Fed Update

Fed Note:

The March FOMC meeting ended as many predicted—with no change to the fed funds rate, which is currently set at 2.25-2.50%. Regardless, the meeting was closely watched in terms of how the Fed planned to communicate a stance on policy for the remainder of 2019.

The formal statement noted a slowing in economic growth from the last meeting in January, including slower growth in household and business spending, while employment remained strong and inflation remained lower recently. The summary of economic projections, released quarterly, showed a downgrade in the ‘dot plots’ (which are generally averaged visually) to essentially zero implied rate changes for 2019, and perhaps only a handful at best over the next few years.

Investors were also watching for signs of a change in current or future policy regarding the runoff of the large Fed balance sheet (which it announced will taper off and in September). While the runoff had been described as being on ‘autopilot,’ fears have increased over an unreviewed runoff amount becoming excessive, essentially resulting in a ‘tapping of the policy brakes’ at the long-end of the treasury yield curve and perpetuating higher rates than ideal. One tweak is that maturing agency MBS will eventually be invested in treasuries instead—in keeping with the Fed’s preference for using treasuries as a purer policy tool and exiting the mortgage market, the participation in which was less ideal long-term as it implies a nudge toward helping housing markets (not part of the Fed’s mandate).

One very interesting development has been the change in Fed Funds futures market probabilities. Late last year, it was largely assumed the Fed would hike perhaps 1-2 times in 2019, a downgrade from the 3-4 many first expected based on the pace of rate hikes last year. As global uncertainty has increased, including the mixed bag of economic data showing deceleration in a variety of areas, this has since morphed into a market expectation for ‘no change’ this year, which has been in conflict with the Fed’s own estimates. Now, the tide has completely turned, with market probabilities for December showing 70% no change and 30% for a 0.25% or more rate cut. This would have almost unthinkable not that long ago, but worries over a possible slowdown into recession have begun to dominate market psyche. A variety of market strategists continue to believe the underlying economy is stronger than it looks, and could easily still handle a hike or two. Within reason, a few hikes could help the Fed with more ammunition to fight the next recession through room to cut rates at that time as needed.

Also interestingly, the Fed is reviewing its approach toward inflation targeting this year, and it is quite possible they could move toward an ‘averaging’ method. This would treat the 2% policy target as a multi-year objective, as opposed to a full-time anchor. What this means is if inflation were to run below target, such as during a recessionary period, it may be later allowed to run ‘hot,’ for example perhaps a half-percent higher than target during a subsequent expansion—resulting in a net result near target for the cycle as a whole. Such a method would give the Fed greater flexibility for interest rate policy, but not having been used up until now, we don’t know what any potential side effects could be from such a change. No doubt there will be more to come on this discussion.

The dashboard of key Fed mandates shows a little-changed story, despite what one might assume from the whipsaw in market sentiment over the past few months:

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Weekly Economic Update

Economic Update 3-20-2019

  • A busy week for economic data included stronger-than-expected results in retail sales, durable goods, construction spending, consumer sentiment and several jobs indicators, while industrial production fell short. Several inflation measures also came in a bit lower than anticipated.
  • U.S. and foreign markets both experienced solid gains for the week. Bonds also fared positively, led by riskier sectors, such as high yield and emerging markets. Commodities gained along with a weaker dollar and higher pricing for crude oil.
  • U.S. stocks fared well during the week, as economic data on the macro side was supportive of fundamentals, although offering few big surprises. Optimism persists over a potential U.S.-China trade deal in coming weeks, along with a Chinese pledge last week to not rely on currency devaluation as a trade leveraging tool.

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Weekly Economic Update

Economic Update 3-11-2019

  • Economic data for the week, with a delayed schedule still affected by the government shutdown, showed positive results for ISM non-manufacturing/services and housing, coupled with a lackluster February employment report, which looked to have strongly negative winter weather effects.
  • Equity markets declined by several percent globally, due to concerns over world growth, with a stronger U.S. dollar punishing local returns a bit more for foreign stock markets. In fixed income, safe haven U.S. government bonds gained ground, while high yield struggled. Commodities were little changed, in keeping with a rare calm week for crude oil prices.

