The Weekly Economic & Market Recap
March 24, 2017
The financial markets have been keenly focused on the progress of the Obamacare replacement bill constructed by Speaker Paul Ryan, and championed by President Trump, that has struggled to find enough support to pass a predominantly Republican House. The difficulty that the Republicans have had on repealing and replacing Obamacare has made many observers question their ability to accomplish tax reform in a reasonable timeframe. While this has the potential to have meaningful short-term market implications, we are also watching China’s reaction to last week’s Fed rate hike. Rate increases by the Federal Reserve put pressure on China to also increase rates to support the yuan. The yuan has been eroding against the dollar since the middle of 2014. The Chinese have spent roughly 1 trillion dollars in foreign reserves in an attempt to support the yuan. Additionally, as China cuts back on infrastructure spending in an effort to transition toward a more consumer-led economy, it is counting on the private sector to ameliorate the economic slowdown. Rising rates would be an impediment to private sector growth. Although the Chinese have raised some secondary rates after the Fed hike, they have left the benchmark 1-year lending rate unchanged. We think China’s reaction to rising short rates in the U.S. has very important implications for financial markets.
March 17, 2017
Monetary policy was in the headlines this week with the FOMC announcing a 25 basis point (bp) rate increase in the Fed funds rate on Wednesday afternoon. Markets had accurately priced in the 25 bp increase, but were surprised by the lack of a hawkish tone. The FOMC reiterated their guidance of two more 25 bp rate hikes in 2017 even though headline inflation has moved close to the Fed’s target. The Fed pays considerable attention to core Personal Consumption Expenditures (PCE) and according to their numbers, core PCE was little changed since they last met and is still running slightly below their two percent target. The FOMC predicts that GDP will grow by 2.1% in 2017 and if global economic conditions continue to strengthen, volatility remains low and core inflation does not increase much, we believe the Fed funds rate should end the year up an additional 50 bps.
The rise in populism took a pause with the Dutch voters not showing much support for Geert Wilders and the Freedom Party. With the Netherlands being one of the EU’s six founding members, the election showed the EU still has unity at its core. That unity will be tested in April and May when France goes to the polls and again in September with the German elections. However, we feel that the French and German voters will follow the Netherland’s lead and populism should remain contained in both countries.
March 10, 2017
Market participants are looking for the Fed to hike the Fed Funds rate at their March 15th meeting. According to the Reuters poll of more than 100 economists, the economic data is strong enough to support this rate hike. The Bloomberg implied probability of a rate hike next week is now at 100% after a number of hawkish comments last week. If the Fed is able to orchestrate three rate hikes this year at 25 basis points each, the Fed Funds target rate would be 1.25%-1.50% by year-end. The commentary from the meeting and the update to the Fed’s economic forecast will be closely watched and compared to what was released at December’s meeting. Mario Draghi announced on Thursday that the European Central Bank is maintaining its benchmark rate and will continue with the monthly asset purchase program at a reduced level. The tone was more positive on the Eurozone economy and gave a lift to the European banking sector. The rise in U. S. interest rates and change in policy is a break from the coordinated global stimulus since the 2008 financial crisis. The Fed will be closely watching and balancing interest rate normalization with economic growth and financial stability. We expect that there will be increasing volatility in both the fixed income and equity markets as the Fed embarks on this new course.
March 3, 2017
Once again, the market’s focus has been drawn back to watching the Federal Reserve. Since the election the equity markets have rallied on expectations of fiscal stimulus, and the underlying fundamentals for both the economy and earnings have modestly improved. Market participants, despite the Fed rate increase in December, have been heavily focused on the Trump Administration and less on the Fed. This week, Multiple Federal Reserve officials have signaled in speeches that the Fed will be raising rates at their March meeting. A March increase opens the door to perhaps as many as three increases in 2017. Is the Fed feeling pressure to raise rates? Using CPI as the inflation gauge, the real yield on the 10-year Treasury bond is currently barely positive. The effective Fed funds rate is 0.63% and with inflation north of 2.0%, real rates are negative at the short end of the curve and have been for a long time. These low rates have driven equity valuations, as future equity cash flows are being discounted back at very low discount rates. Given today’s low rate structure, the next few rate increases will not materially impact valuations. At some point, it will matter to the markets and they will be very focused on the Fed.
