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MV Weekly Market Flash: Hope Accelerates – Will Reality Follow?

February 23, 2018

By Masood Vojdani & Katrina Lamb, CFA

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Every fiscal quarter, publicly traded companies and the securities analysts who cover them engage in a series of time-honored rituals. The rituals follow the elaborate pantomimes of a Japanese Kabuki drama, and the underlying message is almost always the same: Hope Springs Eternal. Consider the chart below, which shows quarterly earnings per share trends for the S&P 500. 

How to Speak Kabuki

Here’s how to interpret this chart. The green line represents projected earnings per share for the next twelve months. Basically, analysts project what they think will happen to the companies they analyze in the year ahead, based on the economic context and all the usual industry- and company-specific competitive variables, and those assumptions boil down to the one NTM (next twelve months) EPS figure. This chart shows the composite NTM EPS for all the companies in the S&P 500. For example, on January 31, 2017, the composite estimate for what S&P 500 shares would be worth a year hence (i.e. at the end of January 2018) was $133.17 per share.

The red line illustrates the actual earnings per share for the twelve trailing months, known in finance-speak as LTM (last twelve months). So if the green line represents the hope, then the red line shows the reality, or what actually happened. As you can see, the actual LTM earnings per share for the S&P 500 on January 31, 2018 was $118.08. It wasn’t $133, as the analysts had forecast a year earlier.

Moreover, the chart shows that this “reality gap” plays out in virtually every quarter, year after year. What often happens as earnings season approaches is that analysts start to dial back their earlier predictions to bring them closer to reality. In so doing, they are playing another important role in the Kabuki drama: managing expectations. Earnings season is only partly about the actual growth number; it is also about whether this number is better than, or worse than, what was expected. The downward revision that customarily takes place in the weeks before a company reports has the effect of lowering the bar, so that whatever number the management team actually reports has a better chance of beating expectations.

This Time Is (Sort of) Different

Clear as a bell, right? In summation: expected earnings are usually rosier than the actual figures that come out later, and the elaborate play-acting between management teams (forward guidance) and securities analysts (downward revisions to expectations) contrives to deliver happy surprises to the market.

Except that the script is a bit different this year. Analysts are actually raising – not lowering – their expectations for 2018 earnings performance. Let’s consider the case for Q1 2018. This is the quarter we are currently in, so we don’t know how the companies are actually going to perform. What we do know is that the analysts’ consensus estimate for Q1 S&P 500 earnings as of today is 17.1 percent growth. When the same analysts made their Q1 forecasts at the end of last year, the estimate was 10.9 percent. That’s a big difference! And not just for Q1. The analysts’ Q2 estimate is also significantly higher today than it was seven weeks ago. In fact, the consensus estimate for full year 2018 earnings growth is 18.2 percent, which is 8 percent higher than on December 31, when analysts predicted growth of just 10.3 percent.

That difference – the difference between 18 percent and 10 percent – matters a lot for equity valuation. If companies in the S&P 500 grow their earnings by 18 percent this year, then a similar rise in share prices will not make stocks any more expensive, when measured by the price-earnings multiple variable. That would ease investors’ worries about a potential share price bubble. Double digit price growth matched by double digit earnings growth is arguably the best of all possible worlds for long equity investors.

Here is the one caveat. Much of the apparent optimism in the current earnings projections comes from one single fact – the tax cuts enacted in December that were disproportionately skewed towards corporate tax relief. You can see from the green line in the above chart just how dramatically expectations accelerated right around the time the relief package took shape. More than any other factor, the tax cuts help explain why, contrary to the usual practice, earnings estimates have been raised rather than lowered as reporting dates come closer (though we should also note that a weaker US dollar, should it persist, could also be an earning tailwind for companies with significant overseas activities).

More to Life than Taxes

Investors should take in this seemingly good news with a measure of caution. First, to the extent that the tax relief does make a strong impact on the bottom line (which would be the case for companies that actually pay something close to the previous statutory tax rate, by no means a majority of S&P 500 companies) it will be a one-and-done kind of deal. The growth rate will kick up for one fiscal year cycle of “comps” – comparisons to the previous year – and then stabilize at the new level.

