Our Annual Market Outlook will be published next week. Please find below the Outlook’s Executive Summary.
• 2016 may earn a place in the record books as one of the strangest years in capital markets history. Very little that was expected at the beginning of the year happened, and much that was not expected came to pass as the year wore on. Risk asset markets lost their footing early with some data tremors from China, but soon channeled their inner Taylor Swift to “shake it off.” Ms. Swift’s imperative became, in fact, the mantra for the rest of the year. Britain decides to leave the European Union? Shake it off! Donald Trump shocks the entire world of political punditry with his out-of-right-field Electoral College Victory? Shake it off, and then party like it’s 1929! Shaky Italian financial institutions were of no concern, geopolitical instability merited little more than a shrug of Mr. Market’s shoulders. On the Friday before the U.S. election, the S&P 500 languished 4.7 percent below the all-time high set back in August. Two weeks later the benchmark index set four consecutive records (and has notched up another five since then). Meanwhile, volatility went and crawled under a rock: the CBOE VIX index, the market’s so-called “fear gauge”, plummeted to multi-year lows in the latter weeks of the year.
• Based on these developments, we see the market today as “priced for perfection.” It’s the opposite of Murphy’s Law – if something can go right, it will. Much of the momentum pushing the market higher in the last two months of 2016 came, in our opinion, from the release of animal spirits – a giddy running with the bulls after the confines of a relatively narrow trading corridor for much of the previous two years. The notional rationale for the bull run was the putative return of fiscal policy as an economic stimulant after the total dominance by monetary policy for the past six years. Corporate tax reform and infrastructure spending were the lead acts in the fiscal playbill – the first expected to add a sizable jolt to corporate earnings per share, the latter to somehow find its way to improving real GDP growth. Unsurprisingly, the main beneficiaries thus far of the so-called “reflation-infrastructure trade” (or, in vulgate prose, the “Trump bump”) have been financial institutions, along with energy, industrial materials and related sectors.
• Our main concern with the “priced for perfection” market is that many of the actual catalysts are anything but certain to happen. We are still one week away from the new administration’s first day, and there remain far more questions than answers in terms of what the new economic agenda will be, how it will be implemented, and what will get lost or watered down along the way. Corporate tax reform, in our view, does make sense if done properly – lower the statutory rate and widen the base by getting rid of the Rube Goldberg contraption of loophole goodies. Unfortunately, companies love those loopholes, via which the average S&P 500 company pays an effective tax rate closer to the mid-teens than to the statutory rate. As for infrastructure spend: most of it would likely come through tax incentives to private developers rather than new public works projects, and it is not obvious that, even if there were a handful of shovel-ready projects that would offer attractive enough returns for private developers to act on, there would be a direct connecting of the dots to GDP growth. In short, we believe the market is currently overbought.
• Overbought, though, does not necessarily imply the onset of a sharp and protracted reversal. Our 2017 base case does not envision a bear market, mostly because we do not see compelling evidence of any kind of looming economic downturn. In fact, if one strips out the noise of the last two months and the ongoing kerfuffle around the incoming administration, very little appears to have changed in regard to the underlying economic picture. GDP growth turned up in the third quarter to a quarter-on-quarter 3.5 percent and is expected to come in somewhere north of two percent when the Q4 number comes out later this month (which would be a strong increase from the 0.9 percent growth rate of 2015’s fourth quarter). Headline inflation is also expected to finally catch up to the Fed’s target of two percent, while jobs data has us very close to full employment. Wages continue to outpace inflation, which could in turn provide further upward momentum to consumer spending, the dominant component of GDP. These are favorable macro fundamentals and, we think, should hold the bears at bay for some time yet. More likely, we think, could be another year of corridor trading, with stocks still facing valuation headwinds on the upside while not offering a convincing rationale for investors to sell off wholesale.
