Covenant Weekly Market Synopsis as of January 6, 2017

January 9, 2017

Risk assets got off to a good start in the first week of trading. Domestic, international and emerging market stocks all moved higher by around 2%, shaking off some of the softness witnessed in the final week of 2016. The yields on US Treasury bonds were volatile (expect a lot of that this year), but ended the week slightly lower (as the prices on the bonds increased marginally). The commodity complex also participated in the rising tide as precious metals, copper and crude prices all increased. The US Dollar was flat on the week, while the VIX Index (a measure of expected equity market volatility) was the poster-child for complacency as it was slammed down to 11.3 (a 19.4% decline on the week).

For a detailed view of weekly, month-to-date and year-to-date asset class performance please click here.

Inflated Inflation Concerns – The inflation drum is being beaten louder and louder in catchy headlines authored by various financial publications and bloggers. In all likelihood, they will be proven right….but only in the short-term. That is to say, the widely cited Consumer Price Index (CPI), which currently stands at 1.7% year-over-year growth, will shoot through 2% in the coming months as we lap weak energy data from early last year. This move will surely cause volatility in fixed income investments and other interest-rate sensitive investments, as many will extrapolate the short-term spike into a longer-term trend. But this will be a mistake, and a welcome one to nimble traders and investors with a more informed long-term view on the structural issues working against pronounced inflation. The CPI is heavily influenced by temporary (referred to as “transitory” in Fed speak) factors such as the price of oil, which introduces excessive volatility to the data series. Core CPI, which strips out energy (and food) prices, is a more stable data series and has proven to be a better predictor of inflationary trends. As such, Core CPI is worth keeping an eye on and it remains just a hair over 2%, per the following chart from FTN Financial.

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According to the minutes from the most recent FOMC meeting in December, the Fed is pretty relaxed about inflationary pressures. The Fed sees a modest upward bias, through 2017, but “…inflation was projected to be marginally below the Committee’s longer-run objective of 2% in 2019” (Source: Fed staff outlook). The bottom line is the longer-run data doesn’t support the short-term media narrative that inflation is poised to get out of hand.

But what about Trump’s fiscal stimulus – won’t that cause inflation to increase above 2% on a sustained basis? We don’t think so and neither does the Fed. Several FOMC members considered a stimulus package in their long-run inflation forecasts, but it didn’t move the needle significantly. Keep in mind that the Fed will move rates higher to counteract the inflationary effects of fiscal stimulus should it be judged that the economy is overheating… so that becomes a zero-sum game, or something close to it as it relates to inflation.

To be clear, inflation is present in the economy, and that is a good thing. Yet, inflation well in excess of 2% on a sustained basis is unlikely in the next couple of years. This view will be covered in more detail in our Q1 2017 Quarterly Economic Review & Outlook that will be distributed towards the end of the month.

Near Term Tax Reform Unlikely – Since the election the markets have ripped higher, propelled by expectations of fiscal stimulus, deregulation, and tax reform. Stocks are seemingly priced to perfection on expectations that this prosperity-trifecta will be implemented both at the magnitude advertised during the campaign and within a short timeframe. Over the last week I have heard from a D.C. insider/lobbyist and a politically-savvy economist that a vote on tax reform will not come until late 2017 or perhaps 2018. The reason for the extended timeframe is that the Democrats will be doing everything in their power to drag their feet and delay appointments in the Federal Reserve, courts and cabinet. This process must be completed before Congress can turn their attention to their normal business of lawmaking, and then their first priority will be to replace the Affordable Care Act. So while market expectations are for a quick realization of the prosperity-trifecta, there is ample room for disappointment as one or more of the key initiatives are either delayed or watered-down.

Weekly Economic Data Summary: The New Year began with a very positive week for economic data. The December ISM Manufacturing Index reached a two-year high rising to 54.7 (from 53.2 in November). It was a very solid report with increases in new orders, production and prices paid. The recent acceleration in the US Dollar is bound to hurt exporters, but nevertheless it was a solid report to end the year – hopefully, the momentum can be maintained in 2017. The December ISM Non-Manufacturing Index held steady at 57.2, solidly above the 50.0 reading that demarcates expansion vs. contraction. The December payroll report revealed mostly good news, with the addition of 156k jobs and an acceleration in wages. The Unemployment Rate ticked up to 4.7% (from 4.6%) as more people entered the Labor Force (a good thing for future economic growth, assuming they are hired).

 

Be well,

Jp.