Second, there are other variables in flux that could at least partially offset the tax advantages. Corporate borrowing will be more expensive if (a) interest rates generally continue to rise and (b) credit spreads widen in response to higher market volatility. Companies in more price sensitive industry sectors may have to address issues of how much new inflation they can pass on to their customers. And, of course, corporate top lines (sales) will be dependent on the continuation of global economic growth leading to increased organic demand for their products and services.

Finally, the only way that companies can consistently grow their earnings above the overall rate of GDP growth is through productivity-enhancing innovations to their value chains. There may be a new wave of such innovations just around the corner – or there may not be. How these developments play out over the coming months will determine whether the current rosy predictions of the analyst community play out – or whether they quickly go back to that familiar old Kabuki script of hope and reality.

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MV Weekly Market Flash: The Dollar Is Sitting Out This Party

February 16, 2018

By Masood Vojdani & Katrina Lamb, CFA

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So, everything’s back to normal, right? The sharp pullback that began with the hourly wage number exactly two weeks ago has assumed its usual V-shape, with 5 straight trading days in the green following the technical correction level of minus 10.2 percent reached on February 8. Just like that silly Ebola freak-out back in 2014, this one looks like it will pass over, a brief squall yielding back to calm seas without so much as a full day spent below the 200-day moving average.

Right?

Yields Go North, Dollar Goes South

The good news, for those who prefer their equities portfolios neither shaken nor stirred, is that the continuing rise in bond yields is failing to inject fear into risk-on asset classes. The 10-year Treasury yield broke through 2.9 percent on Wednesday, even as the S&P 500 recorded yet another intraday gain of more than 1 percent. Those inflationary fears would seem tempered, even though Wednesday’s news cycle also served up a core CPI growth number a bit higher than consensus expectations. For the moment, anyway, the stock market seems comfortable enough with higher rates.

Which brings us to today’s big question: what is up with the US dollar? The chart below shows the downward trajectory of the dollar against the euro over the past six months, during which period the 10-year yield soared from just over 2 percent to the recent 2.9 percent.

All else being equal, rising rates should make the home currency more, not less attractive. Investors prefer to invest where returns are higher. Moreover, the dominant economic narrative around the US for the past half-year or so has been positive: above-trend growth, strong corporate earnings and high levels of business and consumer confidence. What’s not to love? Yet, even while the spread between the 10-year Treasury and the 10-year German Bund is 0.45 percent wider than it was six months ago the euro, as seen in the chart above, has soared against the dollar. And the pace has only accelerated since the beginning of 2018. Yes, the dollar jumped ever so briefly as a safe haven mentality took hold two weeks ago, but it fell back just as quickly – even while the 10-year yield reached new 4-year highs.

Supply and Demand, Yet Again

We’re starting to feel like Econ 101 professors around here lately, given how often the phrase “supply and demand” shows up in our commentaries and client conversations. We think it may be the single most important catchphrase for 2018, and in it lies a plausible explanation for that odd relationship between the dollar and bond yields. The supply-demand road inevitably leads back to China.

China’s central bank buys US government debt – lots of it. Chinese foreign reserves exceed $3 trillion, and the vast bulk of those reserves exist in the form of US government securities. Two things happen when Chinese monetary authorities (or any other foreign institution) buy US paper, all else being equal. First, the price goes up, and thus the yield, which moves in the opposite direction of the price, goes down. Second, the dollar goes up because Treasuries are a dollar-denominated asset. You see, it really is all about those supply and demand curves.

Recent evidence (including a weak Treasury auction last week) suggests that Chinese Treasury purchases are somewhat lower than they have been in recent years. That rumor back in early January, though quickly disputed, may have a kernel of truth to it. Foreign buyers indeed may have less appetite for Uncle Sam’s IOUs. Maybe they expect more inflation down the road (which would assume higher nominal rates). Maybe other factors are afoot. Whatever the reasons, reduced demand from non-US sources would indeed have the likely effect of pushing up rates and pushing down the dollar at the same time.

If this is the case, then we may be in for more bumpiness in equities. The S&P 500 digested the move to 2.9 percent very smoothly. We may see in the coming weeks whether the story plays out the same way at 3 percent or more. There will be a truckload of Treasuries coming down the road as we borrow to fund all that new spending and those tax cuts. More supply, in other words, potentially chasing less demand.

