Market Update

Posted on March 17, 2017 by Gemmer Asset

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Now this is something we haven’t see for a while – a marked underperformance in the S&P 500. For the week the S&P inched out a +0.2% gain versus +2% to +4% gains for the overseas markets. A weak dollar certainly helped turn the tide, as did growing confidence the Fed would not undermine the global economy in the months to come.

 

Bond yields fell and bond prices rallied right after Wednesday’s Fed meeting. The yield on the 10-year fell 8bps and intermediate-term Treasury bonds gained +0.7%. Credit performed well, with high-yield notching up a +0.9% gain.

 

This turned out to be one of the more eventful weeks of 2017 news-wise. Let’s start with the Fed.

 

The Economy Will Embolden the Fed

 

First up let’s look at the Fed and the economy. On Wednesday, the Fed bumped rates up another quarter point, taking the range to 0.75% – 1.00% and indicating two more hikes this year. This was largely as expected. As a matter of fact, the market was starting to think Janet Yellen might signal even more aggressive hikes in the months to come. The orange dots in the chart below show the Fed’s expected rate path back in December. The white dots are from Wednesday’s meeting. Not much difference.

 

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This tells us that the Fed thinks the fed funds rate will be 1.375% by the end of this year and 2.125% by the end of 2018. Their long run expectation is for 3%.

 

The market greeted this news warmly. Bond prices rallied as did stocks while the dollar sold off hard, as you can see below. Precious metals popped higher.

 

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This week’s hike was all but assured after last Friday’s payrolls report. Headline job growth came in above expectations (+235K) and previous months were increased by 9K. Probably most importantly, wage growth picked up. Average hourly earnings grew at an annual rate of +2.8% in February, as you can see below.

 

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Rising price pressures were confirmed this week by Wednesday’s CPI report. It showed that the price index rose at a +2.5% annual rate in February. The graph below shows the year-over-year change for four key measures of inflation. The median CPI is up +2.5%, CPI less food and energy is up +2.2%, while the core PCE is up +1.7% year-over-year. All trending higher and 2 out of 3 are above the Fed’s 2% target.

 

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What is interesting is that you are seeing some conflicting projections on the economy for this quarter. For example, the Nowcast projection from the Fed bank of New York predicts growth of +2.8%.

 

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However, the Fed bank of Atlanta is at just +0.9%.

 

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This is the biggest gap in expectations we’ve seen. One of the crystal balls is cloudy!!

 

Status Quo in the Netherlands

 

Coming into this year the anxiety levels were pretty high about the election cycle in Europe. Populist parties in France, Italy, and the Netherlands were polling well and the German election, while much more certain, was also looming.

 

This week the Dutch went to the polls. Geert Wilders had been polling well up until the last few weeks on a staunchly anti-immigrant/anti-euro platform. However, his lead started to wane recently and Dutch prime minister Mark Rutte won by a solid margin. Mr Rutte’s VVD party won 33 seats out of 150 – a dozen more than their nearest rivals, which include the center-right CDA, liberal centrist D66 and Mr Wilders’ far-right Party for Freedom, which all took 19 or 20 seats. As you can see below, the labour party was the biggest loser in the whole affair.

 

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Labour bore the brunt of anger at unpopular reforms, such as increasing the retirement age, that was pushed through by the grand coalition between Labour and the VVD.

 

And coalition is the key term. The VVD will need to cobble together a coalition to rule, and Dutch politics is a bit like herding cats. The number of parties in parliament increased from 12 to 14. Some single-issue groups like the Party for the Animals and 50Plus, a pensioner’ party, vastly complicate the job of governance. As The Economist notes:

 

“The broader story in the Netherlands is one of popular frustration with the normal process of governance. That will make it hard to run the country no matter how the vote turns out.”

 

Brexit, Article 50, and Scotland

 

Brexit seems so 2016, but it will soon be back. On Monday, Prime Minister May got the parliamentary approval the courts ruled was necessary to formally trigger Article 50. This could happen as early as next week, but almost certainly this month.