February 24, 2017
We are all aware that the U.S. Equity markets have been on fire with the S&P 500 increasing by 5.25% year to date. Less apparent is the fact that the 10-Year Treasury has also advanced in value with its yield declining from 2.45% to 2.31% over the same period. This is somewhat unusual as these two asset classes tend to be negatively correlated. We think the current relationship may be routed in a difference in the timing of current market expectations. Since last November’s presidential election, stock investors have been focused on the prospects of a dramatic increase in GDP and corporate earnings growth resulting from fiscal spending policies, tax reform and the relaxation of various business regulations. The bond market is not totally discounting these potential growth catalysts as rates overall have risen since Trump was elected President, although signaling it may take longer than expected to become reality. This week, Treasury Secretary Mnuchin acknowledged that his goal for significant tax reform by August was ambitious. Furthermore, Arios Media cited Republican sources saying infrastructure could fall into 2018 because of prioritization of healthcare changes, immigration policies and regulatory reform.
February 17, 2017
Corporate share buybacks have been an important component to equity market performance over the last five years. Since 2011, companies in the S&P 500 have repurchased more than $2.7 trillion of their own stock. During that same time period, both individual and institutional investors have been net sellers. The share repurchase programs, in many cases, have used borrowed money for the repurchases. The end result is a modestly higher per share earnings at the cost of a risky capital structure. Operational performance, as measured by aggregate operating earnings, has not been good over the last five years; operating earnings on an annualized basis are only marginally higher. At current equity valuations, it is harder for corporate boards to justify continuing to purchase stock. Back in 2011, the S&P 500 was trading around 1100 and was trading at a price-to-earnings multiple of roughly 13x trailing earnings. Today, the S&P 500 is trading at 2,340 with a trailing P/E of 23.9. Over the next few weeks, we expect to hear some details emerging regarding tax reform. We would hope to see an investment tax credit to incentivize companies to invest capital in their businesses rather than using excess cash flow to repurchase shares. In the long run, by making investments that enhance their productivity, companies will be strengthening their growth potential – which is a far more productive use of capital.
February 10, 2017
The current financial market environment is fraught with uncertainty and seems to be overly responsive to marginal news. Many asset classes have been oscillating due to poor visibility for their potential outcomes. Emerging markets clearly have been subject to this volatility. The EM asset class sold off post election largely as interest rates adjusted higher on expectations of U.S. fiscal stimulus. As rates have stabilized, emerging markets have reversed and are approaching pre-election levels. Emerging market equities rose 11.2% last year, but remain inexpensive after a multi-year bear market. With confidence for improved global growth, especially with respect to the United States, it seems logical that emerging market equities should tangentially benefit. We believe investors should opportunistically add to emerging market equities on weakness. Exogenous risks, such as rising protectionism and Chinese structural changes, remain a concern that could cause corrections in this asset class. Overall, we see value in emerging market equities, and adding exposure will allow portfolios to become more diversified.
February 3, 2017
Equity markets in developed countries have moved sideways since the second week in December. Despite a noisy and contentious start of the Trump presidency, implied volatility of equity indexes fell to very low levels. Does this calm indifference by the financial markets indicate too much complacency on the part of investors? We think muted market action perhaps reflects current valuations and a dearth of concrete proposals that will have a meaningful impact on the macro environment. The caustic relationship developing between President Trump and the Democrats in Congress could potentially damage or delay the chances of a major fiscal stimulus program. With the domestic economy already exhibiting some acceleration off a tepid level of growth, a delay in fiscal stimulus could negatively impact business confidence. An element in Mr. Trump’s control however is regulation. On Friday, at a White House meeting with corporate leaders, Mr. Trump promised major reductions in financial regulations. The Dodd-Frank and the creation of the Consumer Financial Protection Bureau have been often cited by opponents as government overreach. Lowering financial regulation should allow capital to flow more freely and increase economic activity.