• Corporate earnings will have a substantial role to play in determining how much upside there actually is in a market where conventional valuation measures like price-earnings and price-sales are at decade-plus highs. The price-sales ratio, as we noted in a recent weekly commentary, is a rounding error away from 2.0 times, which in turn is not too far from the all-time high of 2.36 times set at the peak of the late-1990s technology bubble. Corporate sales will likely continue to face the resistance of a strong U.S. dollar – though the greenback’s torrid pace has waned a little in the past couple weeks. At the bottom line of earnings per share, investors will be looking for double digit EPS growth to justify any kind of similar pace of price appreciation. But global demand, though arguably improved from where it was a couple years ago, remains below trend. At the same time, relatively weak business investment levels in recent quarters may limit operating leverage improvements that would shore up profit margins. On a fundamental level, at least, it is hard to make a convincing case for another year of double-digit growth in domestic stocks.
• In Europe, economic conditions steadily, if slowly, improved over the course of 2016. Real GDP growth in Germany for the year was the highest in five years. Deflation appears to have been avoided, and ECB stimulus measures will stay in effect until (at least) the end of this year. But the political situation in Europe is fragile and could be the source of further instability. Start with Italy, where a failed referendum late last year led to the resignation of Prime Minister Matteo Renzi. While the current caretaker government may last until the current parliamentary term ends in a little over a year, we can expect continued agitation from anti-establishment outsiders – notably the Five Star Movement – to keep earlier elections in play as a potential destabilizing variable this year. France and Germany are already going to the polls, and while the conventional wisdom still holds that (a) Angela Merkel will win her fourth term, and (b) Marine Le Pen will fail to garner enough support to win the second round and ascend to Versailles, conventional political wisdom has had a somewhat poor track record of late. At some point, whether this year or not, the patented EU approach of patching up problems and kicking the can down the road will reach the end of that road.
• China has been somewhat off the radar screen for a while, after all the drama around its currency devaluations in August 2015 and January 2016. Headline growth numbers mostly came in as expected last year, and the latent threat posed by a debt-GDP ratio still over 230 percent goes mostly unnoticed in the daily discourse. But the problems have not disappeared. Arguably the most revealing indicator of all not being entirely well in the world’s second largest economy is the steady pressure of capital outflows, resulting in a decline in foreign exchange reserves from over $4 trillion in 2015 to just over $3 trillion now. The People’s Bank of China, the central bank, has worked diligently to support the domestic currency through reserve sales (most of which consist of U.S. Treasury securities), but monthly outflows show little sign of abating. Meanwhile, the global economic fortunes of China along with other key emerging markets in Asia, Latin America and elsewhere hinge on the unknown outcome of potential protectionist policy coming out of Washington. It may be another volatile year for this asset class, where higher than average risks may not yield acceptably commensurate risk-adjusted returns.
• Along with the crazy spikes in financial and resource stocks late last year, soaring bond yields were the other notable talisman of the “reflation-infrastructure” trade. Both the 2-year Treasury note, a ready proxy for monetary policy expectations, and the intermediate 10-year note are comfortably at their twelve month highs, and the 2-year yield is higher than it has been at any time since 2009. Of course, one of the iconic images for 2016’s quirky scrapbook is the all-time low set by the 10-year yield in July (all-time low meaning “since the American Republic started issuing its own debt in the late 18th century” low). We do not expect to be revisiting that multi-century accomplishment anytime soon, and think it likelier than not that the secular bond bull that began in 1982 is close to its final days. Fixed income portfolios will likely be challenged in 2017. That being said, though, and notwithstanding expectations of multiple Fed moves this year, we do not see bond yields moving towards historical averages any time soon (the average yield on the 10-year bond over the past thirty years, for example, is 5.1 percent). As we noted above, economic conditions still appear not remarkably different from how they looked one year ago. The secular stagnation theme that many observers summarily discarded in the immediate aftermath of the Trump victory has not, in our view, lost its usefulness as a way to explain the lackluster pace of organic economic growth. However challenging, fixed income will continue to be a necessary component of diversified portfolios for risk management and income purposes.