 

But it is not clear what UK she will lead out of the EU. Scottish first minister Nicola Sturgeon confirmed on Monday that she will seek legal authority to hold a second referendum on Scottish independence as early as next year amid concerns over the impact of Brexit on the Scottish economy.

 

Scotland is fascinating. There’s a lot to like about Scotland. Friendly people, beautiful scenery (if you can look past the rain), a wee bit of solitude. And scotch. Shouldn’t forget the scotch of course. And in many ways, the latest move by the Scottish government to divorce their dysfunctional southern partner is admirable. The Scot’s voted overwhelmingly against Brexit and who can blame them. Close ties to Europe are critical for their economy.

 

Of course, the Scot’s voted against divorce in 2014, pre-Brexit. But Nicola Sturgeon would like to try again sometime between autumn 2018 and spring 2019. Support for independence in Scotland has gained ground since 2014. Back then about 1 in 3 were in favor of divorce, today it is closing in on 50% (the dark blue line in the chart below).

 

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But Ms. Sturgeon has a problem. As The Economist notes:

 

“Euroscepticism is on the rise among Scots. Two-thirds either want Britain to leave the EU or would like the EU’s powers to be reduced, up from just over half in 2014. Even among the 62% of Scots who voted to Remain last year, more than half think that Brussels’s authority should be curbed. And of those who plumped for independence in 2014, a third voted to leave the EU.”

 

So, more Scots want to leave Europe than want to leave the U.K. So, a race is on over the next couple years. Who do voters lose confidence in first – the U.K. or Europe – because a Scotland outside of both would be a lonely place indeed.

 

The First Trump Budget

 

Speaking of dysfunctional, we got a hint from the White House this week about their intent for fiscal policy. The Washington Post had a great visual on the specifics, as you can see below. The first thing to notice is that the entire budget debate centers in on the 27% of spending that is discretionary. The mandatory spending on social security, Medicare, etc. isn’t even on the table.

 

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Next, the Trump administration basically wants to increase defense spending by $54 billion, add another $4 billion to the border wall and school choice, and cut $58 billion from the rest of the non-defensive discretionary programs. As the Washington Post noted:

 

“To pay for an increase in defense spending, a down payment on the border wall and school voucher programs, among other things, funding was cut from the discretionary budgets of other executive departments and agencies. The Environmental Protection Agency, the State Department and the Agriculture Department took the hardest hits. The proposal also eliminates funding for…19 agencies.”

 

The most notable cuts are at the EPA and State Department which see their budgets cut by close to a third (see below). The Corporation for Public Broadcasting and the National Endowment for the Arts are eliminated under the proposal.

 

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Again, it is worth stressing that overall discretionary spending isn’t cut at all and mandatory spending isn’t even being talked about. The scary projections for U.S. solvency over the next decade are driven by the 73% of the budget that goes towards mandatory spending. This budget does nothing to address this. As The Economist notes:

 

“Even with deep cuts to the State Department, environmental protection and so on, the White House is only able to fulfil one of its aims: more defense spending… Where, then, is the money for everything else, and for closing the deficit, going to come from? Borrowing is forecast to be $559bn in 2017. Even if Mr. Trump abolished all government departments—leaving Washington paying only for entitlements, debt interest and defense—a deficit would remain.”

 

Of course, the on-going debate about health care reform shows that there are no easy answers on the mandatory side. I’m sure someone far more knowledgeable than me could look at the chart below and explain the dynamic, but I’m not sure we can ‘fix’ healthcare unless this trend is reversed. Do we really spend twice as much as Japan per person for a worse result?

 

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Now the budget proposal goes to Congress. The President and Congress have until April to come to an agreement. We should remember that last year lawmakers disregarded Obama’s budget altogether. Given that pretty much everyone will hate something in this proposal, it wouldn’t be a shock to see history repeat. And if you find this all a bit exhausting, we still haven’t gotten to tax reform yet.

Have a good weekend.

 

Charles Email Sig

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