices and increase in earnings has reduced the market P/E (Price to Earnings) multiple, which could allow stocks to rise back to January levels. Tax Reform has accounted for about 1/2 of the earnings growth. There are two issues going forward. One is that continuing
to grow at that pace will be difficult since we cannot cut taxes every year (and the tax changes to individuals are front loaded—the reductions we have seen will fade in the coming years). Secondly, earnings’ growth slowing, even from 20% to maybe 12%, can be seen as a negative: “slowing earnings growth”. Surprising positive economic data because of tax reform needs to show up immediately, otherwise, the ‘hope’ baked into stock prices may be removed in the coming months.
Through the month of April, the narrative of ‘global synchronized growth’ has changed as European economic data has come in softer than expected and the US economy has pressed on. So now we see the US as a main driver of global growth. In the very short term, this narrative change has given the US Dollar a boost up. Over the past few months, ‘dollar short’ and ‘rates higher’ have been very popular trades and have begun to unravel. A stronger dollar will do harm to future US corporate earnings, make $-denominated emerging market debt more difficult to pay back, and serve as a headwind to ex-US assets (emerging, Asian and European stocks and bonds). And slower growth will not support higher rates for longer term bonds.
The change in the growth narrative/data has been substantial enough for the Federal Reserve to remove from its FOMC Statement, “The economic outlook has strengthened in recent months.” Often the Fed will change a word or two in certain sentences. They could have change it from ‘strengthened’ to ‘remains strong’ or ‘continues to expand’. Instead they dropped it altogether. This is influencing perceptions of how many times more this year the Fed will raise short term rates. In the WSJ today the front-page headline, “Fed is On Course for Rate Increases”. Given the boldness of this headline, its odd to see in the article an inference that even if inflation was stronger, the Fed wont raise rates more than already indicated, which is twice more this year. There is a dichotomy in the Fed’s statement: taking out the growth story but keeping to the idea that rising inflation is OK, or even good. Last time I checked, slowing growth and rising interest rates weren’t a good combination: stagflation. The Fed needs to review the difference between ‘cost-push’, and ‘demand-pull’ inflation.
AAII sentiment for the week ending May 2 came out this morning and Bullishness declined, and Bearishness increased. This is as expected given that stocks were down over those survey days. Bullishness isn’t quite as low as I’d like to see for a good bottom, but if stocks can undercut February’s lows, we should see Sentiment get negative enough to support a rally in stock prices going into the late Spring.
First quarter of 2018 turned out much differently than investors had been expecting at the turn of the New Year. In January’s note, there were many sentiment indicators that had eclipsed their all-time highs. The highest percentage of investors expecting higher prices in twelve months was recorded. Equity markets peaked on January 26 and fell 12%, followed by a large bounce into mid-March then subsequent decline that left us at quarter end about 4% above intraday lows from February. We may be seeing the first stages of the end of the 9-year-old bull market. Looking back at 2007 and 2000, the topping process can be choppy with market gyrations of +/-10%. This is a complete 180 degree turn from the past two years where volatility was non-existent and equity markets went the longest period ever without a 5% decline. Expect continued choppiness as the impact of Tax Reform filters through the economy and if corporations can continue the blistering pace of earnings growth going forward. At the same time for mostly the same reasons, interest rates are likely to be range-bound. Very recently the price of oil climbed on a news release that the Saudis would like to see $80/bbl oil. Rising oil prices would be akin to a tax on consumers and hamper US growth.
Sentiment as seen by the AAII % bullish rolling 8-week average has declined from its euphoric high at 49% in January, down to 33%. At the bottom of the last correction in early 2016 this average was 23%. The current correction may be over and a lot of selling pressure has been exhausted there is room to the downside still. A reading in the mid 20% has been a good area to mark a low in the markets. Sentiment is often a lagging indicator. Investors are most enthusiastic after large price gains. The opposite is true too in that sentiment numbers go low after a price decline. It can be helpful to take a contrarian view as sentiment measures move to extremes.
Blame for the downturn in January was due to a slightly hotter than expected print of Average Hourly Earnings (AHE), and the resulting concern over how quickly the Fed will raise interest rates. The rapid change in AHE has not followed through into February and March, yet stocks remain well off their highs. Analysts have been looking for wage pressures due to very low unemployment numbers for a long time. The lack of wage growth is likely to the re-entrance of discouraged workers back into the labor force. As a discouraged worker, who ‘hasn’t looked for work in the past month’, they are removed from the workforce. When the number of unemployed decreases (the numerator) along with the total workforce (the denominator), the unemployment percentage rate goes down. A low unemployment rate at the same time there is little wage pressure is due to the workforce participation rate being very low. Focusing on the total number of people employed, which is still growing on a year over year basis, may give us a better read on employment situation without looking at the unemployment rate. Any impact from Tax Reform should show up in an acceleration of year over year Total Employees growth.
A more telling chart, and perhaps the real reason behind President Trump’s fiscal stimulus is the following chart. Using the same raw data that created the above chart, the chart below tracks the monthly, year over year percentage change in total nonfarm employees in the United States. There are no seasonal adjustments etc. While we are growing, the rate of increase in the total number of people working, is slowing.
