Since my last blog, even more volatility has been present in the marketplace (both equities and debt spurred by the narrative that whatever tax legislation was passed by Congress would greatly benefit the economy and especially U.S. corporate profits. In the two weeks running up to the passage of the Senate’s version of the tax bill, the equity markets moved significantly depending on how any particular Republican Senator intended on voting. Then, when the bill was finally passed by the Senate, on the next business day, markets made new intra-day record highs, but then reversed course.
So, let’s not get carried away by the narrative. The reality is that, given the current sky high market valuation levels, the tax benefits are already priced in. Economist David Rosenberg examined market reaction to the five major tax bills of the last 70 years. He found that, on average, the S&P 500 rises 14.3% (median 18.9%) in the year leading up to the passage of the tax legislation. In the year following, on average, the index falls 7.5% (median 13.1%). It could be he is on to something.
The Markets and Easy Money
If it has been historically easy money that has propelled the U.S. and every other major stock market to record heights over the past few years, then it is noteworthy that the last 12 moves from the world’s central banks have been tightening moves.
We know that the Fed is certain to tighten the week of December 10th. This despite the fact that the Fed’s governing board is deeply divided on the outlook for interest rates and inflation. According to their own minutes, some Fed governing members continue to hold to the academic view that the Phillips Curve (i.e., inflation always rises when the unemployment rate is low) is alive and well. Under this view, inflation is just around the corner and the Fed had better be pre-emptive, lest inflation get ahead of them. The other view is that today’s economy exhibits behaviors that are significantly different from those that dominated the 60+ years of post-WWII America, and that inflation is no longer the threat it used to be. In fact, deflation may be a bigger threat, especially given the high and rising debt levels.
Markets and Fed are on Different Pages
Regular readers know that I have espoused the latter viewpoint. I have pointed out several times that the Fed has erroneously predicted 2% inflation for 66 months and continues to tell us that the low levels of inflation are “transitory.” Fed Chair-Elect Powell espoused this viewpoint in his confirmation hearing, so, there is not much hope that they Fed will back-off. Some of the governors, but Yellen in particular, are also concerned about what they view as unnecessary “fiscal stimulus” from the looming tax legislation. Yellen was particularly vocal about this in her testimony to Congress the week after Thanksgiving. For the Fed hawks on the governing board, this is one more excuse to get “ahead” of the reflationary forces that the resulting deficits are likely to bring (never mind that those are several quarters if not years away).
On the other hand, there are some on the Fed’s board with the view that deflation, led by globalization, demographics, the shared economy, AI, robotics, the new retail model (Amazon), etc. is the bigger threat, but they remain a minority.
The bond vigilantes (the large bond market players) also appear to hold the “disinflation” view. It is true that short-term interest rates (1 – 5 year maturities) have risen with the Yellen Fed’s promise to push short-rates higher and the start of the run-off of short dated securities in the Fed’s portfolio beginning in October. But longer-term rates have been stubborn. The 10-year U.S. T-Note has traded in a tight 2.30% to 2.42% range since late September, while some short-term yields have doubled. So, there is a clear disconnect between what the majority of Fed governors see and what bond market players believe. A continued disconnect will lead to a yield curve inversion (short-term rates higher than long-term rates), normally a precursor to an oncoming recession.
The China Factor
One driver of rising equity markets has been concurrent rising economic activity, not only in the industrial economies (Europe, Japan, China, the U.S.), but also in the emerging market space. One can get a feel for valuations, especially in the U.S. market, by examining the equity prices of S&P 500 companies with 50%+ of their sales in foreign markets vs. those with 50%+ strictly in the U.S. For the former, the equity prices have advanced 13%, on average in 2017, vs. just over 2% for the latter. That tells you where the real growth has been.
But now, we are starting to see some cracks in that growth. While Japan continues to have its best growth in 25 years, recent data out of Germany and France have disappointed. Yet, the biggest concern may well turn out to be China. Remember, it was China that led the world out of the Great Recession. But, since then, China’s debt loads have doubled, and that may be a key factor in the 2018 outlook (as of yet, unrecognized by Wall Street). Remember, it was Wall Street’s concern about China’s currency, beginning in mid-2015 and lasting through early 2016, that played a major role in the last meaningful U.S. equity market correction.
The ECB and PBOC
Once again, if markets have been driven by the world’s central banks’ easy money policies, then the fact that those central banks are also moving toward tighter monetary policies is significant, and that could be pivotal in 2018.
Besides the Fed, the European Central Bank (ECB) has announce that they will be “tapering” their purchases of bonds. This is the first move toward less accommodation. Of significance, the ECB President, currently an Italian (read “easy money”) is scheduled to be replaced, probably by a German (read “tighter money”).
The Peoples’ Bank of China (PBOC) also appears to have begun a tightening cycle. In mid-November, the yield on Chinese 10-year government paper rose to its highest level since 2014, and concerns are rising that the overleverage in the country’s local government sector will soon impact the rest of their economy. During Thanksgiving week, the rise in Chinese bond yields spilled over into their equity markets. Prices in their various markets fell 2%-3% in the worst performance in 18 months.
The “Rebuild” Economy
Back in the U.S., Q3’s real GDP growth rate was revised up from 3.0% to 3.3%, and Q4’s growth also appears to be well on its way to a 3%+ print. Be careful here. Much of this has been from the “rebuild” after the hurricanes, and we are likely to see a continuation of construction spending well into Q1/18 (CA fires). But, the under-armor is weak. Not only have wages and incomes not risen in real terms, but the savings rate has fallen to the 3% range (normally 4%-5%). The last two times it was at these levels were in ’00 and ’07, and we know what happened to the economy and equity markets in the subsequent years.
Deflation, Deflation, Deflation
In my local area, the sign at the supermarket (a regional chain) reads: “Lower prices on 5,000 item,” clearly a reaction to the Amazon purchase of Whole Foods. On Black Friday, signs at every major chain, department store, and in every mall in the U.S. announced “50% off.” We live in a disinflationary world! From a business point of view, such discounting means lower margins. But, of more importance, 50% discounts pull demand forward. From a consumer’s viewpoint, even if there is no current bank balance with which to pay, why wait to make the purchase, especially at 50% off? If credit card debt is available, it is used (debt grows, and the savings rate declines). Let’s face facts: At the end of a cycle, demand is satiated. It does take extraordinary discounting to attract sales, and such discounting really borrows sales from future quarters.
Finally, debt levels have soared since the recession, and the proposed tax legislation only promises more. Rising long-term interest rates are simply not compatible with these conditions.
Conclusion: Despite the Fed, and who its Chair may be, long-term interest rates will remain lower for even longer. 2018 promises to be a pivotal year.
Robert Barone, Ph.D.
Robert Barone, Ph.D. is a Georgetown educated economist. He is a financial advisor at Fieldstone Financial. www.FieldstoneFinancial.com .
He is nationally known for his writings and Robert’s storied career includes his having served as a Professor of Finance, a community bank CEO and a Director and Chairman of the Federal Home Loan Bank of San Francisco. Robert is currently a Director of CSAA Insurance Company (a AAA company) where he chairs the Finance and Investment Committee. Robert leads the investment governance program at Fieldstone Financial, is the head of Fieldstone Research www.FieldstoneResearch.com, and is co-portfolio manager of the Fieldstone Financial Fixed Income ETF (FFIU).
Statistics and other information have been compiled from various sources. The facts and information are believed to be accurate and credible, but there is no guarantee as to the complete accuracy of this information.