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Weekly Economic Update

Economic Update 3-04-2019

  • Economic data for the week consisted of prior quarter GDP growth coming in late but a bit better than expected, mixed results for housing and consumer sentiment, while ISM manufacturing and jobless claims were weaker.
  • U.S. equity markets gained slightly, as did those in foreign developed markets, while emerging markets declined. Bonds lost some ground as interest rates increased. Commodities fell, led by declines in multiple segments, including the price of crude oil by several percent.

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Weekly Economic Update

Economic Update 2-25-2019

  • Economic data for the week consisted of weaker results from durable goods orders and a key regional manufacturing index, as well as a lower existing home sales. An index of leading economic indicators was flattish, with incomplete data. However, jobless claims and homebuilder sentiment improved.
  • Global equity markets earned positive returns again, as sentiment stayed buoyant, and emerging markets leading the way. Bonds were flat, in keeping with minimal changes in interest rates. Commodities rose as the result of gains in industrial metals, natural gas and crude oil.

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Weekly Economic Update

Economic Update 2-19-2019

  • Economic data for the week included poor showings from retail sales and industrial production, in addition to higher jobless claims; inflation came in relatively muted on a producer and consumer basis; on the positive side, manufacturing and consumer sentiment survey data were better than expected.
  • U.S. equity and developed foreign markets experienced sharp gains on the week, outperforming weaker results in emerging markets. Bonds were little changed, other than riskier debt outperforming treasuries. Commodities pushed higher on the back of a strong week in crude oil.

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Weekly Economic Update

Economic Update 2-11-2019

  • Economic releases were again light, as the impact of the government shutdown has altered schedules for now-stale data, but the week did see a weaker, but still strong, result for ISM non-manufacturing, a trade balance that moved further into deficit than expected, and jobless claims continued to indicate strength in labor markets.
  • U.S. equity markets were flattish on the week as earlier optimism again tapered off due to skepticism about a U.S.-China trade agreement, although foreign stocks fared worse due to a stronger dollar.  Bonds performed decently on the back of lower interest rates.  Commodities declined on the week, driven by lower prices for crude oil and natural gas.

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Weekly Economic Update

Economic Update 2-04-2019

  • Economic data for the week included no change in the Federal Reserve’s policy interest rate, and more mixed results from housing, while positive results originated from ISM manufacturing data and labor markets, particularly the employment situation for January.
  • U.S. equity markets gained for the week, with foreign equities just behind.  Bonds eked out a minor gain as interest rates declined along the yield curve.  Commodities rose a bit upon a further recovery in crude oil prices.

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Fed Update

The FOMC unanimously decided on no policy action upon the conclusion of their January meeting, which was as expected.

The formal statement noted continued strength in the labor market and economic activity rising at a ‘solid’ rate (downgraded from December’s ‘strong’).  While household spending has continued to grow, a slowdown in business fixed investment last year was also mentioned.  Notably, the committee’s description of being ‘patient’ about determining future changes was newly inserted into the brief note, in consideration of both muted inflation but also global economic and financial developments as of late.  In fact, all mention of the ‘gradual increase’ path for interest rates was removed, which was telling.

Interestingly, one change for 2019 is that the Jerome Powell-led Fed will host a press conference with Q&A after all eight meetings, as opposed to only after the four quarterly ‘formal’ variety in past years.  While this may not have a major impact on policy, it could give the FOMC more latitude to make more controversial decisions at any of these meetings, since they’ve tended to do so only when a media backdrop was available to further clarify aims.  In contrast to the Fed of old, communications and ‘forward guidance’ have become important pieces of their toolkit.

Volatility in several segments over the past few months—including financial markets (volatile stock prices and wider credit spreads), the political environment/government shutdown, trade policy between the U.S. and China and a continued strong dollar—have also added to a general headwind of tightening financial conditions.  Such a tightening in overall conditions serves a similar purpose to the Fed raising rates directly, by tapping the brakes on the economy—which can either help the Fed, by doing the job for it, or acting as a hindrance in other cases.

