Q3 2017 July 21
ECONOMIC FORECAST
DBFitzpatrick
REGISTERED INVESTMENT ADVISORS
INSIDE THIS ISSUE:
Fed Struggles to Get Timing Right
Bull Market Rolls On, But Stocks Look Pricey
DB Fitzpatrick 800 W. Main Street, Suite 1200 Boise, Idaho 83702 (208) 342-2280 www.dbfitzpatrick.com
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ECONOMIC FORECAST | Q3 2017
FED STRUGGLES TO GET TIMING RIGHT U.S. Federal Reserve policymakers confront a difficult environment today, as they would very much like to begin shrinking the Fed’s $4.5 trillion balance sheet (which is made up principally of U.S. Treasuries and agency mortgage-backed securities bought during the last several years) but fear that doing so too quickly could push the economy into recession. The rank and file at the Fed appear to be divided regarding the best course of action and, indeed, there are good arguments on both sides of the debate. Those arguing in favor of beginning the process of shrinking the balance sheet point out that the national unemployment rate has fallen to 4.4%, the stock market has been booming, and inflation, though not quite at the Fed’s 2.0% target, is fairly close. Delaying the move, the argument goes, risks unacceptably high inflation down the road. Furthermore, if its balance sheet were smaller the Fed would have enhanced ability to institute new rounds of bond purchases if some unforeseen disaster were to befall the economy. A significant faction of the Fed’s policymaking team, however, believes it is too early to act on
the balance sheet. They point to an inflation rate that is still below the Fed’s target, a labor participation rate near a 40-year low, and economic growth numbers in the U.S. that are good but not great. Additionally, they point to the risks that such a move would create for currency markets. The European Central Bank is still instituting its own bond buying program and a
policy divergence of the two most important central banks in the world could push the dollar significantly higher. Finally, the doves at the Fed argue, the political environment in the U.S. appears somewhat unstable, with upcoming fiscal and trade policies difficult to predict. This also argues (they contend) for a cautious and patient approach to the balance sheet.
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An additional complication to this debate is that Fed chair Janet Yellen’s term expires next February. President Trump has not ruled out appointing her to another term but given his pointed criticisms of her past decisions a reappointment seems unlikely. Most of the names being discussed as replacements for Yellen – a mix of academic economists and Wall Street pros – come down on the hawkish side of the policy debate.
and agency MBS roll off the balance sheet later this year. Falling breakeven rates are a signal that investors believe such a move would strain the real economy and could lead to slower economic growth. Breakeven rates have recovered somewhat in the following month, but it’s not clear if this is because investors are more comfortable with the plan or more skeptical that the Fed will be able to follow through.
The argument against additional monetary policy tightening was given a boost in June as inflation breakeven rates (investors’ forecast for what inflation will be in the future) fell immediately after Yellen announced a fairly detailed plan to begin letting U.S. Treasuries
The Fed has consistently decided to err on the side of caution since the depths of the financial crisis in 2009, providing appropriately loose monetary policy to help the real economy get back on its feet. Janet Yellen’s recent comments, however, indicate that there has been an important change in the dynamic of the debate at the Fed Board of Governors. After many years in the minority, it appears the Fed’s inflation hawks have gotten the upper hand. Our forecast, therefore, is that the Fed will push forward later this year with its plan to begin unwinding the balance sheet. We are not optimistic about the resulting impact in the fixed income and equity markets, however. The fact that inflation breakeven rates fell significantly in June after Yellen announced the new plan is an important warning sign. We believe the doves are generally right that the economy is not yet strong
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ECONOMIC FORECAST | Q3 2017
enough to withstand significantly tighter monetary policy. Inflation hawks often cite the low national unemployment rate as support for their argument, but it’s also true that wage inflation is low. And despite a low national unemployment rate, the fact that the labor participation rate is near a 40-year low provides considerable evidence that there is still slack in the labor market.
U.S. dollar will strengthen, and inflation breakeven rates will fall. In the longer term, however, it’s probable that the Fed will be forced to slow down or even pause the runoff of bonds from its balance sheet as inflation falls beneath what policymakers are comfortable with. This very well may be the dynamic as a new leader at the Federal Reserve takes charge in early 2018.
