Last Week Today: President Trump again criticized the Fed for raising interest rates, which seemed to have some effect in pushing the US Dollar lower early in the week. | Perceived legal problems for the President resulted in a minor risk-off trade on Tuesday when his former attorney pleaded guilty (implicating the President in the process), and his former campaign chairman was convicted on eight criminal charges. | Minutes released from the recent Fed meeting show that certain members of the committee are concerned about the Fed’s ability to fight the next recession (more on this below). | Trade negotiations between a Chinese delegation and the U.S. went nowhere as reciprocal tariffs on $16 billion goods and services were implemented. | Fed Chair Jerome Powell’s speech at the annual Jackson Hole symposium was interpreted as long-term dovish giving equities a boost, even as the yield curve flattened further – the US Treasury 10/2-year spread ended the week at less than 20bps, moving ever closer to inversion. | Dallas Fed President Robert Kaplan appeared to push back on Trump’s tweets regarding interest rates, “The job of a central bank and my job is to make decisions on monetary policy without regard to political considerations or political influence. I’m very confident we’ll do that.” Speaking of which, two more rate hikes this year are a near certainty unless international trade or emerging market turmoil spreads SIGNIFICANTLY into domestic markets.
Equity markets pushed higher in a record-setting week for the S&P 500 (+0.9%), Nasdaq (+1.7%), and Russell 2000 (+1.9%) indexes. Global stocks, while not setting new highs, kept pace with their large-cap domestic counterparts, with developed market international stocks rising 1.1% (as measured by the EAFE Index) and the relentless selling of Emerging Market stocks abated, as would-be bottom fishers pushed the MXEF Index higher by 2.5% (though it remains down -3.4% MTD at -7.7% YTD). As mentioned above, the US Treasury curve flattened, as 2-year treasury yields rose 0.1%, while the yield on the 10-year UST dropped -0.05% to 2.81%. The yield on the 30-year UST fell -0.06%, crossing below the 3% threshold to end the week at 2.96%. The US Dollar declined on the week, releasing pressure on the commodity complex: gold +1.8%, copper +2.7%, and WTI Crude +4.3% ($68.72 per barrel).
For detail on weekly, month-to-date and year-to-date asset class performance, please click here.
Questions: On Friday at the Jackson Hole symposium, Fed Chair Jerome Powell’s keynote speech described the dove/hawk divide in the Federal Open Market Committee and the path of future monetary policy. Powell used the following questions to summarize the views of the doves vs. the hawks.
Asketh the Dove: “With no clear sign of an inflation problem, why is the FOMC tightening policy at all, at the risk of choking off job growth and continued expansion?” The dove contingent believes that if the Fed does not change the way it forms monetary policy by slowing the pace of rate hikes, they will once again be confronting the threat of deflation within the next ten years, forecasting the following:
- The fed funds rate will fall to the effective lower bound (i.e., a Fed Funds rate of 0%) and remain there for 3-4 years within the next decade.
- Inflation will average 1.2% over the 10-year period.
- Economic growth will average 1% below potential over the decade.
Asketh the Hawk: “With the unemployment rate well below estimates of its longer-term normal level, why isn’t the FOMC tightening monetary policy more sharply to head off overheating and inflation?” The hawks argue the Fed should raise rates at an accelerated pace when the unemployment rate falls to very low levels (i.e., below the estimated natural rate of unemployment) to avoid elevated inflation and asset bubbles.
Quoth the Fed Chair: “These questions strike me as representing the two errors that the Committee [the Fed] is always seeking to avoid as expansions continue – moving too fast and needlessly shortening the expansions, versus moving too slowly and risking a destabilizing overheating.” In other words, while the underlying data and analytical methodologies may change, this debate is nothing new, and the questions frame the Fed’s challenge in setting monetary policy.
Powell’s stated solution is to borrow from both the doves and the hawks by walking a middle path of monetary policy. This approach includes continuing to remove accommodation slowly and looking beyond the unemployment rate for signs of slack in the economy. Powell hopes to avoid the inflationary episode of the 1970’s and achieve the low-inflation growth of the 1990’s. We certainly wish him well, but we also appreciate that the 1970’s and the 1990’s do not serve as useful templates for monetary policy today. Neither of those periods followed a path in which a global recession caused the Fed to reduce interest rates to zero and employ aggressive, unconventional monetary stimulus. The Fed was indeed not alone in applying emergency stimulus. Negative interest rates crossed the Rubicon from theory to reality when the European Central Bank, Bank of Japan and others, began charging interest on deposits. As a result, Fed Chair Powell and his colleagues are facing the backend of the grand monetary policy experiment, trying to safely guide the economy through a high tide of liquidity precipitated by central banks around the world.
Food for Thought: While we (as in, the collective marketplace of investors) bask in the glow of second quarter’s 4.1% annualized GDP growth rate (noting that Q3 is off to a good start as well), it’s essential to keep our eye on the ball and not to allow ourselves to blindly accept that 4% growth is the “new normal”. Accelerating economic growth has been fueled by government debt (tax cuts and fiscal stimulus increase government borrowing to fund the gap between tax receipts and spending). Likewise, corporations have been binging on low-interest rate leverage. Although capital expenditures picked up recently, much of the proceeds from cheap corporate debt amassed since the Great Financial Crisis has been directed toward non-productive purposes such as stock buybacks and special dividends. The term “non-productive” is meant in the economic sense, in that stock buybacks do not increase the economic output of a corporation to offset interest payments on the debt. Now that the tide is changing, and the Fed is on a path to raise interest rates, it’s worth keeping an eye on the health of corporate balance sheets. On that point, corporate debt is at levels typically seen during recessions when measured as a percentage of GDP.
There are, of course, two inputs to this equation: total debt levels (numerator) and Gross Domestic Product (divisor). A decline in the numerator (i.e., corporations paying down debt) or a rise in the divisor (accelerating GDP growth) will cause this metric to decline. The recent downturn of the squiggly line in the chart above reflects the latter scenario. However, 4% annualized GDP growth is unlikely to continue for long, and the market is confirming as much through the flattening yield curve. The takeaway is that, in the aggregate, corporations are running bloated balance sheets that will inhibit flexibility to maneuver when growth inevitably slows. Although there does not appear to be imminent danger, at a time when domestic stocks look expensive by most generally accepted measures, don’t allow yourself to get carried away by looking in the rearview mirror. Instead, cast your eyes forward through the proverbial windshield, and remain disciplined in diversifying your portfolio by balancing equity risk with other types of investments.
P.S. Good morning Donna E.