January 27, 2017
The U.S. Bureau of Economic Analysis released GDP statistics for the fourth quarter of 2016 on Friday. GDP growth was modestly below expectations growing at an annualized rate of 1.9 percent despite solid consumer and investment spending. The disappointment stemmed from a 4.3 percent annualized decline in exports that reversed a 10 percent increase in the third quarter. Net exports is a relatively small contributor to the overall domestic economy, but the GDP release does highlight the importance of the trade environment. Obviously, the global trade system is complex with many influences. Generally, goods should be produced to provide the product at the lowest possible cost. It raises everyone’s standard of living. The Trump administration’s desire to forge mutually beneficial bilateral trade agreements would be very helpful in constructing a healthy trade environment. Punitive border-adjusted tax levies have the potential to be incendiary and could lead to retaliatory trade action. The result of a trade war would be higher-priced products for everyone and a lower standard of living. The real driver of secular growth would be a more competitive corporate (and personal) tax structure. It will be a much more demanding lift given the various fractions in Washington and the current animosity. We would prefer the new administration to focus their efforts on tax reform.
January 20, 2017
As the new Trump Administration grabs hold of the levers of power in Washington, financial markets wait for clarity regarding economic and regulatory policy to emerge. For over a month many financial pundits, us included, have tried to assess the potential global impact of the various proposals that have been suggested. We would expect the process of sweeping overhauls to the U.S. tax code and broad and invasive laws, such as the Affordable Care Act, to be messy. Given the toxic and contentious tone in Washington, we expect it will take awhile for Congress and the Administration to converge on workable legislation. Investors should expect heightened headline risk and potentially greater volatility in the months ahead. Trade policy is an area where we could see relatively quick action. New trade agreements require congressional approval, but modifying or undoing existing commitments does not. We still have few details on Mr. Trump’s intentions regarding specific trade policy, but would expect him to renegotiate components of NAFTA (rules of origin) and undo the Trans-Pacific Partnership almost immediately.
January 13, 2017
Aspects of the Trump rally seem to be unravelling to some degree. The dollar has been very strong since the election. The U.S. Dollar Index (DYX) rallied from 97 in early November to over 103 in early January, but weakened to around 101 this week. Dollar selling was more pronounced after Presidential-elect Donald Trump’s press conference on Tuesday. To a large measure, the financial market’s post-election reaction has been predicated on the expectation of tax reform and infrastructure spending. Mr. Trump’s first press conference since being elected president focused on Russia and “fake news”, as opposed to the anticipated economic and tax policy changes. Another sign of reversal has been in the Treasury market. After a selloff that took the 10-year Treasury to a 2.65% yield, Treasuries reversed and the 10-year settled at 2.40% as the week closed. The equity market sectors and industries that have been strong post election have begun to see some consolidation (such as banks). It would not be surprising to see a broader price adjustment as the new administration takes office and confronts the hard work ahead. Often expectations get ahead of reality and financial markets are susceptible to this human behavior.
January 6, 2017
Expect Tax Reform in 2017
Tax reform has been a frequent topic of discussion in Washington over the last decade. Many members of Congress, both Republicans and Democrats, recognize that the U.S. current corporate tax code places domestic corporations at a competitive disadvantage globally. The combined U.S. federal and state corporate tax rate is over 39% versus roughly a 25% average for other developed nations. Both the Bush (Economic Growth and Tax Relief Reconciliation Act of 2001) and Clinton (Taxpayer Relief Act of 1997) tax cuts were proposed, went through Congressional committee, and were signed into law by summer. Both of these laws were also passed by the controversial budget reconciliation that requires only a 50% majority approval. Given the Republican control of both the Senate and the House, we expect to see a sweeping tax law approved by August. We expect a meaningful reduction in the corporate tax rate (very good for earnings) and perhaps a provision allowing for the immediate expensing of capital equipment (very beneficial for technology companies). The Trump Administration may attempt to affect trade policy through the tax code by creating different levels of deductibility depending on the location of production inputs. This would be very contentious and would delay the process.