The Days Ahead: Tax act to pass (could happen). But slow days.
We had the last FOMC meeting of the year and, yes, they raised rates. There’s one very good feature of the Fed post-WWFC (World’s Worst Financial Crisis) and that is the Fed’s communication policy left little misunderstanding. All rate increases since 2015 have been telegraphed clearly and well ahead of the meetings. So when the rates were increased, long-term bonds rallied and the yield curve flattened again. Stocks hit another all-time high. The YTD total return for U.S. stocks is now just under 20%.
Tax discussions continued. Inflation came in low but retail sales were high. Mixed bag.
1. What if I told you?
With all the stuff that happened in 2017, uncertainty, politics, equity bull market, and a doubling of the Fed Funds rate, what were the chances of a Treasury rally this year? We'll use this graph we last used a year ago, showing 10-Year Treasuries and a 100-month moving average:
The plateau at the far right shows the actual rate settling in just around the long-term moving average. At the beginning of the year, many Wall Street houses were calling for rates to climb to over 3.0% and for credit to provide large outperformance. In the last 12 months, however, the broad bond index gave a total return of 3.5% and 10-Year Treasuries returned 3.0%. The fact that many houses are doubling down on last year’s forecasts for 2018 give us some caution.
So what? Well, apart from the obvious that we’ve had a very long bull run in bonds, it also suggest that markets do not see inflation (see below) or an upside rip to the economy.
It seems inflation expectations come in three shapes:
a. It’s just around the corner. The low unemployment rate will see to that.
b. There is a ton of deflationary forces. Wages won't rise and competition keeps a lid on prices.
c. It’s a puzzle. We can't figure out why it's not more.
Full disclosure, we’re in “B”, the Fed is in “C” but moving to “A”, the ECB is in “C” and the Bank of Japan is in “B”. Last week saw Janet Yellen concede that inflation will stay below 2% for a while. Earlier in the year, she said low inflation was temporary because of lower cell phone costs (which we've talked about), that it would go up because of the hurricanes (it didn't) or as the labor market improved (it didn't). It’s much the same story over at the ECB , which is again puzzling given their more rigid labor laws.
So, we had another CPI print and this is what it now looks like:
Core inflation at 1.7%, gasoline costs up a lot but important housing cost (it’s 25% of the index) fell to a 3.3% rate and may well fall further as it’s closely tied to vacancy rates, which are up this year.
As for the wage push…this reasoning says that labor becomes scarce at low unemployment levels, so wage earners demand more and employers pay more so sthey can get the best workforce they can. The NFIB has been saying for months that they're eager to hire but can't find the people. You would think that would translate into higher wages or, if not, more non-cash compensation (think vacation, hours, health insurance). But no. It seems employers just don't follow through in their hiring plans or wage increases. Here's the latest data on real wages from last week. Weekly wages fell in absolute terms and the growth level dropped to less than 0.25%.
All this is meant to go away with the drop in corporate tax. The CEA says so when they showed that the lowest taxed OECD countries had the fastest wage growth. True. But the lowest taxed OECD economies are Turkey, Latvia, Slovenia and Hungary, which are not, you know, quite like the U.S.
Anyway, put this all together, add in a Fed that defines its success as an inflation fighter, and we don't see any sustained uptick in inflation.
3. Who’s working now?
We've argued for years that the post-WWFC employment picture led to some fundamental changes in the way the economy works. We're somewhat in the minority here but things like growth in non-mortgage debt, low retail sales, poor wage growth and the low level of job turnover suggest the labor market has lost dynamism.
During the crisis, the 25 to 54 year-old cohort was hit hardest. None has reached the same level of labor force participation as before. Here they are in the three lower lines.
Some put this down to demographics. The population is ageing and boomers are leaving the workforce. But that’s not the case. The top line shows the 55 and over age group. It’s the only one that increased participation. This may be an employee just staying on because they're fitter and healthier, like work, need to work or their skills are in demand.
All true. But the younger age groups buy houses, furnish them and start families. There are fewer of them and more of the older group who just don't spend as much. It’s another reason why we see general spending remaining subdued for years. Demographics trumps tax management every time so the proposed tax cut will do little to change that.
Bottom Line: We would not change much from two weeks ago. As we said then, we've had a great run on equities for all the right reasons. We may have some “buy the rumor, sell the fact” if the tax package goes through (and we have no reason to expect it won't). But we’ll see some thin trading in the next few days.
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--Christian Thwaites, Brouwer & Janachowski, LLC
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