• In summary, while we have profound concerns about how markets will evolve over the coming years – concerns we elaborate in more detail elsewhere in our Annual Outlook – our base case for 2017 attaches a relatively low likelihood to either a robust bull market or the onset of a multi-period bear market. High valuations will continue to rein in upside growth, according to this view, while the macroeconomic climate continues to slowly improve and corporate earnings should at least stay modestly positive, providing support against sustained drawdowns. However, we do regard our base case view as subject to a potentially more volatile dose of X-factors than normal, and the actualization of one or more of these unknown variables could profoundly impact our assumptions and cause us to reevaluate our expectations. We don’t expect a massive trade war to send the world back into nation-state fortresses of closed economies, for example. But merely having to articulate that this is a not-totally-out-there possibility raises the mercury on our X-factor measuring stick. Things that have simply not mattered much to markets in recent years – geopolitics being an excellent example – may force themselves back onto investors’ radar screens with real consequences. Our recommendation is simply this: plan for the likely, but imagine the unimaginable.
It’s a new calendar year, but markets continue to party like it’s late-2016. Remember Murphy’s Law? “If something can go wrong, it will” goes the old nostrum. U.S. equity markets, in the pale early dawn of 2017, exhibit what we could call the inverse of Murphy’s Law. “If something can go right, it will!” goes the happy talk.
Happy Talk Meets Sales & Profits
We’re about to get an indicative taste of how far these rose-tinted glasses will take us through the next twelve months. Earnings season is upon us. Analysts expect that earnings per share for last year’s fourth quarter will have grown by 2.81 percent from a year earlier, according to FactSet, a market research company. Stock prices grew by a bit more than that – 3.2 percent – over the same period, so valuation measures like price to earnings (P/E) and price to sales (P/S) edged up further still. In fact, the price to sales ratio is higher than it has ever been since the end of 2000, and within striking distance of the nosebleed all-time high reached at the peak of that bubble in March 2000. The chart below illustrates this trend.
Price to sales is a useful metric because it shines the spotlight on how much revenue a company generates – from sales of its goods and services – relative to the price of the company’s stock. We inhabit a world where global demand has been persistently below-trend for most of the time since the 2007-08 recession. Weaker demand from world consumer markets, along with the added headwind of a strong dollar, has impeded U.S. companies’ ability to grow their sales from year to year, and that in turn helps explain why stock prices have run so far ahead of revenue growth.
Knock Three Times on the Ceiling
While price to sales is important, investors generally tend to place more emphasis on the bottom line – earnings – than on the revenue metric. Some investors focus on past results, such as last twelve months, or full-cycle measurements like Robert Shiller’s Cyclically Adjusted Price to Earnings (CAPE) ratio. Others believe that forward-looking measures are more useful and pay closer attention to analysts’ consensus estimates for the next twelve months. By any of these measures the market is expensive. The Shiller CAPE ratio, for example, currently stands at 28.3 times. That’s higher than it has been any but two times in the last 137 years (yes, one hundred and thirty seven, that is not a typo). The CAPE ratio was higher in September 1929, before the Great Crash, and again in March 2000 before that year’s market implosion.
While CAPE is a useful reality check on the market, neither it nor any other metric is necessarily a useful timing tool. There is no reason to believe that the so-called “Trump trade,” based largely on Red Bull-fused animal spirits, will end on a specific date (all the silly chatter of the “sell the inauguration trade” aside). What particularly interests us as earnings season gets underway is whether – and this would be contrary to the trend of the last several years – the earnings expectations voiced by that consensus outlook actually squares with reality. Consider the chart below.
There’s a lot on this chart, so let’s unpack it piece by piece. Let’s start with the horizontal lines depicting two “valuation ceilings” which, over the past two years, have served as resistance levels against upward breakouts. The first such ceiling is defined by the S&P 500’s high water mark reached in May 2015. The index challenged that high several times over the next 14 months but consistently failed to breach it. Then Brexit happened. The post-Brexit relief rally in July 2016 powered the index to a succession of new highs before topping out in August. It then again traded in mostly sideways pattern through early fall up to Election Day. Of course, we know what happened next.