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MV Weekly Market Flash: The Peril and the Promise of Higher Rates

February 9, 2018

By Masood Vojdani & Katrina Lamb, CFA

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Watch the bond market: that was a core theme of our recent Annual Outlook and earlier commentaries in this brief, suddenly volatile year to date. Benchmark Treasury yields jumped on the first day of the year and never looked back. For the first month equities kept pace with rising yields, delivering the strongest January for the broad US stock market since 1987. Then it all went pear-shaped. Yields kept rising, while risk-on investors developed a case of the chills and sent stocks into a sharp retreat. The S&P 500 saw its biggest intraday declines since 2011, and the fastest move from high to 10 percent correction – 9 trading days – since 1980. Investors, naturally, want to know if this is just a long-overdue hiccup on the way to ever-greener pastures, or the start of a new, less benign reality.

The Expectations Game

The chart below shows the performance of the S&P 500 and the 10-year yield for the past 12 months through the market close on Thursday.

What caused that abrupt change in sentiment? Investors seemed perfectly happy to watch the 10-year yield rise from 2.05 to 2.45 percent last September and October, and again from 2.4 to 2.7 percent over the course of January. What was it about the move from 2.7 to 2.86 percent to precipitate the freak-out in stocks? The most widely cited catalyst has been the wage growth number that came out in last Friday’s jobs report; after growing at a steady rate of 2.5 percent for seemingly forever, the wage rate ticked up to 2.9 percent in January. According to this train of thought, the wage number raised inflationary expectations, which in turn raised the likelihood of a faster than expected rate move by the Fed, which in turn led to portfolio managers adjusting their cash flow models with higher discount rates, which in turn led to the sell-off in equities this week.

Algos Travel in Packs

There is a kernel of truth to that analysis, but it doesn’t really explain the magnitude or the speed of the pullback. For more insight on that, we turn to the mechanics of what forces are at play behind the actual shares that trade hands on stock exchanges every day. In fact, very few shares trade between actual human hands, while the vast majority (as high as 90 percent by some estimates) trade between algorithm-driven computer models. The “algos,” as they are affectionately known, are wired to respond automatically to triggers coded into the models.

On most days these models tend to cancel each other out, sort of like the interference effect of one wave’s crest colliding with another’s trough. But a key feature of many of these models is to start building a cash position (by selling risk assets) when a certain level of volatility is reached. Even before the selling kicked in last week, the internal volatility of the S&P 500 had climbed steadily for several weeks, while the long-dormant VIX was also slowly creeping up. The wage number may or may not have been a direct trigger, but enough of these models read a sell signal to start the carnage. Rather than waves canceling out, it was more like crests meeting and growing exponentially. More volatility then begat more selling.

The Case for Promise

So we’ve been given a taste of the peril that can come from higher rates. What about the promise? Here we leave the mechanics of short-term market movements and return to the fundamental context. The synchronized growth in the global economy has not changed over the past two weeks. The Q4 earnings season currently under way continues to deliver upside in both sales and earnings growth, while the outlook for Q1 remains promising. If wages and prices grow modestly from current levels – say, for example, so that the Personal Consumption Expenditure index actually rises to the Fed’s 2 percent target – well, that is in no way indicative of runaway inflation.

This should all be good news; in other words, if the current global macro trend is sustainable, it would strongly suggest that the current pullback in risk assets is more like a typical correction (remember that these normally happen relatively frequently) and less like the onset of a bear market (remember that these happen very infrequently). Higher rates have an upside as well, when they reflect positive underlying economic health. With one caveat.

The Debt Factor

Call it the dark side of the “reflation-infrastructure trade” that caught investors’ fancy in late 2016. The US is set to borrow nearly $1 trillion in 2018, much of which is to pay for the fiscal stimulus delivered in the administration’s tax cut package. That borrowing, of course, takes the form of Treasury bond auctions. A weak auction of 10-year Treasuries on Wednesday is credited for pushing yields up (and stocks down) late Wednesday into Thursday. These auctions, of course, are all about supply and demand. Remember that brief freak-out in early January when rumors floated about China scaling back its Treasury purchases? Supply and demand trends stand to weigh heavily on investor sentiment as the year progresses.