There has also been speculation as to whether the Fed would slow the pace of drawing down their balance sheet of treasury and agency mortgage-backed securities (which it did not, but remains prepared to ‘adjust the details’ of this program over time as needed).  Beginning in Oct. 2017, the Fed began the process of unwinding the large quantitative easing program by letting a pre-determined amount of bond assets mature (up to a cap, which has increased in stages), which allows the reduction to be done gradually and avoid market distortions.  Since peaking at around $4.5 tril. at the time of the drawdown program’s inception, the current balance sheet size has declined to $4.0 tril.  Interestingly, the gradual pace of these drawdowns has not seemed to disrupt bond market supply/demand dynamics on the surface.  However, while this has been put in place as a ‘normalization’ program, intended to eventually get the Fed balance sheet to far lower sustainable levels, it does have the impact of ‘tightening’—as increasing treasury/MBS supply and reducing reinvestment demand could have the technical effect of raising interest rates, all else equal.  Somewhat fortunately, in a world of low overall interest rates throughout the developed markets of Europe and Asia, other global buyers had stepped in to fill the gap—especially since the cost of currency hedging was reasonable (those low costs have dissipated since, making this a less attractive trade).  Long-story short, the Fed may elect to alter their pace of balance sheet drawdown should additional signs of economic slowing occur, resulting in less possible upward pressure on longer-term rates, but also keep the balance sheet bloated for a longer period of time.  It’s no secret that the Fed would prefer to keep the balance sheet ‘purer’ by only holding treasury debt, and unload the unique pile of MBS, and removing the more politically-charged implied support of housing markets (which is not in their mandate).

Probabilities for rate hikes in 2019 have fallen sharply, down to about 25% for June and 30% for December (with the latter also including 5% odds of a rate cut—a recently added twist).  The laundry list of Fed mandate items hasn’t changed radically over the last few meetings, other than concerns over growth having increased:

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Weekly Economic Update

Economic Update 1-28-2019

• Economic data for the week was again limited by the government shutdown, and consisted of stronger house prices but weaker existing home sales, a tick down in the incomplete leading economic indicators, and sharply better and again record-breaking jobless claims.

• Global equity markets were mixed with foreign stocks outperforming U.S., with the help of a weaker dollar. Bonds gained slightly, as lower interest rates outweighed other factors, with foreign also outperforming due to currency effects. Commodities were down overall, with natural gas prices dropping sharply.

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Weekly Economic Update

Economic Update 1-21-2019

  • Although limited to some extent due to the Federal government shutdown, economic data for the week included a slight decline in producer prices, weaker consumer sentiment, mixed regional manufacturing results, but strong industrial production and jobless claims.
  • U.S. equity markets continued their recovery upward upon stronger sentiment, with foreign stocks in developed and emerging markets just behind.  Bonds ended the week with negative returns, as interest rates again ticked higher.  Commodities gained on the back of crude oil, which regained ground by several percent on the week.

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Weekly Economic Update

Economic Update 1-14-2019

  • Economic data for the week was lighter than usual, due to the Federal government shutdown, but was highlighted by a tempered but still-strong ISM services report, pullback in consumer inflation, decent labor data and release of the minutes from the last Fed meeting.
  • Global equity markets recovered by several percent, in a continued effort to shake off the bear market of last quarter.  Bonds were mixed, with interest rates inching higher.  Commodities gained ground, again led by a recovery in crude oil pricing.

 

U.S. stocks continued their recovery last week, up several percent on hopes (again) that the U.S.-China trade dispute would be resolved through ongoing talks.  It appears progress has been made in the areas of U.S. farm exports and better access to Chinese markets, while the key issue of Chinese technology pilfering remains unresolved.  There also appears to be some recognition of value in equity markets, with P/E’s falling below long-term averages, after spending parts of the last year or two looking a bit ‘tired’, which is a euphemism for mildly expensive, even if not quite bubble-like.  The now record-long government shutdown has not resulted in a major deterioration in market sentiment, although Fed chair Powell also acknowledged that a long-lasting episode could ultimately end up negatively influencing economic growth.

From a sector perspective, cyclicals outperformed, with industrials, consumer discretionary and technology leading, while defensive staples and utilities ended with minimal gains.

Foreign stocks rose along with U.S. equities, albeit to a lesser degree, with continued hope for U.S.-China trade resolution.  This correlation with domestic stocks has been the tendency over the past several months, which has outweighed fundamental concerns over weakness in economic growth shown by slower industrial production numbers in Germany and France, in particular, and mixed results in Japan, which is hoping to generate some inflation to show that growth could be eventually improving.  Overall, growth levels remain challenged in the foreign developed world, which has explained the weak results of regional stock markets.  Emerging markets outperformed developed, with hope for trade resolution, which boosted China and Pacific region equities, in addition to stronger commodity results as of late, which has boosted prospects for materials exporters.

