It was mixed week in the global equity markets. U.S. stocks were broadly lower with the S&P 500 dipping -0.7% while small-cap stocks were off over -1%. The international markets, however, were higher. The developed EAFE index advanced +0.4% while emerging equities were up +1.7%. China, Germany, and France were all up over +1% while Brazil was up +2.0%.
It is always tough to pin a catalyst on market moves, but politics is almost certainly playing a role. Last week it was fear of conflict with North Korea. This time, it’s fear of conflict in the White House itself. A number of press agencies are making the point that President Donald Trump’s comments on Saturday’s protests in Virginia has rattled his staff and risk setting back his policy agenda in Congress. Furthermore, markets gyrated back and forth on rumors that Mr. Trump’s top economic adviser, Gary Cohn, was upset by the remarks and might consider resigning. Steve Bannon’s removal sparked a short-lived rally on Friday.
It is tough to say what this all means from a market and economic perspective other than to point out that uncertainty has increased and volatility has spiked from multi-year lows, as you can see below.
Maybe the political theater is pushing the markets lower, but it is just as likely that Washington becomes a convenient excuse for what would have happened anyhow. Few have thought for a while that the administration will make much headway in terms of economic initiatives. As you can see below, the market has essentially priced out any meaningful progress on either taxes or infrastructure.
So, it is probably safe to say the markets have rallied this year on something other than hopes for policy change. Economic and earnings growth continue to be key.
Growth Expectations Picking Up…
On the economic growth front, the situation remains relatively stable. Second quarter gross domestic product (GDP) showed the now familiar rebound, and third quarter growth is looking fine. As you can see below, consensus growth estimates are running at around 2.7%, while the closely watched Atlanta Fed estimate is almost at +4.0%.
Another measure that many watch is the Citigroup Economic Surprise Index. This indicator measures how actual economic data releases compared to expectations. It took a pretty meaningful dip earlier this year, but has hooked higher lately. This is a sign that economists might have become overly pessimistic for once.
For all the anguish about manufacturing jobs in the U.S., the manufacturing sector is humming. Both the New York and Philly Federal Reserve banks conduct monthly surveys of manufacturing activity in their regions, and business activity is doing well. As you can see below, the average of both the New York and Philly surveys are running near multi-year highs.
…While Pressures Build
But if you want something to worry about longer-term, take a look at the debt markets.
1) Corporate debt is near all-time highs as a percent of GDP:
2) Consumer credit card debt is at new highs (granted, in dollar terms):
3) Credit card delinquencies are also rising:
4) And despite rising leverage, high-yield bond spreads are bouncing around historic lows:
For example, Amazon was able to sell $16 billion of bonds this week at just 3.17% on the 10-year paper. This is just 90bps over U.S. government bonds. Australia borrows at 2.62%. New Zealand at 2.81%. Amazon’s financing is close to that of some major countries.
And Tesla was able to float a $1.8 billion bond deal at 5.3% (eight-year maturity). Now don’t get me wrong, I love Tesla. But they burned through $1.16 billion in the second quarter. They are going to have to sell a lot of Model 3’s very quickly to avoid another debt/equity offering.
None of this means recession or bear market. Only that the economy is building up imbalances that will accentuate any downturn in the years to come.
The Fed Grapples with a Dilemma
This brings us to the Fed minutes from the July meeting that were released during the week. The key news was that several Federal Reserve policymakers were prepared to announce a start date for reducing the size of the Fed’s balance sheet. However, they were outnumbered by those who preferred to wait.
By way of background, when the Fed implemented their quantitative easing programs over the last few years, they basically bought bonds and put them on their balance sheet. As a result, the balance sheet ballooned from roughly $600 billion to over $4 trillion, as you can see below.
Now the Fed is thinking about shrinking the size of the balance sheet to try to get back to some semblance of normality. This is far from new. Fed chair Janet Yellen has spent the year preparing for the landmark moment when the central bank puts its quantitative easing program into reverse. We even know how much ($10bn per month, increasing by $10bn every quarter until it hits $50bn).
So even though most the members wanted to wait, the betting is that this program is launched in September.
However, they are far more uncertain about the next rate hike. The minutes from the mid-July meeting shows that the majority of officials (and the Fed’s staff for that matter) still believe the recent weakness in core inflation is transitory and reflects “idiosyncratic factors”. However, several participants did suggest that the risks to the inflation outlook could be “tilted to the downside” and the Fed could therefore “afford to be patient” in raising interest rates.
But the minutes also noted that some members are starting to worry about easing financial conditions. The chart below shows a measure of financial conditions that takes into account the level of interest rates, credit spreads, and credit availability. Yes, rates have gone up. However, financial conditions have eased because credit is more available at tighter spreads (witness the growth in credit card debt and fall in high yield spreads noted below)
So, the Fed is in a bind. They are worried about keeping rates too low for too long and encouraging excesses in the debt markets. However, the case to hike rates is weak because inflation is slowing, not accelerating. This all has shades of Greenspan’s ‘irrational exuberance’ comments back in 1996. While he talked a good game, he did little to address growing market distortions during either the tech or housing bubbles. Will Yellen (or whoever replaces her) broaden their focus away from just employment and inflation in setting policy? Only time will tell.
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