Hope Springs Eternal
Now we come to the second key part of the above chart, and the one to which we are most closely paying attention as we study the forward earnings landscape. The thick green and red dotted lines show, respectively, the last twelve months (LTM) and next twelve months (NTM) earnings per share for the S&P 500. In other words, this chart is simply breaking the P/E ratio into its component parts of price and earnings, using both the LTM and NTM figures.
So how do we interpret these LTM and NTM lines? Take any given day – just for fun, let’s say December 10, 2015. On that day, the NTM earnings per share figure was $125.79. If we could travel back in time to 12/10/15 and talk to those “consensus experts,” they would tell us that they expected S&P 500 EPS to be $125.79 one year hence, on December 10, 2016. But now look at the green line, showing the last twelve months EPS. What were the actual S&P 500 earnings in December ’16, twelve months after that $125.79 prediction? $108.86 is the right answer, quite a bit lower than the consensus brain trust had expected!
Why is this Kabuki theater of mind games between company C-suites, securities analysts and investors important? Look at the NTM EPS trend line, which has gone up steadily for the last year even as real earnings have failed to kick into growth mode. Right now, those gimlet-eyed experts are figuring on double-digit earnings growth for 2017. Double digit earnings growth would offer at least some justification for those decade-plus high valuation levels we described above. Is there a chance that reality will fall short of that rosy outlook? That is the question that should be on the mind of any investor at all concerned about the fundamentals of value and price.
Global demand patterns have yet to show any kind of a significant pick-up from recent years, though the overall economic picture continues to improve at least moderately. And the headwinds from a strong U.S. dollar do not appear to be set to abate any time soon. As we said above – and have said numerous times elsewhere – none of this means that the market is poised for a near-term reversal. Animal spirits can blithely chug along as long as there is more cash sitting on the sidelines ready to jump back in, or a sense that there is still a “Greater Fool” out there, yet, to come in and buy.
But pay attention to valuation, and specifically to whether double-digit earnings truly are just around the corner or yet another case of hope flailing against reality.
“It is demonstrable that things cannot be otherwise than as they are; for as all things have been created for some end, they must necessarily be created for the best end.” Thus spake Dr. Pangloss in Voltaire’s satirical short story Candide. Stripping away the eighteenth century rhetorical flourishes, Pangloss’s philosophy can be read thus: “All things always happen for the best.” Satirizing that attitude was the French Enlightenment wit, Voltaire’s way of poking fun at the smug certainties of the popular mindset of his day.
Mr. Market and the Gradually Filling Glass
Voltaire seems an appropriate touchstone for this, our final commentary of the year 2016, as we have spent much of the past six weeks or so gently poking fun at the popular mindset of our day, at least as it pertains to sentiment in risk asset markets. Let’s step back, take a brief trip down memory lane (as one is wont to do at this time of year) and look at the larger picture.
2016 started off with Mr. Market viewing the glass as half empty. The Fed’s rate hike in December 2015, followed by some mildly disturbing news from China as the opening bell rung stocks into the New Year on January 2, served up our first technical correction (pullback of 10 percent or more) since 2011. The “Fed put” reliably arrived to contain the damage, and interest rates marked time. Stocks rebounded and settled into a corridor, with the S&P 500 mostly fluctuating between its May 2015 high of 2130 and an arbitrary magic-number floor of 2000.
Britain Leaves, Elephants Heave
Then along came Brexit, and the glass went from being half empty to half full. Stocks surged, crashing through the valuation ceiling to set a series of new highs in July before settling into another lackluster sideways trading pattern in August. In September, investors were on watch for some important policy events, but Mr. Market sailed through these with an air of insouciance.
Finally, in November, Republican candidate Donald Trump scraped together some 100,000-odd votes in the key battleground states of Pennsylvania, Michigan and Wisconsin to eke out a victory in the Electoral College that surprised just about everybody, including the Trump campaign team. Now the glass went from being half full to being full to the brim and sloshing over the sides onto the coffee table.
