As we all know by now, the Fed exited its September monetary policy meeting yesterday. Chairwoman Janet Yellen said that in the Fed’s view, the domestic economy is on solid enough footing to handle another Fed rate increase before the end of the year as well as the initiation of the Fed’s plan to unwind its $4.5 trillion balance sheet. This view effectively brushes aside the fact that the Fed’s inflation target has yet to be realized, despite its herculean monetary policy efforts, and in the near-term, the economy is headed for a tumble following hurricanes Harvey and Irma, and maybe more depending on how Hurricane Maria develops.
In recent days, we’ve seen several cuts to GDP expectations for the current quarter, including from the Atlanta Federal Reserve as well as several investment bank economists. The general thinking is that Hurricanes Harvey and Irma trimmed roughly 1% off of economic activity. With the bulk of the damage coming in September, including what we have yet to experience with Maria, we’ll have a fuller sense of the trifecta’s extent in October when we get the September data.
The market reaction to the FOMC statement is that it was more hawkish than what had already been priced in. While the market was priced at a 50/50 chance for a rate hike before the end of the year, the now infamous dot-plot shows that 12 of the 16 members expect one more hike this year, with one expecting two. In sharing the committee’s view Chairwoman Yellen remarked, “The median projection for the federal funds rate is 1.4 percent at the end of this year, 2.1 percent at the end of next year, 2.7 percent at the end of 2019, and 2.9 percent in 2020.”
This means the next rate hike, which is now likely to occur in December, will be a quarter point in nature, and based on the Fed’s forecast the three targeted rate hikes in 2018 are likely to be of the same magnitude. As Yellen shared this, she once again cautioned the Fed will remain “data dependent” in its thinking. As the markets recalibrate from a 50% likelihood to the new 70% that we will see another hike in 2017, gold lost $10 per ounce, the dollar gained some strength and the yield on the 2-year rose 4 basis points while the long bond has barely moved, flattening the yield curve.
From our perspective, with a recovery that is increasingly long in the tooth (something that is not likely lost on Yellen and the Fed heads), we see the Fed looking to regain monetary stimulus firepower ahead of the next eventual recession. To be clear, we’re not calling for one, just recognizing that at some point one will happen – it’s the nature of the business cycle. As we share that reality, we’d also note that historically the Fed has a very good track record of boosting rates as the economy heads into a recession.
We’d like to point out that while most are viewing these minutes as more hawkish than expected, the phrasing of their economic analysis has become more sedate. Oh for the days when we didn’t need to analyze every little word out of the Fed like a bunch of teenagers assessing the meaning of their crush’s every utterance! The Fed’s assessment of unemployment has dropped the reference to “has declined,” leaving just “unemployment rate has stayed low.” With respect to spending, the wording has gone from “continued to expand” in July to “expanding at a moderate rate.” As for the dot plots, of the four FOMC members who expected two more hikes in 2017, only one remains.
As much as the Fed will likely try to avoid that and preserve Yellen’s time as chairwoman, it’s different this time. Next month, the Fed will begin unwinding its balance sheet that bulked as a result of its quantitative easing measures. The Fed admits to “months of careful preparation,” but let’s be real here, this is unlike anything we have seen before as the Fed expects to boost interest rates further. Yes, the Fed will baby step with its balance sheet as its targets selling no more than “$6 billion per month in Treasuries and $4 billion per month for agencies” in 2017. In 2018, however, those caps will rise to “maximums of $30 billion per month for treasuries and $20 billion per month for agency securities.” Given the Fed’s balance sheet weighs in at a hefty $4.5 trillion, this is poised to be a lengthy process and we suspect that as well intended as the Fed’s thinking on this is, odds are there are likely to be some unintended consequences.
The question we continue to ponder is whether the economy is strong enough to not falter as the Fed ramps its selling while boosting rates. Even the Fed sees GPD falling from its 2.4% forecast this year to “about 2 percent in 2018 and 2019. By 2020, the median growth projection moderates to 1.8 percent.” To get to that 2.4%, we need the Atlanta Fed’s GDPNow forecast for 2.2% in Q3 to materialize, which we think is going to be tough given the impact of this season of insane storms, as well as at least a 3% bump in Q4. Our bets are that’s about as likely as either of us giving up chocolate.
As we mull this forecast vs. the business cycle, we must keep in mind the Fed is ever the cheerleader for the economy and tends to be optimistic with its GDP forecasts. We prefer to be Rhonda Realist vs. Debbie Downer or Cheery Charles, and when we triangulate the Fed’s comments, we continue to think it’s underlying strategy is to re-arm itself for the next downturn.