Forward guidance from companies will be critical. Expectations are still quite high regarding full year earnings and end of year price target for the S&P500, currently about 3000, 15% higher than todays price level. During the first quarter, when earnings from Q4 2017 were reported, companies beating earnings estimates were rewarded only slightly, while companies missing earnings had their stock prices pushed down. It seems there is still a ‘priced to perfection’ hurdle that companies must overcome.
The largest macroeconomic driver for the remainder of the year is the now global shift from QE (quantitative easing) to QT (quantitative tightening). This global liquidity spigot the Central Banks have been running on full blast for the past 9 years has begun to end. The US Federal Reserve stopped buying bonds (adding dollars to markets) and began raising rates. These are tightening liquidity. While in 2017 the European and Japanese central banks more than made up for the Federal Reserves actions, both have been broadcasting plans to temper their liquidity injections. China is tightening as now in preparation for increased stimulus to coincide with the Communist Party’s 100th anniversary in power in 2021.
Over the past 9 years global liquidity additions has been the key driver to global asset prices. As these additions slow and become subtractions, one must assume it will impact financial markets. Most importantly global US Dollar-liquidity is the most important as the Dollar is the global reserve currency. Recently the LIBOR-OIS has been in the news, having risen dramatically over the past few months. This index is a rate that compares the overnight cost of interbank dollar borrowing in the US vs Europe. The cost to borrow US Dollars in Europe has gone up dramatically. A low cost would reflect ample Dollars for those who need them, a higher cost reflects a shortage of dollar-liquidity. The TED Spread compares the interest rate on 90-day treasury bills and the 90-day LIBOR rate. The TED spread is 90-day rates and the LIBOR OIS is overnight rates, and they follow each other closely. The crux of it that they both measure the availability of funds in the money markets. If these rates go up, it is seen as a decrease in available funds.
The chart above tracks the TED spread and the US dollar. The relationship is loose but fits well over multiple quarters. If this relationship is correct, the US dollar should dramatically increase in value in the coming months. An increase in the US Dollar will push the prices of non-US assets lower, make dollar denominated debt widely used in emerging markets more difficult to pay back and have further repercussions in debt markets. A weak US Dollar is the underpin of global asset prices, and a stronger dollar, along with Quantitative tightening will be a strong headwind to asset prices in the second half of 2018. If earnings can continue to growth strongly and more workers can be added at a strong pace, both leading to more credit growth, this headwind may be able to be offset.
In addition to international money market rates, the slowing velocity of money has been a constant impediment to economic growth. Or, rather, the low velocity of money is indicative of an economy that continues to languish despite massive amounts of new money put into the system. If the pace of money flowing through the economy slows, GDP can be increased by putting more money into the system. More money moving slowly can be like a small amount of money moving quickly. If money is removed from the system via tightening measure from central banks, and we do not see an increase in the velocity of money, GDP will decline. The slowing of VoM has been a problem since 2000 and is likely directly related to ‘why’ the Fed keeps rates extremely low for very long periods of time. Of course, if VoM were to return to 1960’s levels, interest rates would be substantially higher, causing a re-pricing of all assets—which is a topic for another day.
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Over the past week, the Dow fell by 4%, more than halving its ytd gains through Friday 1/19 (all time high). Bonds continued the decline started in mid-December, bringing losses during the current ‘bond rout’ to -5.7% year to date. That is a one week decline in the Dow of 4% and a four-week decline in long-bond prices of 5.7%. Balanced investors have seen stocks gain and bonds lose, putting most investors (moderately conservative to moderately aggressive) at a mild gain or loss so far this year. Generally, diversification across asset classes reduces volatility when bonds go up, stocks generally are weaker and vice versa. When the classes move together differentiation across risk profiles diminishes. Stocks remain in a strong uptrend and given the substantial gains over the past few months, equity centric investors should be able to take this in stride (or they shouldn’t be equity-centric) as 4% is a small blip in a strong multi-quarter uptrend awash in investor optimism, all-time low cash levels, all-time high exposure to stocks and financial assets and expectations of higher wages, earnings and GDP growth. In this light, a rebound, or ‘buy the dip’ would not be surprising. The new feature though is that volatility has returned.
The ‘bond rout spilling into equities’ explaination has to do with relative attractiveness. If rates keep rising, bond prices are hurt, while becoming more attractive (due to higher yields) to equity investors, putting pressure on equity prices. At some point, earning safe interest attracts enough investors from stocks to weaken stock prices. The S&P 500 dividend yield is now 1.8%, similar to what can be found offered on 18 month CD.
Rate have climbed due to rising inflation expectations. Inflation is expected to, finally, exceed the 2% goal set by the Federal Reserve ‘in the coming months’. Current thinking is that a tight labor market is pushing AHE (average hourly earnings, +2.9% Jan ’18 vs Jan ’17), combined with more take home pay (via tax reform), will result in more spending from consumers and investment from business. This will take time but markets have already priced it all in. Just like the stock market has priced in exceptional earnings growth to match its exceptional valuations. The chart below shows us that we’ve been in a tightening labor market for years without being able to hold above 2.0% inflation but briefly.
Given the new feedback loop between stocks and bonds, perhaps we shouldn’t be so excited about inflation, even if its ‘good’. On the bright side, the past few years has seen 3.25% as a top in 30yr bond yields and perhaps a decline in rates near term may help both bond holders and stock investors alike.