It is not entirely true to say that a new paradigm was born overnight. Financial stocks, the big winners of the last two months of the year, had been outperforming the market before the election as steadily improving wage data indicated a likely upswell of pressure on prices. But the election did catalyze two dominant themes: the “reflation-infrastructure” trade, based on expectations of a flood of new public works projects (and a corresponding spike in the deficit, interest rates and the dollar); and a sharply lower corporate tax rate that would flow straight to the bottom line and goose up corporate earnings per share.
Simply the Best, Better Than All the Rest
Enter Dr. Pangloss and the best of all possible worlds. Where the market is priced today (including market risk levels at multi-year lows alongside record high stock prices) seems to reflect a broad sentiment among investors that, of all the variables good and bad swirling around in the global economy and its policymaking centers of influence, only the good ones will actually happen. Infrastructure spending that translates to actual GDP growth? Check. Corporate tax reform that not only cuts the statutory rate but widens the base by getting rid of all the loophole goodies (through which most companies pay far less than the statutory rate today)? Yes, certainly! Debilitating trade war with China? No way! Geopolitical shock waves as long-standing alliances are called into question and traditional adversaries brazenly throw down the gauntlet to challenge them? Uh-uh, not gonna happen. All things were created for some end, and that must necessarily be the best end, said Pangloss.
To be perfectly clear, we, too, hope that 2017 will serve up more in the way of positive than negative developments. But our analysis is never based on hope. It is based on connecting the dots between disparate pieces of empirical evidence to arrive at a view on where assets appear priced relative to the value drivers and risk factors affecting them. As 2016 closes out we find ourselves still faced with large open spaces between as-yet unconnected dots. We will be coming back to work next week with our pencils sharpened, ready to crunch the numbers as they come in.
Meanwhile, we wish all our clients and friends the happiest of New Years, and a healthy and personally fulfilling start to 2017.
So here we are again, nearing one of those seminal milestones in stock market lore. The Dow Jones Industrial Average, comprised of thirty (mostly household name-y) large-cap stocks, is an index whose main claim to fame is that its life span as a barometer of market sentiment extends all the way back to 1896. The Dow is poised to break through 20,000, a number whose main claim to fame is that it contains four zeroes. “Dow 20,000” screamed the entire front cover of Barron’s magazine last week. At the round earth’s imagined corners, blow your trumpets angels!
For portfolio analysts toiling away in the data-dense world of relative value movements, 250-day rolling returns and the like, these periodic “magic number moments” are scarcely worth a second look. That is particularly true when the index in question is the Dow, a much less useful or significant gauge than, say, the S&P 500 or the Russell 3000. Rationally speaking, there is nothing whatsoever of importance in these periodic episodes.
But rationality only counts for so much. In the vulgate of the wider population of investors and kibitzers, “the Dow” and “the market” are virtually interchangeable, and a nice round number like 20,000 has all the cultural significance of a special calendar date like January 1 or July 4. As with much else in the market, perception often becomes reality. Indexes do exhibit somewhat distinct trading patterns around these magic number moments, however silly it may seem. Thus, attention shall be paid.
Uncage the Elephant
The present magic number moment happens to coincide with a period of animal spirits stampeding up and down Wall Street. The Dow is up nine percent since the post-election rally kicked off on November 9. While the index has not actually broken through the threshold as we write this, it is entirely plausible that it will be on the other side by the time we publish. Given the momentum that continues to feed off itself, counterfactuals be damned, it is more likely than not that the melt-up will carry stocks through to year-end. What then? Inquiring minds will want to know.
We have no crystal ball, of course, but we can supply a bit of historical perspective. As it turns out, the last time the Dow reached a four-zero magic moment, we were also in the middle of a market melt-up. Consider the chart below.
This chart tracks the performance of the Dow – with the tech-heavy NASDAQ shown for comparison – during the last gasp of the late-1990s tech bubble and the ensuing bear market. As the chart shows, the Dow (green line and left-hand y axis) broke through the magic number of 10,000 in late March of 1999. Dow 10,000! These round numbers often act as very tough resistance levels, but 1999’s animal spirits pushed through the barrier with relative ease and, for good measure, surged an additional 1,000 points before settling into a brief holding pattern.
