Weekly Commentary

As of Friday, February 17th, 2017

Volatility vs. Vitriol – Feelings and the Future

SUMMARY

Equity markets were positive across the globe with U.S. stocks (S&P 500) up +1.55% and international stocks (EAFE) up +0.60%
Fixed income markets were mixed with investment grade bonds (AGG) down -0.09% and high yield bonds (JNK) up +0.16%
Fed Chairwoman Yellen – testified before Congress this week and strongly indicated that the Fed will raise rates again by midyear—markets wobbled on the news.
North Korean Missile Tests – were not only denounced by South Korea but also President Trump and Japanese Prime Minister Abe in a joint press conference.
Canadian PM Trudeau – visited D.C. this week to discuss trade with President Trump, as well as the President’s approval of the Keystone Pipeline which runs from the Alberta oil sands, with both sides indicating the meeting went relatively well.
Former PM Tony Blair – is urging citizens to demand a re-vote on Brexit, but given his current unpopularity is unlikely to influence such a decision.
Greek Debt Crisis – the saga continues with Greek PM Tsipras saying he feels there will be a positive outcome, while European Commission President Juncker says a new deal remains on “shaky ground.” Next week is the stated deadline to agree on terms for a new bailout.
Contrarian Trade? – U.S. stocks are now at a 40-year high relative to their European counterparts. European companies are currently trading at a forward-looking price-to-earnings (P/E) ratio of around 14.7 (MSCI Europe Index), compared to 17.8 for U.S. companies (S&P 500 Index). Geopolitical risks such as Brexit and the Greek debt situation still loom in the minds of Euro skeptics.
Commentary: There is currently an interesting dichotomy regarding people’s mindsets as manifested in their outlook vs. investing behavior. Below we will take a quick look at this “personality split” in the U.S., and then review a macro look at the four fundamental areas that have historically been true threats to an economy.

MARKET RECAP

THE FACTS

Positive data this week included:

Philly Fed Business Conditions Survey – hit its highest level since 1984, and included positive capital expenditure readings for the second month in a row after 13 consecutive months of declines, signaling a high level of optimism regarding economic policy amongst businesses. This optimism was also apparent in the strong reading of the most recent NFIB Small Business survey.
Leading Economic Indicators Index – rose 0.6% month-over-month and is up 2.5% year-over-year. Such numbers suggest the odds of a recession are approximately 10%.
U.S. Corporate Earnings – with over 75% of S&P 500 companies having reported, S&P 500 earnings are on track to post an increase in year over year earnings of more than 8% (Thomson Reuters data).
Retail Sales – accelerated (rates of change matter even more than absolutes) to +4.4% year-over-year growth, as did the US Consumer Price Inflation reading which was +2.5% year-over year.
Japanese Growth – their economy grew at annualized rate of around 1% in Q4, in line with improved expectations and above their long-run potential, suggesting Abenomics is working.
Housing Starts – declined 2.6% in January, but still beat expectations. It is noteworthy that starts are up 10.5% year-over-year, and are leaning positive despite the rise in interest rates.
Eurozone Construction – is up a very solid 3.2% year-over-year.

Disappointing data this week included:

Industrial Production – contracted in January -0.3%, missing expectations of 0.0%. It is important to remember that this slight contraction is coming off of a very strong December, and that part of the headline numbers weakness was due to the volatile sub-sectors of utilities and autos.
Eurozone GDP – disappointed expectations slightly coming in at +0.4% for Q4 and 1.7% for all of 2016. Leading economic indicators, including PMI data and sentiment readings, point to a strong 2017 for the region.

Commentary: Volatility vs. Vitriol – Feelings and the Future

“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” – Peter Lynch (legendary investor)

Intro

The frustrating reality for many is that how they feel doesn’t change reality or have any real predictive value. As we mentioned in some of our previous Commentaries there are many out there that feel the market must be about to “crash.” When one takes a moment to hear them out the basis of their analysis isn’t much more than an extrapolation of the old saying of “what goes up must come down.” Just because it’s been rainy or sunny for a few days doesn’t mean the weather has to change, and just because a coin has landed on heads five times in a row doesn’t change the odds of the next flip. All of those sentiments are understandable feelings but are also examples of flawed logic.

Sure the market will go down for a while at some point but to the extent people’s feelings have any impact on the market, it usually manifests in a way contrary to popular sentiment. As famous investor Sir John Templeton once said, “Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.”

By most metrics we would still appear to be somewhere in the skepticism range. However, there is currently an interesting dichotomy regarding people’s mindsets as manifested in their outlook vs. investing behavior. Below we will take a quick look at this “personality split” in the U.S., and then review a macro look at the four fundamental areas that have historically been true threats to an economy.

The Current Split-Personality Here in the U.S.

Market volatility is extremely low (see chart below), and has fallen over 25% during the last three months. Any calls for volatility to pick up a bit would hardly be courageous from these levels, and wouldn’t necessarily be indicative of something sinister.

While this would be unusual enough, it is especially interesting when one considers the near-historic high of “uncertainty” people are currently expressing regarding their future outlook for the country/economy.

One possible way to reconcile this seeming contradiction is with the old saying “don’t let your politics influence your market outlook.” However, perhaps the more complete explanation lies not in the fact that the country remains fairly divided along partisan lines, but that many investors are still recovering emotionally from the great recession/market crash of ’08/09. These two items have created a fairly consistent pessimistic outlook since 2008. However, as we’ve been pointing out in the last few Weekly Commentaries such pessimism isn’t supported by current data.