If the Fed goes ahead with its plan the yield curve will likely steepen (in the short term), the
BULL MARKET ROLLS ON, BUT STOCKS LOOK PRICEY The stock market rose in the second quarter and has put up solid numbers for the first half of 2017. The MSCI All Country World Index and the S&P 500 returned 4.4% and 3.1% in the second quarter, respectively, and have returned 11.8% and 9.3% year-to-date through the end of June. The technology sector has led the way with the Dow Jones U.S. Technology Sector Index returning 16.8% through June. The healthcare sector also had a solid start to the year, with the Dow Jones U.S. Healthcare Sector Index returning 16.0%. The energy sector has been the worst performer, with the Dow Jones U.S. Energy Sector Index returning -13.5% through June, as the price of crude has fallen 15% this year.
In the first half of 2017 stocks benefitted from an improving economy, increased consumer spending, and the hope among investors that a new administration in the White House would be able to effectuate desirable economic reforms. As the third quarter gets underway the first two of those forces are still alive, but the third is under increasing doubt as the Trump administration has been slow to outline its policy prescriptions
and has shown little ability to galvanize popular support. This is not to say there is no hope of tax reform or increased infrastructure spending becoming executed policies, but the probabilities of them occurring are certainly lower today than was the case six months ago. Meanwhile the stock market has marched higher with valuations growing. The S&P 500, for example, is currently trading at
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18.9 times expected full-year 2017 earnings, while the MSCI All Country World Index is trading at 17.0 times. These are full valuations and make equities vulnerable to a change of outlook among investors. Another portent of trouble ahead is the VIX (Chicago Board Options Exchange Volatility) Index, which uses options pricing to measure investors’ expectations of volatility in the future. The VIX is currently near a five-year to occur. Regarding the first risk, such a low, suggesting optimism is very high among realization could occur quickly and unexpectedly. equity investors today. To us this dynamic is worrisome. Given this environment we expect increased volatility in the stock market in the second half of The two principal risks for stocks today are that 2017 and believe it’s best to be defensive, with investors decide their hopes for policy reform in significant allocations to consumer staples and Washington are not going to be realized, and other sectors that have lessened reliance on that the Federal Reserve pushes forward with short-term investor sentiment. monetary policy tightening even though the — Brandon Fitzpatrick economy is not yet able to withstand it. With respect to the second risk, we believe it is likely
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ECONOMIC FORECAST | Q3 2017
THIS PUBLICATION IS FOR INFORMATIONAL PURPOSES ONLY. THIS PUBLICATION IS IN NO WAY A SOLICITATION OR OFFER TO SELL SECURITIES OR INVESTMENT ADVISORY SERVICES, EXCEPT WHERE APPLICABLE, IN STATES WHERE D.B. FITZPATRICK & COMPANY IS REGISTERED OR WHERE AN EXEMPTION OR EXCLUSION FROM SUCH REGISTRATION EXISTS. INFORMATION THROUGHOUT THIS PUBLICATION, WHETHER STOCK QUOTES, CHARTS, ARTICLES, OR ANY OTHER STATEMENT OR STATEMENTS REGARDING MARKET OR OTHER FINANCIAL INFORMATION, IS OBTAINED FROM SOURCES WHICH WE AND OUR SUPPLIERS BELIEVE RELIABLE, BUT WE DO NOT WARRANT OR GUARANTEE THE TIMELINESS OR ACCURACY OF THIS INFORMATION. NEITHER WE NOR OUR INFORMATION PROVIDERS SHALL BE LIABLE FOR ANY ERRORS OR INACCURACIES, REGARDLESS OF CAUSE, OR THE LACK OF TIMELINESS OF, OR FOR ANY DELAY OR INTERRUPTION IN THE TRANSMISSION THEREOF TO THE USER. THERE ARE NO WARRANTIES, EXPRESSED OR IMPLIED, AS TO ACCURACY, COMPLETENESS, OR RESULTS OBTAINED FROM ANY INFORMATION CONTAINED IN THIS PUBLICATION. NOTHING IN THIS PUBLICATION SHOULD BE INTERPRETED TO STATE OR IMPLY THAT PAST RESULTS ARE AN INDICATION OF FUTURE PERFORMANCE. ALL RETURNS ARE MODEL RETURNS FROM A COMPOSITE.
DB Fitzpatrick 800 W. Main Street, Suite 1200 Boise, Idaho 83702 www.dbfitzpatrick.com | (208) 342-2280