Forks in the Road
One interesting feature of this end-game stage of the late-90s melt-up is the pronounced divergence between the Dow and the NASDAQ on several occasions. This observation may have some relevance in thinking about today’s environment. The last gasp of the tech bubble, when investors more or less indiscriminately bought anything that sounded tech-y and Internet-y regardless of valuation or other counterfactuals, started in late summer 1999 and topped out in March 2000. The NASDAQ, as a proxy for the tech rally, enjoyed about seven months of near-unidirectional upward momentum during this melt-up.
The Dow, conversely, fell more than 11 percent from August to October 1999, and experienced another, even more pronounced correction of minus 16 percent from January 17 to March 7, 2000. The trough for this Dow pullback, then, roughly coincided with the NASDAQ’s March 10 bubble peak of 5,048. And, in fact, the Dow proceeded to bounce up by 15 percent from March 14 to April 11, during which time the wheels came off the dot-coms and NASDAQ experienced the first of what would be a series of bone-jarring descents over the next twelve months.
Mass Movements Then…
Why did the Dow diverge so far away from the NASDAQ (and, to a somewhat lesser extent, from the S&P 500) over that last leg of the 1999-2000 melt-up, and what light may that shed on market movements in today’s environment?
The driving narrative of that late-era ‘90s rally was technology. Investors were less concerned about what individual stocks they owned, and more concerned about getting in on the general action. The ability to obtain broad exposure to the tech and Internet sector – either through one of the then-small number of nascent ETFs, a passive index fund or similar pooled vehicle structure – was more important than the relative merits of any given stock.
By contrast to the tech-dominated NASDAQ, the Dow had a relative scarcity of tech names; only IBM, in fact, at the beginning of 1999, with Intel and Microsoft somewhat latterly tossed into the mix in November of that year. The Dow’s pullbacks in late 1999 and early 2000 thus had almost nothing in common with prevailing attitudes about the tech sector, and plausibly much more to do with valuation-wary investors looking for ways to pare back equity holdings without risking their clients’ ire by dumping those beloved shares of Cisco and Pets.com.
…Mass Movements Now
This year’s post-November 8 environment is likewise largely driven by a couple top-down themes. This time, the blessings of the narrative have fallen disproportionately on a couple sectors, in particular financials, but so far the broad indexes continue to move fairly closely in lockstep.
The mass movement vehicle of choice today is the exchange traded fund. ETFs offer exposure to just about any equity or fixed income asset class, including all the major broad indexes. Complex (and not so complex) algorithms employ ETFs for quick and efficient exposure to thematic narratives, such as the reflation-infrastructure trade that has been dominant since November.
But not all indexes attract the same level of interest from the short-term money. Consider that the average daily trading volume of SPY, the SPDR S&P 500 ETF, is about 94 million shares. For XLF, SPDR’s financial sector offering, average daily volume is about 80 million shares, and for QQQ, the PowerShares NASDAQ 100 vehicle, it is a still-respectable 24 million shares.
How Now, Dow?
By contrast, the average daily volume for DIA, the BlackRock iShares ETF for the Dow Jones Industrial Average, is just around 3 million shares – less than five percent of the volume for SPY. This statistic underscores one of our opening observations in this paper: as much as the average investor equates “the Dow” with “the market,” professional investors have little use for this quaint artifact of U.S. stock market history. Since the Dow is really not a ready proxy for either a specific asset class or a wider market gauge, it doesn’t offer much of a compelling reason for use in those algorithm-driven strategies that dominate short-term trading volume.