Now, a great many other factors will be at play influencing demand for Treasuries, including what other central banks decide to do, or not do, about their own monetary stimulus programs. Higher borrowing by the US may be offset if overseas demand is strong enough to absorb the expected new issuance. Time will tell. In the meantime, we think it quite likely that the surreal quiet we saw in markets last year will give way to more volatility, and to sentiment that may shift several times more as the year goes on between the peril and the promise of higher interest rates.

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MV Weekly Market Flash: Our 2018 Investment Thesis

January 19, 2018

By Masood Vojdani & Katrina Lamb, CFA

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We will be publishing and distributing our Annual Outlook next week, a 24-page opus reflecting not only our analysis of the quotidian variables likely to be at play in the economy over the coming twelve months, but also a commentary on today’s world in a larger historical context. Meanwhile, we will use the opportunity of this week’s regular commentary to share with you the executive summary from the forthcoming Outlook, to give you an advance look of what you will read in further detail next week.

• “Moderate growth, low inflation, improving labor market”: this would have been a reasonable way to characterize US economic trends in 2013. And in 2014, 2015 and 2016. So it was not exactly an earth-shaking surprise when 2017 delivered…yes, moderate growth, low inflation and a still-improving labor market, if the latter slowed down just a bit in net new job creation. Tracking the macroeconomy has become something akin to watching daily episodes of Seinfeld. Not much of any consequence ever happens, and every now and then some amusing diversion appears to briefly engage one’s attention. Try as we might to unearth some new piece of information suggesting the approaching end of this placid state of affairs, we cannot. The data say what the data say. 2018, for the moment, looks set to deliver more of the same.

• The key difference between 2017 and earlier years in this recovery cycle was that the rest of the developed world came on board. Organic demand and consumer confidence perked up in the Eurozone, Britain managed to at least temporarily forestall a reckoning with the consequences of Brexit, Japan stayed positive while ex-Japan Asia Pacific countries did just fine. China, meanwhile, met its growth benchmarks by initially going back to the tried and true mix of debt-sourced spending on infrastructure and property. Beijing reversed course midyear, though, with a concerted program to reduce borrowing and recommit to economic rebalancing (this coincided with a further consolidation of power by President Xi Jinping). Elsewhere in emerging Asia and beyond, concerns about looming trade wars faded and domestic assets, including long-beleaguered currencies, perked up for a winner of a year. Again – while there are plenty of geopolitical variables that could form into tangible threats at any time – the basic macroeconomic variables appear stable. Markets ignored geopolitics last year, we expect them to do the same in the year ahead.

• Calendar-gazers are filling up the airwaves with the observation that the current recovery – from July 2009 to the present – is one of the longest on record. If we manage to avoid a recession between now and May, the current growth cycle will move ahead of that of 1961-70 as the second-longest, trailing only the ten years of good times from 1991 to 2001. To those nervously ticking off elapsed calendar days we offer two ripostes. First, markets and economies don’t pay attention to calendars, which are entirely a human construct. Second, there are potentially valid reasons why the current uptrend could go on for longer. From 2009 to 2014, arguably the main force behind continued growth was the Fed and its quantitative easing mechanics that flooded the world with money. Only more recently has the growth started to look more traditional – more like actual improvements in business and consumer sentiment begetting a virtuous cycle of increased supply feeding increased demand. If anything, the perky demand trends we see today more resemble those of an early than of a late stage in the cycle. The uniqueness of that multi-year experiment in unorthodox monetary policy may make comparisons with other growth periods less meaningful.

• So if the default assumption is that 2018 will be a year of very few changes to the presiding macroeconomic trends, what alternative scenarios could upend the base case? The key X-factor, we believe, is the one that nobody from Fed governors to that fellow holding court at the end of the bar completely understands; namely, the curious absence of inflation. The inflation rate has fallen short of the Fed’s explicit target of 2 percent throughout the entire recovery to date (when excluding the volatile categories of energy and foodstuffs). This despite the dramatic fall in the unemployment rate from 10 percent at its peak to just 4.1 percent today. The economic models built over the decades following the Second World War baked in the fundamental assumption of a trade-off between inflation and employment: be prepared to sacrifice one in pursuit of the other. That assumption has not held up at all in recent years. But before pronouncing last rites on the Phillips Curve, we again draw your attention to our observation in the previous bullet point: the kind of growth one normally sees early in a recovery cycle may only now be showing up. If so, then a sudden surge of higher than expected inflation would not be entirely implausible.

