Fed Note

It wasn’t expected for the Fed to take any action at their meeting concluding today, so there were no disappointments (i.e. nothing happened from an interest rate standpoint, by unanimous vote).

Their formal statement reflected their views that the economy is continuing to expand at a ‘moderate’ pace, coupled with ‘solid’ labor growth. Overall, the language wasn’t altered much from December, but improvement was noted in consumer and business sentiment as well as higher inflation, despite continued low inflation expectations.

In looking at the dashboard of Fed mandates, the numbers similarly haven’t largely changed from the end of 2016, but we could be seeing more of a gradual evolution in a few areas, that may or may not be jump-started by stronger post-election business sentiment and/or legislative/fiscal action.  The baseline case appears to be 2-3 rate hikes in 2017, perhaps spread out to about one per quarter or so, but that is certainly subject to change based on data releases and other conditions.

Economic growth:  While the advance release of Q4 GDP was disappointing, coming in at under 2%, hopes remain for a stronger 2017 from tax cuts, fiscal stimulus and reduced regulation—with the latter being a key issue in small business sentiment.  However, there is a lot of legislative work to be done for any of these to occur, and, regardless, it will take time for the results of new efforts to trickle down to the balance sheets of consumers and businesses.  However, the ‘animal spirits’ component has helped spending, and down to manufacturing and capex as of late.  At the same time, though, the longer-term headwinds caused by weaker developed market demographics haven’t gone anywhere, so hoping for a miracle and new permanent paradigm might prove challenging.  But, slightly better growth of even a half-percent or so would be a help, both in the U.S. and globally.

Inflation:  Since CPI is calendar-based, typically quoted using the trailing 12-month rate of change, the recovery in oil prices has pushed the inflation stats higher from the lows we saw just a few quarters ago.  But at the same time, it’s not exorbitant, at +2.1% for headline and +2.2% for core.  Primary drivers other than energy have been house prices/rents as well as medical costs, each of which experienced different dynamics.  Fears persist that inflation may rear its ugly head again if fiscal stimulus becomes too excessive, labor markets begin to run too hot and wage growth sees a consistent pattern higher, but not many economists are calling for hyperinflation quite yet.  Risks of those types of extreme outcomes traditionally have included wars, oil price supply shocks and the like.  However, energy surprises have become less of a threat in recent years with the U.S. emerging as the swing crude producer, which has loosened OPEC’s grip, which is still present but not as tight as it was in the mid-1970’s.

Employment:  We’ve discussed the status of labor markets several times in recent Fed notes, and the situation hasn’t changed much as of late (since conditions are quite strong, this is not a bad thing).  Economists debate the exact level of ‘full’ employment, but generally agree that it’s somewhere in the 4.5-5.0% range—where we are today.  While we could see further improvement in this through a lower unemployment rate, it may also surface through year-over-year wage growth, very much in line with the Fed’s intention to let the economy run ‘hot’ for a bit.  Of course, the danger is that it could begin to run too hot and the Fed falling behind the curve in not rising rates fast enough, which has been a tendency of central banks historically.

From an investment standpoint, we’ve seen a slow shift from a very skeptical U.S. bull market to more of an optimistic bull market—but one not quite at the euphoric stage.  At the same time, we’ve seen more divergence in other asset classes, such as foreign equities, due to skepticism remaining higher in Europe and Asia, which has kept valuations overseas cheaper.  Bonds are still the wildcard, with large asset inflows finally tapering off following recent rising rates.  Fixed income remains important for diversification purposes and risk control in portfolios, but being more selective has been rewarded, as has a continued focus on credit (larger spreads equal higher return) and shorter duration (lower interest rate risk).  What brings bull markets to an end?  It could be policy mistakes, commodity spikes or recessionary clouds on the horizon, but strategists are dismissive on these risks thus far.  Good times always come to an end eventually, but the base case seems to be extra innings first.