Which, in turn, may make it worth keeping an eye on the Dow once that magic number moment of 20,000 has receded into the rear view mirror. If those thirty stocks diverge away from their broad index cousins – S&P, Russell, NASDAQ et al – they may again be the canary in the coal mine warning that the fundamentals are out of line with the still-giddy prevailing market narrative. Of course, there is no assurance that this scenario will play out, and we would advise against hanging one’s hat on this outcome. Good investing is about paying attention to lots of moving parts while maintaining the discipline not to rely unduly on one or two. But we will be keeping track of the Dow’s fortunes in the coming weeks, even after the Dow 20,000! hoopla has come and gone.
Fiscal policy is where all the cool kids hang out now, as we noted in last week’s commentary. But the monetary policy nerds at the Fed got at least a modicum of attention this week as the dots settled on the Fed funds plot chart Wednesday afternoon. As was widely expected, the meeting resulted in a 0.25 percent target rate hike and some meaningful, if subtle, changes to the 2017 outlook. Three policy actions are on tap for next year, and this time the market seems to take this outlook seriously. Chair Yellen & Co. expect the recently favorable trends in output growth and employment to continue, while expecting to see headline prices reach the two percent target by 2018. These observations appear to be largely irrespective of what does or does not happen with all the hyped-up fiscal policy that has been driving markets of late. Be well advised: monetary policy will still matter, quite a bit, in 2017. It will have an impact on many things, not least of which will be the opportunity set of fiscal policy choices.
Divergent Today, Insurgent Tomorrow
Market watchers on Wednesday made much of the (temporary, as it turns out) pullback in stock indexes in post-FOMC trading. But the real action, as has often been the case in the last six weeks, was in the bond market. The yield spike is noteworthy in absolute terms, but even more striking on a relative basis. Consider the chart below, showing the spread between the 2-year U.S. Treasury note and its German Bund counterpart.
Short-term U.S. rates are at 52-week highs while German rates are at their 2016 lows. The spread between the two is wider, at 2.07 percent, than it has been at any time since 2003. Remember divergence? That was the big theme in the discourse one year ago, when the Fed followed through on its 2015 policy action last December. The Eurozone and Bank of Japan were full steam ahead with their respective stimulus programs as the Fed prepared to zag in the other direction. Then markets hit a speed bump in January, the Fed backed off any further action and rates came back down. As the above chart shows, U.S. and German short-term rates followed a more or less similar trajectory for most of the year.
But divergence is back with vengeance. Holders of U.S. dollar-denominated assets will be pleased, as the euro gets pushed ever closer to parity. Policy divergence leads to dollar insurgence. On the negative side, that insurgence looks set to redouble the FX headwinds that have clipped corporate top line revenue growth for much of the past two years. That, in turn, will make it challenging to achieve the kind of double-digit earnings growth investors are banking on to justify another couple laps of the bull market.
Three Times the Charm?
What we took away from Chair Yellen’s post-meeting press conference was a sense that the Fed’s world view has changed only modestly amid all the hoopla of the post-election environment. She took pains to note that the outlook shift to three possible rate changes in 2017 does not reflect a seismic change in thinking among the dot-plotters, but an incremental shift reflecting a somewhat more positive take on the latest growth, employment and price data.
And fiscal policy? Yellen could hardly avoid the topic; it was the point of the vast majority of the questions she fielded from the press. Over the course of her tenure at the Fed she has spoken many times of the need for monetary and fiscal policy to complement each other at appropriate times in the business cycle. This, however, may not be one of those times. Consider her comment in response to one question: “So I would say at this point that fiscal policy is not obviously needed to help get us back to full employment.” For the moment, at least, and in the absence of any tangible data to suggest otherwise, the Fed does not appear to be giving undue attention to the fiscal variable.
As Location Is To Real Estate, Productivity Is to Growth
Chair Yellen did make a point of emphasizing what kind of fiscal policy she does like: namely, that which directly helps boost productivity. That’s a point you have heard us make in this space ad nauseum, so it was good to hear it from the Eccles Building. What kind of fiscal policy could that be? Education, jobs and skills training programs and improving the quality of installed capital used by American workers were specifically called out by the Fed chair. Of course, there is no clarity of any kind that such productivity-friendly programs will make it through the legislative sausage factory. One can always hope, though.