• The second alternative scenario that could disrupt the smooth sailing of most capital markets asset classes would be, perhaps, the other end of the spectrum from a growth-fueled resurgence of inflation. The Fed intends to raise rates again this year – three times if the stated expectations of the FOMC’s voting members are to be believed – and to begin winding down the balance sheet that grew to $4.5 trillion over the course of the QE years. These intentions reflect a confidence that the economy is fully ready to stand on its own two feet – which confidence, of course, proceeds from those same steady macro trends we described a few bullet points ago. But there is still a chance, and not necessarily a small one, that today’s bubbly sentiment is ephemeral and will dissipate once the crutch of monetary policy is finally and conclusively removed. Specifically, not one of the three structural drivers of long-term growth – population, labor force participation and productivity – are demonstrably stronger now than they were two years ago when we devoted some number of pages in our Annual Outlook to the concept of secular stagnation. There may be less to the current growth uptick than meets the eye. If so, a Fed misstep on the pace of unwinding easy money – too much, too soon – could be the trigger that boots the Goldilocks economy to the exit door.

• What both those alternative scenarios – an unexpected inflation surge and a Fed policy fumble – have in common is the potential to wreak havoc on credit markets. From an asset markets perspective, credit markets hold the key to how virtually any asset class – debt, equity or alternative – will perform. Here’s why. The risk-free rate – in general practice the yield on intermediate / long Treasury notes – is employed in just about every standard asset valuation model. All else being equal, an increase in interest rates has the effect of decreasing the present value of future cash flows. Asset managers will reprice their models if reality outstrips expectations about yields. A likely ripple effect resulting from a Treasury rate repricing would be widened risk spreads (affecting, for example, corporate investment grade and high yield bonds), a pullback in equity prices and a commensurate uptick in volatility. Whether the riskier conditions persist would be situation-specific, but there would very likely be at least some damage done.

• Again, we view these as alternative scenarios to be a more benign base case. Even if one of the other were to come to pass, though, it would not necessarily start the clock on a countdown to the end of this long bull market. For that to occur, we believe one of three events would have to emerge: a full-blown recession (which is different in nature from a periodic surge in inflation), a crisis such as the implosion of the financial system that led to the 2008 crash, or the outbreak of an actual hot war somewhere in the world that significantly involved the US and/or other large powers. The risk of any of these things happening in 2018 is not zero, but we would ascribe a probability of less than 25 percent to any of them.

• US equity valuations are stretched, particularly for the large cap growth segment of the total market that has consistently outperformed over the past several years. Relying on relative valuations alone would potentially lead investors to other areas, like Europe or emerging markets, that still have some catching up to do even after a strong performance in 2017. In the long run valuations matter – there is no coherent way to view a share price as anything other than the present value of a series of future cash flows. In the short run, valuations don’t always matter. Relative geographic performance in 2018 will be subject to other influences, not least of which will be the direction of the US dollar.

• The dollar was one of the big surprise stories of 2017. Long before equity shares in financial institutions or resource companies snapped out of their “reflation-infrastructure trade” myopia, the US currency had done a U-turn from its rapid post-election ascent. The dollar fell by nearly 10 percent against a basket of other major currencies last year, and that soft trend has continued thus far into 2018. Currency strength was a major force driving performance for developed and emerging market equities and debt last year. Whether a reprise of that trade is in store for the year ahead depends – again – on that tricky combination of alternative economic scenarios. If US interest rates rise substantially, with the ECB and the BoJ at the same time proceeding more cautiously, then a stronger dollar would be a rational expectation as investors pursue higher yields. That outcome is not set in stone, however. Major foreign investors – most notably China – may look to diversify their foreign exchange assets if their perception of US risk changes, which would, all else being equal, have a negative effect on the dollar. 

• Commodities may stand on the other side of the dollar’s fortunes. A weaker dollar makes commodities more affordable in other currencies; that, along with the return of strong organic demand, may supply a tailwind to a range of energy and industrial commodities. But oil, which has recently surged to its highest levels in three years, remains vulnerable to the prospect of increased shale production in the US. As with currencies, there are many factors at play that could work either for or against key commodity classes.

