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Weekly Market Commentary

September 4, 2018

The Markets

Where is our country’s biggest export market?

Markets were fired up last week after the United States and Mexico agreed on new trade rules. The Standard & Poor’s 500 (S&P 500) Index reached an all-time high and finished the month of August up about 3 percent, reported Michael Sheetz, Thomas Franck, and Alexandra Gibbs of CNBC.

• When will the Fed stop raising rates? The Fed is all but guaranteed to raise rates in September, with market odds at a 96 percent probability and a 60 percent probability for another hike in December. The Fed will continue its gradual interest rate increases for now as long as economic activity is consistently expanding at a sustainable rate. The minutes revealed the Fed governors will soon revise its policy stance from “accommodative to neutral,” reported MarketWatch.

• What does the Fed think about tariffs? The Fed is aware tariffs could derail their initial plan of steady rate hikes. Although concerned about President Trump’s tariffs, they are waiting for economic data to assess the damage. They did, however, say tariffs would have “adverse effects on business sentiment, investment spending, and employment. Moreover, wide-ranging tariff increases would also reduce the purchasing power of U.S. households,” reported The New York Times.

Summary and Conclusion:

Asset prices rose in July driven by strong earnings that reflected continued solid economic growth and the corporate tax cut. Central Bank actions that resulted in a decline in the quantity of dollars, net, on the Central Banks’ balance sheets moderated the rise in asset prices. Following a bullish FOMC assessment of the economy, the 10 year Treasury bond yield climbed back to the 3 percent level from the 2.8 levels that prevailed during the past few months. The S&P500 index of U.S. equity market prices rose 4.3 percent during July ending the month roughly 4.7 percent above the level of yearend 2017. The equity market in July maintained the trend of steady growth in asset prices at relatively low volume and volatility that has characterized equity markets over the past several years, save the February – April period when assets were repricing to reflect the changes to relative after-tax earnings due to U.S. Federal tax legislation. The VIX dropped back to its low level of July 2017 in July but is still nearly 25 percent above the levels of autumn 2017 and roughly fifty percent of the levels prevailing from February-April 2018. The yield on 10 year U.S. government bonds breached the 3.0 percent rate during the end of July after spending the last several months in the 2.8 to 2.9 percent range. The higher level of the 10 year rate, relative to that of autumn 2017, is consistent with a pickup in productivity growth based on stronger investment spending last year, as well as expectations of continued strong investment due to the incentives for investment spending in the recently passed tax bull. The recent decline reflects concerns that a change in trade policies might offset the effects of deregulation and tax policies that have spurred investment and spending growth. The 2018Q2 GDP release as well as the FOMC’s Press Release removed traders concerns regarding business investment and inflation. Net sales of Treasury and Mortgage backed Securities by the Federal Reserve and some other Central Banks is also contributing to the rise in the yield on 10 year bonds. The Federal Reserve decided to leave the target range of the Federal Funds rate unchanged at a target range of 1.75 to 2.00 percent at its August 1 meeting. (The latest release on core and headline inflation based on the PCE price index registered 2.2% (headline) in June relative to June of 2017 and 1.9% on core (excluding food and energy). The Fed’s target is 2.0 percent inflation on the headline PCE price deflator. (The Fed in its May Press Release emphasized that the 2 percent objective is a symmetric one allowing for some overshoot as well as undershoot of inflation.) The dollar remained relatively unchanged against the major currencies -- a level 3.0 percent stronger than its January 2018 reading, but 6.1 percent weaker than in January 2017. I attribute the stronger dollar since January 2018 to a combination of the Federal Reserve’s normalization of its balance sheet (- $220 billion) that has offset the increases in international reserves of foreign central banks as well as the continuation of strong U.S. growth and the risk of weaker than expected growth abroad.

Summary and Conclusion:

Asset prices fell in June driven by Central Bank actions that resulted in a decline in the quantity of dollars, net, on the Central Banks’ balance sheets. These moves by Central Banks offset the effects of a strong U.S. economy (that has yielded strong earnings), despite a rise in the 10 year Treasury bond yield from the levels that prevailed during the last half of 2017. The S&P500 index of U.S. equity market prices declined 1.4 percent during June ending the month roughly 0.4 percent above the level of yearend 2017. The equity market in June maintained the trend of steady growth in asset prices at relatively low volume and volatility that has characterized equity markets over the past several years, save the February – April period when assets were repricing to reflect the changes to relative after-tax earnings due to U.S. Federal tax legislation. The VIX increased to slightly above its low levels of early 2017 in June but still nearly 70 percent above the levels of Autumn 2017 and roughly seventy percent of the levels prevailing from February-April 2018. The yield on 10 year U.S. government bonds breached the 3.0 percent rate during May but retraced some of its rise in June falling back to the 2.8 to 2.9 percent rate. The 10 year yield ended May roughly 10 basis points higher than end April and currently stands at 2.97 percent. The higher level of the 10 year rate, relative to that of autumn 2017, is consistent with a pickup in productivity growth based on stronger investment spending last year, as well as expectations of continued strong investment due to the incentives for investment spending in the recently passed tax bull. The recent decline reflects concerns that a change in trade policies will offset the effects of deregulation and tax policies that have spurred investment and spending growth. I doubt that bond traders are pricing in a significant increase in inflation as only at best a modest increase is apparent in the data. Net sales of Treasury and Mortgage backed Securities by the Federal Reserve and some other Central Banks is also contributing to the rise in the yield on 10 year bonds. The Federal Reserve decided to raise the target range of the Federal Funds rate to a target range of 1.75 to 2.00 percent at its June 13 meeting. (The latest release on core and headline inflation based on the PCE price index registered 2.3% (headline) in May relative to May of 2017 and 2.0% on core (excluding food and energy). The Fed’s target is 2.0 percent inflation on the headline PCE price deflator. (The Fed in its May Press Release emphasized that the 2 percent objective is a symmetric one allowing for some overshoot as well as undershoot of inflation.) The dollar appreciated 0.8 percent against the major currencies -- a level 3.1 percent stronger than its January 2018 reading, but 6.4 percent weaker than in January 2017. I attribute the stronger dollar since January 2018 to a combination of the Federal Reserve’s normalization of its balance sheet (- $150 billion) and a decline in the dollar reserves held by the main international reserve holders (-$12.5 billion during the past May) and the continuation of stronger U.S. growth as well as risks of weaker than expected growth abroad.