U.S. bonds were mixed in the week, with government indexes down as interest rates ticked back higher slightly, but credit outperformed with spreads contracting.  Accordingly, high yield bonds experienced strongly positive results, followed by floating rate bank loans.  Each of the latter two asset classes suffered during the fourth quarter as investor flows away from risk highlighted their somewhat higher equity correlations compared to other segments of fixed income.  Foreign bonds gained slightly, with help from a weaker dollar.

U.S. treasury debt has long been thought of as the global ‘risk-free’ asset, where default is assumed to be unthinkable, and, therefore, is often the recipient of inflows when conditions turn sour in other asset classes.  However, there are times when ‘risk-free’ isn’t a failsafe, either.  As if the lesson wasn’t learned several years ago, the ongoing federal government shutdown has again caused bond rating agencies to discuss and/or even consider a de-rating for U.S. government debt.  Even while Standard & Poor’s downgraded treasury debt a partial notch to AA+ during that 2011 summer debt ceiling debacle, Moody’s and Fitch held firm at AAA (albeit with their respective outlooks downgraded less severely to ‘negative’).  However, Fitch has been providing warnings that stunts such as the government shutdown could again threaten that coveted AAA status, stating that such uncertainty was not consistent with behavior of nations deserving a top rating.

Real estate experienced very strong gains for the week, surpassing broader equity markets, with the exception of small cap.  Cyclically-sensitive lodging and resorts outperformed, although all segments were sharply positive.

Commodities gained several percent, again driven by the volatile movements of crude oil, but also a weaker dollar and an increase in natural gas prices.  Crude oil continued its roller-coaster ride, regaining ground to end the week 8% higher, at just under $52/barrel.  While OPEC has reiterated its desire to raise prices to more budget-friendly levels in Middle Eastern and Eastern European producing nations, much of the recent volatility has been coupled with equity market gyrations and concerns over global growth—although demand is far more predictable than short-term supply.  While forecasts are often not helpful in the commodity space, with no ‘fair value’ metrics based on actual cash flows, estimates for crude in the coming year appear to be in the mid- to higher-50s at this point.

 

Period ending 1/11/2019 1 Week (%) YTD (%)
DJIA 2.42 2.93
S&P 500 2.58 3.63
Russell 2000 4.84 7.36
MSCI-EAFE 2.89 3.90
MSCI-EM 3.75 3.67
BBgBarc U.S. Aggregate -0.04 0.18

 

U.S. Treasury Yields 3 Mo. 2 Yr. 5 Yr. 10 Yr. 30 Yr.
12/31/2018 2.45 2.48 2.51 2.69 3.02
1/4/2019 2.42 2.50 2.49 2.67 2.98
1/11/2019 2.43 2.55 2.52 2.71 3.04

 

 

Sources:  LSA Portfolio Analytics, American Association for Individual Investors (AAII), Associated Press, Barclays Capital, Bloomberg, Deutsche Bank, FactSet, Financial Times, Goldman Sachs, JPMorgan Asset Management, Kiplinger’s, Marketfield Asset Management, Minyanville, Morgan Stanley, MSCI, Morningstar, Northern Trust, Oppenheimer Funds, Payden & Rygel, PIMCO, Rafferty Capital Markets, LLC, Schroder’s, Standard & Poor’s, The Conference Board, Thomson Reuters, U.S. Bureau of Economic Analysis, U.S. Federal Reserve, Wells Capital Management, Yahoo!, Zacks Investment Research.  Index performance is shown as total return, which includes dividends, with the exception of MSCI-EM, which is quoted as price return/excluding dividends.  Performance for the MSCI-EAFE and MSCI-EM indexes is quoted in U.S. Dollar investor terms.                                                                               

The information above has been obtained from sources considered reliable, but no representation is made as to its completeness, accuracy or timeliness.  All information and opinions expressed are subject to change without notice.  Information provided in this report is not intended to be, and should not be construed as, investment, legal or tax advice; and does not constitute an offer, or a solicitation of any offer, to buy or sell any security, investment or other product. 

 

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