To Raise or Note to Raise – The big question that has the attention of markets all over the world is, “Will the U.S. Federal Reserve raise rates in September?” We’ve discussed in both our June newsletter and July newsletter that we believe it is unlikely that the Fed will raise rates and continue to believe so. As the year goes by, the market has come around to our way of thinking. In early August the odds on a rate hike in September were 48%. By Thursday it had fallen to 32% and by the end of Friday at 27%. At this start of this week, it was down to 22%. That being said there are compelling reasons for the Fed to raise rates, so we don’t have a particularly high conviction level on our call. The Fed is made up of a bunch of human beings, and you can never be too sure about what a group of folks might do when they get together and start talking, particularly when reputations may be on the line.
The first reason many may cite for a rate increase is the significantly upwardly revised second quarter U.S. GDP estimate, from 2.3% to 3.7%. Yours truly has some, ahem, concerns with the second estimates. Without getting too wonky, remember that earlier this year, the GDP estimates for 2012 to 2014 were revised significantly lower. Problem is, if they don’t lower the estimate for current GDP, the growth rates for 2015 would have to be much higher. Think of it this way, I’ve always wanted to dunk, but at 5ft 7.5”, (don’t laugh, that 0.5 is important to me!) a hoop 10 feet high is challenging despite my orangutang-like arms, (I know mom, what can you do? I got Dad’s!). If I jump up onto a platform that is 3 feet high, I only have to reach 7 feet up to dunk. But if I jump up onto a platform that is 2 feet high, I need to spring up and reach 8 feet into the air! By revising the 3 years from 2012-2014 down, I moved from the 3 foot platform to the 2 foot, so naturally I have to jump higher. We also note that about 12% of current GDP, which translates into $2 trillion of the roughly $18 trillion, comes from a “trend” estimate, the same trend that had previously been used for the 2012-2014 growth rates prior to the downward revision. Errrh what? So they overestimated back then, but now that same trend assumption is accurate. Hmmmm… could be, but methinks it prudent to be cautiously skeptical.
We also find it ironic that various Fed Presidents have mentioned, while at the annual Jackson Hole meeting this past week, that they are concerned with raising rates during a period of heightened market volatility. Really!? Come on! A good bit of the market’s volatility can be attributed directly to the mixed messages coming out from various members of the Fed with a rate hike both reportedly necessary and imminent while also increasingly unlikely given current conditions, depending on which official is speaking, in a bizarre monetary policy version of Schrödinger’s cat. Conventional wisdom believes that a rate hike will hurt stock prices, so naturally hearing contradictory statements like that will increase market volatility. There was a time when the Fed’s actions weren’t dependent on the stock market and vice versa – oh for a return to those simpler times!
To put the Fed’s fears in context, we’d like to point out that the S&P 500 is currently 6.7% off its all-time highs, yet some Fed officials are claiming they are uncertain about raising rates for the first time in a decade because they fear the equity markets may react negatively? To give that even more context, the S&P 500 is up almost 200% from its March 2009 lows and nearly 30% above its 2007 highs. Is the Fed telling us that the bull market needs their support? Hmmm….
What very few are talking about is what just happened with China’s devaluation of its currency and how it could affect the U.S. going forward. When China loosened its grip, its currency fell relative to the dollar more than China wanted. To stop the slide, the government sold assets and bought yuan to support the currency (a reverse QE). What asset do they have a hell of a lot of? U.S. Treasuries!
In an earlier blog post I mentioned that China had accumulated over $4 trillion in assets starting from 2003, more than all the Fed’s QE programs combined. So if/as China finds it needs to support its currency as the rest of the world sees its economy slowing and puts downward pressure on the yuan, it will need to sell more Treasuries to support its currency, and it has a lot of Treasuries along with other assets available for sale. That will increase the amount of Treasuries on the market, which will push prices down and yields up, again a reverse of what we saw in QE, as we are on the cusp of entering the era of Quantitative Tightening! I’ll have a lot more on this in the months to come.
The table below itemizes the primary arguments for and against.
What we do know is that looking over the history of the Fed, it does pay attention to the world around it. Combining current conditions with past behavior under similar circumstances, a rate hike looks unlikely. The rising U.S. dollar will likely hurt export-oriented sectors without causing the overall equity market to be harmed as importers will conversely benefit and the Fed is more likely to hold its hand. Lower bond yields coupled with a strong U.S. dollar will keep upward pressure on price to earnings ratio, (i.e. upward stock price pressures) and the drop in U.S. bond yields will help credit-sensitive sectors like housing and autos. With around 70% of the U.S. economy being driven by consumer spending, the country is better positioned to withstand the ongoing global slowdown than those economies that are more dependent on exports.
The annoying truth that very few economists want to admit is that the field is more art than science – much like investing. If investing were as easy as simply looking at the past and extrapolating it forward, you’d not need us. When it comes to economics, the best we can do is to develop an idea of general future probabilities based on how events unfolded in the past.
The headlines have been heralding all kinds of economic triumphs lately, which has been giving yours truly much brow furrowing consternation; talk about heads in the sand! Let me walk you through what no one seems else seems to be talking about.