The “Four Horsemen” of Threats to Economic Prosperity

Brian Wesbury, Chief Economist for First Trust recently put out a very nice and succinct outline of the four most common reasons for an economic recession and/or bear market. These pieces also included his take on how likely any one of them is to derail the current situation. For what it’s worth, I have followed Wesbury for years, heard him speak a number of times and had the opportunity to visit with him as well. Whether people share his perspective or not, I have always found him to be a very thoughtful, intelligent and positive person.

Now to his analysis. The four threats he covers are monetary policy, trade policy, tax policy and spending/regulatory policy. (If you’d like to watch the four-part video series you can visit ftportfolios.com, and look for Wesbury’s section under the Research and Commentary tab).

I. Monetary Policy (The Fed)

The largest threat in his view is always monetary policy, which simply put is the Federal Reserve’s policies regarding how much money is in the system and the level of the Fed Funds interest rate. The danger comes from times where the Fed pulls too much money from the system and/or raises interest rates too far.

Neither is a threat currently in his opinion. As to the first part there is still over $2 trillion of access reserves in the system. As to the second point, he notes that looking back over the last sixty years one finds that unless the Fed Funds rate rises above the nominal GDP rate interest rates are not so tight as to threaten economic growth.

Currently the Fed Funds rate is only at 0.75%, and the nominal GDP growth rate is over 2%, signaling we have a long ways to go before rates threaten to create a recession.

II. Trade Policy

The next threat he takes a look at is trade policy. The threat here is that over 27% of our economy is based on imports and exports, and any type of trade war could have profound negative impacts.

Given many of the “protectionist” views President Trump has shared around trade, particularly the discussions of an American “border tax” and rumblings from the EU of appealing such an action to the WTO, this one is at least plausible. However, it is worth noting that the Republican controlled Congress is unlikely to support any substantial anti-trade policies. And given our importance to Canada, China and Mexico they have little interest in a trade conflict as well.

Of all the potential “threats” this is the one that bears the most watching moving forward, but in both Wesbury’s opinion and mine, still seems relatively small.

III. Tax Policy

As someone I would describe as a supply-side economist, Wesbury certainly feels that lower tax-rates and less regulation help the economy to grow by putting more capital in the hands of entrepreneurs and innovators.

He points out that our current top-end personal income tax rate of 42% is significantly higher than it has been for most of the modern era including times of greater economic growth than we have currently. He also notes that our current corporate tax rate of 35% is the highest in the developed world, both of which he credits in part for the historically speaking anemic economic growth rate we’ve had since the recession in 2008.

While not arguing that they are high enough to throw the economy back into a recession his primary point is that should the President and Republican Congress follow through on their pledge to lower taxes, this potential threat could actually become a “pillar of prosperity” moving forward.

IV. Spending and Regulatory Policy (The Fat Jockey Phenomenon)

As was stated above, Wesbury falls into the economic camp that believes that lower taxes and less regulation put more capital and control in the hands of our most productive citizens, and that such a reality enables greater economic prosperity for all. There is certainly strong evidence that his views have substantial merit.

During this section he points out the interesting factoid that during the 1950’s the Federal Register (where all new federal regulations are published) added 107,000 pages, during the 80’s we added about 500,000 pages, and in this decade we are on pace to add over 800,000 pages of new regulations. Wesbury makes the analogy that the American entrepreneur/economy is a thoroughbred racehorse and the government is a jockey. His position is that the existence of, and directions from, the jockey are absolutely necessary, but he notes that should the jockey get too big it slows the racehorse down. As you can see in part from the facts above, the American economy is lugging around a pretty sizable jockey these days.

The current Administration and Congress have begun to address this issue, already removing a number of previous regulations as well as instituted a policy that in order to enact a new regulation there must be the removal of two others. Therefore, this economic “threat” seems to actually be receding.

Like the trade issue above, the issue of government spending is worth watching. The President has alluded to some pretty sizable increasing in spending, largely around infrastructure spending, that could exacerbate the federal deficit and grow the overall government budget. Here again though, he is likely to meet some resistance from Congress.

Summary

The current economic expansion and bull-market in risk assets appear set to continue for some time without a meaningful shock (e.g. geopolitical event). The majority of analysts we work with are actually upping their GDP forecasts for Q1 based on this week’s data releases.

Over the last few weeks, we “debunked” the popular argument that expansions must end after a set period of time, but showed how such ends are based on fundamentals. Wesbury’s summary of common macro-economic threats is not only a helpful framework, but filter that shows the likelihood of a recession is still small.

As I write this I am reminded of the quote, "If someone doesn't value evidence, what evidence are you going to provide to prove that they should value it? If someone doesn't value logic, what logical argument could you provide to show the importance of logic?" (Sam Harris)

Perhaps there is no better explanation for why the economy should remain on solid ground. Markets do not care about people’s feelings, politics or wishes outside of short-term moves, they are driven by data. While I understand, and am even sympathetic to a degree, of people’s skepticism I would encourage them to not get so caught up in issues that don’t impact markets that they overlook the evidence in front of them that does, and most importantly make choices that deviate from a long-term plan.

Thanks for taking the time to read this, and have a great weekend!

Tim and the team at TEN

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