• In conclusion, we could sum up the essence of our views thus: Things Don’t Change, Until They Do. The benign tailwinds of moderate, steady global growth will not last forever. Neither we nor anyone else can point with certainty to the date when the sea change happens. What we can do is pay close attention to the things that matter more. Farmers know how to sense an approaching storm: the rustle of leaves, slight changes in the sky’s color. In the capital marketplace, those rustling leaves are likely to be found in the bond market, from which a broader asset repricing potentially springs forth. Pay attention to bonds in 2018.

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MV Weekly Market Flash: Exuberance and Edginess

January 12, 2018

By Masood Vojdani & Katrina Lamb, CFA

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The S&P 500 has appreciated 3.6 percent in price terms in the first eight days of trading this year. It seems highly unlikely that the index will match this pace for the year’s remaining 242 trading days, so it’s reasonable to wonder what’s going to happen next. It’s always a fool’s errand to predict the timing and magnitude of future price movements; for clues, though, one’s best bet would probably be to follow the bond market. Amid all the exuberance in equities, there is a palpable edginess in the once staid world of fixed income. That edginess was on full display for a few hours Wednesday morning. A rumor floated out that China’s monetary authorities (who also happen to be the world’s principal consumers of US Treasury debt) were considering scaling back their purchases of US sovereigns, presumably as a cautionary move to diversify the composition of their foreign exchange reserves. Bond yields spiked immediately, and the 10-year yield shot up perilously close to last year’s high mark of 2.63 percent. That’s also the 10-year’s peak yield since the crazy days of 2013’s “taper tantrum” – remember those good times? The chart below shows the 10-year yield trend over the past five years. 

At the Mercy of Supply and Demand

Wednesday’s mini-panic dissipated soon enough; the 10-year yield fell back and remains, as we close out the week, around 5 to 8 basis points below that 2.63 percent threshold (a handful of bond pros out there believe markets will all go haywire if that threshold is breached, for reasons with which we don’t necessarily agree). The Chinese put out an anodyne denial of any intentions to scale back Treasury purchases. The S&P 500, which Wednesday morning futures indicated could suffer a meaningful pullback, briskly resumed its winning ways. And all the while volatility has remained in the fetal position which has been its custom for the last year.

But that hair-trigger reaction to the China rumor underscored just how antsy the bond market is right now, and how exposed it is to the basic laws of supply and demand. Bear in mind that intermediate and long term bond prices are subject to many variables, while short term bonds tend to much more closely track the Fed. One of the key drivers keeping yields in check for the past several years has been robust demand from overseas – robust enough to make up for the reduction in demand at home when the Fed ended its quantitative easing program. If international investors turn sour on US credit – for whatever reason, be it inflationary concerns, a bearish outlook on the dollar or even jitters over our chaotic politics – that has the potential to push yields well past the notional 2.63 percent ceiling. A subsequent move towards 3 percent would not be out of the question.

Visions of 1994 Dancing In Their Heads

The bond market angst has its own mantra: “Remember 1994!” That, of course, was the year the Greenspan Fed surprised the markets with an unexpectedly aggressive interest rate policy, starting with a rate hike nobody was anticipating in February of that year. Investors will remember 1994 as being a particularly roller-coaster one for stocks, as the surprise rate hikes caught an ebullient bull market off guard. The chart below illustrates the volatile peaks and valleys experienced by the S&P 500 that year.

Now, the conventional wisdom in 2018 is that the Fed will do its utmost to avoid the kind of surprises the Greenspan Fed engineered over the course of 1994 (which included a surprise 50 basis point hike in the middle of the year). But investors are also cognizant of the reality that there are new faces populating the Open Market Commission, which of course will feature a new chair in the person of Jerome Powell. All else being equal, the new Fed is likely to proceed cautiously and not risk unnerving markets with a policy surprise. But all else may not be equal, particularly if we get that inflationary surprise we’ve been discussing in a number of these weekly commentaries. Then, a new Fed trying to get its sea legs may face the urgency of making decisions amid a tempest not of its own making.

We’ve had some reasonably benign price numbers come out this week: core producer and consumer prices largely within expectations. Bond investors appear relieved – yields have been fairly muted yesterday and today even while equities keep up their frenetic go-go dance routine. But there is not much complacency behind the surface calm.

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