One: Q1 GDP has been revised into a contraction, falling 0.7%. It is important to note that this is the first time in recorded US economic data that the economy has contracted three times during a recovery. That seems like a noteworthy lack of strength, particularly given all the support the Federal Reserve has been supplying coupled with the mindboggling level of federal spending; recall that during the last seven years US debt has doubled, meaning the government overspent as much in the past 7 years as it did in the entire 230 years prior combined!
Two: June 15th we learned that Capacity Utilization for total industry in the United States fell for the sixth month in a row. This is measured by the Federal Reserve and represents, “the percentage of resources used by corporations and factories to produce goods in manufacturing, mining, and electric and gas utilities for all facilities located in the United States (excluding those in U.S. territories). This measure has fallen six months in a row ten times previously since 1967, the earliest recorded data. Every single time it has fallen in the past six times in a row, the economy has been in a recession. In fact, the economy has never been in a recession when the metric did not fall for at least six consecutive months. Think of it this way, the US economy has thrown a big old production party, but hardly anyone’s on the dance floor and everyone’s wondering when the crowd is finally going to arrive.
Three: Industrial Production has now come in below expectations six months in a row, and has shown a rather concerning downward trend since January. Keep in mind that a contraction in GDP for two quarters in a row, i.e. six months, is the definition of a recession. Industrial Production used to be the metric for the economy before GDP started being measured after WWII. May’s number is also a bit of a blow to the hopes for a turnaround to GDP in Q2, as the level of production so far in Q2 is down 2.4% at an annual rate relative to the average for Q1, which was itself down 0.3% from Q4 2014. This means we are likely to see the first back-to-back quarterly contraction in production since Q1 and Q2 of 2009. Were this pre-WWII, this data mean an official declaration of a recession.
Four: The three month moving average for US retail sales is at a level that is never seen outside of a recession, hat tip to Raoul Pal of Real Vision Television, (which I highly recommend for on-demand interviews with the best and brightest in the markets) for pointing out this one to me. While May retail sales were up from April, they were still 25% below March with an overall trend downward trend that is clear in the chart. So much for the return of the American consumer… not just yet.
Five: The talking heads on TV claimed that the contraction in Q1 was due to extreme weather conditions and the port closures/slowdowns due to the labor union kerfuffle on the west coast. First quarter earnings releases and analyst calls where abuzz with retail executive bemoaning the lost sales thanks to goods getting stuck at the west coast ports. Alrighty then… we were willing to give them some wiggle room here. However, the port situation was resolved some months ago, which should have led to a big jump up in transportation needs within the US to get goods to and from those congested ports. Errrh….. May… not looking so good. That phrase is starting to sound like Wall Street speak for, “The dog ate my homework.”
Not exactly inspirational; not only has rail traffic in 2015 been materially lower overall than in 2014, but May saw a sizeable decline both relative to April and to May 2014. This data is reinforced by the Cass Freight Shipping data, which was released on June 15th, showing that while shipments and expenditures rose in May from April, they are still below 2014 levels, which was the strongest year so far since the Great Recession. Both car-loadings and intermodal-loadings were declining by month’s end as well, indicating that June is likely to also be weak.
To emphasize the point with transports, earlier this week Federal Express delivered quarterly earnings and revenue that fell short of expectations, citing pension costs, the impact of the strong dollar and lower fuel surcharges. All reasonable claims except they are nothing new, thus the company’s guidance should have already taken those factors into account. To us this just gives further reason for concern.
Six: For all the talk about how the labor markets are heating up, getting tighter… whatever lovely catch phrase you like, June 18th the Labor of Bureau Statistics announced that real average hourly earnings decreased by 0.1% in May, seasonally adjusted. Real average weekly earnings also decreased by 0.1%. So much for all the talk about tightening labor markets inducing inflation, I keep scratching my head wondering what the heck the talking heads are looking at! On top of that, a recent report from Glassdoor Inc. revealed that job seekers had to wait about 22.9 days for an offer or rejection in 2014, up from 12.6 days in 2010 – again not an indicator of a tight job market.
To drive the point home, the chart below shows just how much of the incoming data has surprised to the downside. Does this mean that expectations are entirely out of whack with reality or does it mean that the economy is weakening? Well, putting it all together…
Bottom Line: As I said earlier, economics and investing involve looking at the new data coming in, comparing it to earlier data and looking for correlations in an attempt to identify trends or causation. In other words, we seek to understand what’s going on now, what’s causing it and where are we going? The current recovery has stumbled an unprecedented three times into contraction, which gives concrete data on how week this recovery actually has been. Capacity utilization, Industrial Production and Retail Sales data all point to a recession. Transportation of goods is well below last year and not showing signs of improvement and if one looks under the covers of the labor market – it is much weaker than the headlines indicate. One of our primary jobs is to manage risk and when we put all that data together, it gives us cause for concern as to the direction of the economy. The chart below indicates that we aren’t the only ones noticing just how weak the economy has become, as executives increasingly decide to return money to shareholders directly rather than invest it in elusive future growth.