Greetings again from your resident monetary policy/Federal Reserve/Central Bank worry wart. I know, you’re tired of me. Tired of my whining and my warnings. After all, my thoughts are even more irrelevant now with all the enthusiasm over hoped for economic regime change with Trumponomics. Right? Sorry, but I’m still here and it’s that time of the year for another FOMC decision and statement so I’m going to speak my mind again.
With Yellen in her last speech essentially saying the US economy is near maximum employment and with inflation readings and 5 yr and 10 yr inflation breakevens at and above the 2% level, the Fed should be raising rates this week. That of course won’t happen as doves rule and they will continue to claim ‘uncertainty’ on the upcoming fiscal outlook. So, will they raise instead in March? Rate hike odds are only about 35% but I can’t see how they walk out of that meeting (all else equal from here) with a straight face and with no rate hike. It would amazingly imply that they think .625% is still the right rate. I actually think they’ll come to their senses and that March fed funds futures contract is a short and we will get that next rate hike to a whopping .875%.
As for markets, it has been refreshing to see the Fed fall into the background of the daily discussion ever since the election. I’m as enthused as anyone about tax cuts (even though we don’t know what final form will look like) and regulatory relief (but worried about trade protectionism and immigration bans). But to think that somehow the Fed is no longer relevant to both the economy and markets as they step up rate hikes I think is delusional. I think we are about to see a likely heightened test of how the US economy and markets will handle a further rise in the cost of capital as rate hikes happen more frequently in the US and QE around the world limps on its last legs.
For stocks, let’s look at the impact that multiple expansion has had since 2013 (the year the Fed printed $1T, joined by QE from Japan, the ECB and BoE). Using numbers direct from the S&P website, 2012 ended with non GAAP earnings of $98.12 and GAAP earnings of $86.51. At the time the S&P 500 was trading at 14.4x and 15.9x these numbers. With almost half of companies having reported for Q4 2016, the full year estimate from S&P for 2016 is $108.66 non GAAP and $97.98 GAAP (largest spread between GAAP and Non GAAP in over 10 years), and bringing the P/E ratio on these trailing numbers to 21.1 and 23.4 respectively. Thus, non GAAP earnings grew by 10.7% in the 4 yrs since 2013 while the multiple expanded by 47%. For GAAP, earnings grew by 13% while the multiple was up by 47%. It would be tough to argue that QE, NIRP and ZIRP weren’t the main reasons.
Bottom line, said a million times by many, valuations is a poor market timing tool. It doesn’t matter until it does. I just needed today to highlight that we can’t ignore the rate hiking cycle we are in and that may begin to quicken at the same time QE overseas may further shrink this year (with the ECB and BoE but likely not in Japan). Again, I’m optimistic that the right tax and regulatory policy will bring quicker US growth but to ignore the aftermath of seven years of zero interest rates and a quintupling of the Fed’s balance sheet is not to fully analyze what may unfold. For stocks to hold up, we must get acceleration in the rate of earnings growth from here that is widely expected because I see an inevitable shrinkage on the multiple paid for those earnings.
I’m going to quote John Dizzard in this weekend’s FT as it echo’s my thoughts in a pretty succinct way:
“The market is underestimating the probable effects of Fed policy on equity prices, and overestimating the immediate effects of any fiscal stimulus. You have already enjoyed the promise of tax cuts in your equity portfolio. Now you should prepare for interest rates that go higher than expected, for longer than expected.”
I will leave you these two charts from Hussmanfunds.com as it includes a visual of a multitude of valuation metrics
The important PCE inflation data is out and the headline print was up .2% m/o/m as expected and up 1.6% y/o/y vs the forecast of up 1.7% (rounding difference). The core rate was up .1% m/o/m also as expected and brings the y/o/y rate of change to 1.7%, in line with November. Energy is certainly driving the headline but it comes on top of sticky services inflation.
Mostly captured within Friday’s Q4 GDP figure, personal spending rose .5% m/o/m, in line with expectations. Personal income was also about in line, up .3% when including the November revision. Under the hood, private sector wage and salaries grew by 3.7% y/o/y, unchanged with November but that’s a slowdown from the 4%+ seen in the months before. The savings rate slowed to 5.4% from 5.6% and that is the least since March 2015.
Bottom line, the income and spending data was about in line so should not alter the Q4 GDP number we saw Friday and thus is not market moving. It would have been nice to have seen a better wage figure but if we are going to get tax and regulatory reform on top of tight employment, wages should accelerate from here. On inflation, the base effects from energy again is having its influence as we know but core services inflation has been pretty persistent underneath. It’s been the goods side that has kept a lid on inflation. Looking past the energy effects at some point will see a moderation in the headline rise and why we will continue to focus more on the core level (mostly rent and medical care). There was not a market response to the inflation data but inflation breakeven’s are holding at their multi year high with the 5 yr level at 2.03% and the 10 yr at 2.07%.
Pending home sales in December rose 1.6% from November and that was above the estimate of up 1%. Sales are about flat with last year seasonally adjusted. Not seasonally adjusted has sales down by 2% y/o/y (I’m not clear on what seasonally adjusted y/o/y numbers are compared to non seasonally adjusted). From November, sales rose out West and down South but fell in the Northeast and Midwest. The NAR said “enough buyers fended off rising mortgage rates and alarmingly low inventory levels to sign a contract. The main storyline in the early months of 2017 will be if supply can meaningfully increase to keep price growth at a moderate enough level for households to absorb higher borrowing costs. Sales will struggle to build on last year’s strong pace if inventory conditions don’t improve.” The inventory problem is most pronounced on the lower end and is why renting is still a legitimate option for first time buyers, notwithstanding the rental price increases there.
Bottom line, off the lowest level since January 2016, the level of contract signings bounced slightly but as the NAR stated, the question for 2017 is how buyers respond to the rise in mortgage rates (many buy decisions are solely based on the monthly nut) on top of persistent 5% y/o/y price gains. The missing piece of a better housing industry remains the first time buyer and I don’t see that changing anytime soon. The average 30 yr mortgage rate was 4.36% in December vs 4.03% in November and 3.72% in October.
German inflation in January accelerated further to a 1.9% y/o/y pace. While that was one tenth less than expected it is up from 1.7% in December and it matches the fastest rate of change since December 2012. The chart speaks for itself in visualizing the rapidity of the gain since mid 2016. Germany is dealing with Defcon 1 emergency monetary policy from the ECB which is the exact opposite to what is appropriate for the German economy that has the lowest unemployment rate since reunification and now spiking inflation.
The non German ECB members don’t really care and we heard from Ewald Nowotny, the Austrian ECB member who said today “monetary policy can’t just cater to one country but to the entire euro zone economy. German developments are watched, but they are just a part.”
European sovereign yields were higher, but mostly influenced by political worries after the far left Socialist candidate won their primary in France over the weekend. Italian yields in particular jumped by 10 bps to just shy of a two year high.