Rising Wages, Trump’s Tariffs, Economic Vital Signs

March 2018 Market Commentary:

By Paul Hoffmeister, Chief Economist

In our view, one of the most important variables that impacted financial markets in February was growing concern about the Federal Reserve raising interest rates more aggressively than previously expected. Of course, there are almost countless variables that drive markets. It’s possible investor complacency heading into February and seemingly crowded, short volatility positions contributed to or intensified the stock market panic last month.

The S&P 500 peaked on January 26th and appeared to really begin its selloff on Friday, February 2nd when the US Bureau of Labor Statistics’ release of average hourly earnings showed surprisingly strong year-over-year growth of 2.9%, compared to the median expectation of 2.6% growth.

The strength in employee earnings growth is now at a post-financial crisis high and has sparked concerns of accelerating inflation down the road that may need to be addressed by stronger monetary tightening. The concern is predicated on the theory of wage push inflation, where end market prices of goods and services are preceded by increases in employment costs.

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According to the Chicago Mercantile Exchange, futures markets estimated at the end of February a nearly 25% probability of a 2.25-2.50% federal funds rate target by December 19, which is the FOMC’s last meeting of the year. This would equate to four quarter point increases to the funds rate for 2018. At the end of January, the probability of a 2.25-2.50% funds rate target was approximately 21%; it was almost 9% at the beginning of the year.

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Confluence of Market-Friendly Variables

Q4 2017 Market Commentary:

By Paul Hoffmeister, Chief Economist

On January 16, the Dow broke through another record. The headline at CNN read, “Dow 26,000: The Stock Market Is a Runaway Freight Train”.1

Journalists and market pundits seem to be stepping over each other to herald the nearly 40% rally in the Dow since late 2016, as well as the speed of its ascent. As CNN reported, it took 14 years for the Dow to climb from 10,000 to 15,000; three and a half years to reach 20,000; and less than 12 months to rally from 20,000 to 25,000.2 Given these statistics, “melt-up” and “euphoria” are some popular terms being used today to describe the market.

In our Q3 market commentary in November, we highlighted the strong equity market performance and narrow credit spreads at the time, and suggested that the primary factors behind the sanguine environment were the prospects of tax reform and a Fed policy approach that had been looking to “do no harm”.

Considering whether the environment (or “enthusiasm”) was sustainable, our conclusion was: …[d]uring the near-term, the passage of tax reform and the continuation of moderate Fed policy could easily extend the strong market trend of the last year. If fiscal and monetary policy (the “twin pillars of productivity”) remain supportive, then the future remains bright.

We believe this has been the case, as we look back at the last two months. The major macroeconomic variables are evolving positively, and igniting investors’ animal spirits.

Of course, on December 22nd, President Trump signed the largest tax cuts in American history, including a reduction in the statutory corporate tax rate from 35% to 21%. For companies previously paying a 35% tax rate, the new 21% rate will enable them to increase corporate earnings by 21.5%, thanks simply to this change in the tax rules. For example, a company that previously paid $35 in taxes on $100 in earnings can now keep $79, a 21.5% earnings increase.

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FORECASTS FOR STOCKS, BONDS, GROWTH AND INFLATION

2018 Outlook

By Paul Hoffmeister, Chief Economist

After such a good year, a common question we’re hearing is, can the good times last in 2018? For the most part, we believe they can.

To put today’s market into context, we believe the strong U.S. equity market returns of the last year were primarily driven by supportive monetary, fiscal, and regulatory policy. And, the nearly unchanged yield in the 10-year Treasury (2.40% at year-end 2017 versus 2.44% at year-end 2016, according to Bloomberg) was mainly due to declining inflation and the resistance by some Federal Reserve officials to raising the federal funds rate aggressively.

One of the big stories of the last year was the historically strong risk appetite in stock and bond markets. Based on our calculations, the average daily VIX level in 2017 was 11.1, the lowest average for a calendar year since 1990. And today’s around 72 basis point spread between medium-grade Baa and high-grade Aaa-rated corporate bonds is less than 25 basis points from its post-1990 low.   

Looking forward to 2018, business-friendly regulatory and fiscal policy will likely continue. It appears that the regulatory rollback instituted since January will remain. And of course, Congress just implemented $1.5 trillion in fiscal stimulus, of which the signature feature is a permanent corporate tax cut.

Rather than having the world’s fourth highest statutory corporate income tax rate, as it was last year according to the Tax Foundation, the US rate will now be fixed almost two percentage points below the world average of 22.96%.[1] This bodes well for U.S. competitiveness.

With these tailwinds, we are forecasting approximately that the S&P 500 to reach 2959 at the end of 2018, and the 10-year Treasury yield to rise to 3.00%, as real GDP accelerates to 3.0%.

Also we approximately expect unemployment to fall to 3.8% and core PCE inflation to grow 1.7% by year-end 2018.

Among the myriad risks that exist to our base case forecast, we foresee the top risks to be overly aggressive monetary policy, political uncertainty, and geopolitical instability associated with North Korea as well as Iran-Saudi Arabia.

We are particularly concerned that in 2018, the strong risk-taking environment along with accelerating GDP and rising inflation will compel some monetary policymakers to advocate aggressively tighter monetary policy. To us, this would be misguided given years of dollar strength and the shift by other major central banks toward tighter policy.

But if Fed officials take a ‘do no harm’ approach and allow for the full effects of fiscal and regulatory relief, 2018 could be another very good year for most stock and bond investors.

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Excellent, But Vulnerable Markets With all the risks today, are investors complacent?

Q3 Market Commentary:

By Paul Hoffmeister, Chief Economist

It is our belief that 2017 has been a rewarding year for most investors. Through the third quarter, the S&P 500 is up nearly 13% and the Nasdaq 23%, while the Barclays Aggregate U.S. Bond Index has returned almost 3%. Even more, in July, stock market volatility was the lowest in the last 10 years. Investment returns appear to have been strong, and markets are calm. We believe the primary factors behind this sanguine environment are the prospects of tax reform and a Fed policy approach that, at least for this year, has been looking to “do no harm”.

By all appearances, the Federal Reserve seems to be implementing policy more reactively than proactively. In other words, the FOMC has been only raising interest rates to a degree that we believe won’t agitate financial markets. And in Congress, the House has passed a tax reform bill whose primary aim is to reduce the corporate tax rate from 35% to 20%, in addition to providing some individual tax relief. Holding all other variables constant, the 15 percentage point reduction in the statutory corporate tax rate should increase corporate earnings up to 23.1%. If market multiples hold, this tax reduction should theoretically correlate with an equivalent increase in stock prices. Perhaps not coincidentally, the S&P 500 has rallied nearly 20% since Election Day.

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