A lot has been thrown at the markets the last couple weeks. North Korea, hurricanes, the debt ceiling are at the top of a pretty long list. All in all stocks have held up pretty well while bond yields have fallen. This week domestic equities dipped with the S&P down -0.6% and small-cap stocks -1.1%. For U.S. investors overseas developed stocks did well largely because of dollar weakness/euro and yen strength. The developed EAFE index added +0.8%, Europe +1.1%, and Japan +0.9%. Emerging equities were off -0.6% despite a +1.5% rally in Brazil.
While the political backdrop for equities is as uncertain as ever, underlying earnings growth has been robust. As you can see below, second quarter earnings growth was robust in the U.S., Europe, Japan, and the emerging world (blue bars), and the overseas markets beat earnings estimates by much more than U.S. companies.
Government bond yields pushed to multi-week lows with the yield on the 10-year Treasury closing at 2.06% on Friday after hitting a low of 2.03% on Thursday. Intermediate-term government bonds gained +0.8% this week while long-term bonds jumped +1.8%.
Finally, the U.S. dollar continues to be pressured with the dollar index hitting its lowest level in 33 months, as you can see below.
The euro was up +1.4% this week while the yen added +2.3%. There is a growing view that the Fed will struggle to raise interest rates anywhere near what they might have thought they could a few months ago, particularly considering the likely growth shock from the hurricanes and the shake-up that is occurring on the Fed’s board of governors (more below).
What’s Ailing the Dollar?
So what is ailing the almighty dollar? There are probably at least four things going on.
1. Uncertainty about U.S. growth.
At first this may seem strange given that second quarter growth was revised higher by 0.4% to +3.0%, the fastest pace in two years. However, there is a growing view that maybe this is as good as it gets. As you can see below, consensus estimates for the next few quarters (blue circles to the right of the vertical dotted line) are running at +2.5% or less.
Then add in the uncertainty of the hurricanes in the gulf. With probably millions of people being displaced from their homes temporality, growth risks are to the downside, at least over the next couple quarters.
Of course we can’t ignore the political aspect here as well. As the Financial Times notes:
“Hope that Donald Trump will be able to push pro-growth measures like corporate tax reform or a large spending programme has dimmed markedly. The president is fighting controversy on several fronts, and this week forged a deal with Democratic lawmakers in Congress over a short-term debt ceiling suspension, something that infuriated leaders in his Republican party.
After news of the pact broke, Alec Phillips, political economist at investment bank Goldman Sachs, reduced his forecast for the odds of tax legislation being passed next year to 40 per cent from ‘slightly better than even.’
Looking at the political issue from another angle, analysts at M&G Investments also note that the dollar has tended to fall in line with Mr Trump’s approval ratings.”
2. Inflation is conspicuous by its absence.
Then there is the inflation question. We have noted previously that inflation levels are actually moderating, not picking up as was widely expected at the beginning of the year. This was underscored by last week’s payrolls report. Job growth in August was a bit softer than expected at +156k, but what really hit the dollar (and the bond market) was the wage growth number. It was anemic. At an annual pace wages are growing at +2.5%, off the highs of only a few months ago (see below). Certainly a positive number is good, but both the currency and bond markets were pricing in over +3% wage growth when the 10-year was at 2.45% and the euro was at $1.05.
3. Markets continue to take the under regarding the Fed
What this all means is that Wall Street has fallen over itself to trim their expectations for Fed policy. As you see below, the odds of a third rate hike this year have fallen from over 60% to just 29%.
The Fed itself has been sending some mixed signals. Fed Governor Lael Brainard captured headings last week talking about the need to be cautious given the lack of inflation. But Cleveland Fed President Loretta Mester downplayed the risks just yesterday and argued that the Fed’s forecast of rising inflation is just early, not wrong. But at the end of the day the Fed follows the markets in terms of policy changes, they don’t lead. They may say they want to hike four times next year, but if the inflation data doesn’t pick up they will have a hard time justifying any move.
And let’s not lose sight of the fact that the Fed could be rudderless in early 2018. The Fed is directed by a seven-person Board of Governors, as you cans see below. Janet Yellen is the chair and her term expires in February 2018. Her odds of reappointment seem to dim daily, and the favored replacement, Gary Cohen, is rumored to be on the outs.
Furthermore, this week Vice Chair Stanley Fischer announced his resignation effective October 13th 2017. By the end of the year four of the seven seats will be open, assuming Congress doesn’t get around to approving Randal Quarles. By early next year there will be potentially five open seats. Will Congress find the time to hold five separate hearings?
As George Saravelos at Deutsche Bank noted:
“…this is not about whether the FOMC will raise rates in December but a broader question of what will happen beyond…the changes in the membership of the central bank’s policy-setting board make it impossible to identify the future policy path given that the nominees will be decided by President Trump.”
4. Brighter outlook overseas.
On the other side of the equation, the economies of significant trading partners are looking brighter. The eurozone in particular has been a focus, with output rising at the fastest pace since the currency bloc’s debt crisis. In turn, economists are now expecting the European Central Bank to begin outlining plans this year to begin unwinding its bond-buying program. Canada has also been looking stronger, overcoming the ructions caused by the 2015 tumble in the oil price. Its central bank has surprisingly lifted rates twice in the past three months, something that has sent the Canadian dollar rallying.
Currencies are the New Central Bank
But currencies moves are a funny thing. In a way they redistribute growth from one country to another. If country X is growing quickly and it’s central bank is increasing interest rates to slow inflation, it currency will appreciate against country Y, which is growing much more slowly. However, this currency move will slow export growth in Country X and boost the exports of country Y. At the margin country X sees a growth headwind from the stronger currency while country Y sees a tailwind. Ultimately currency shifts can be self correcting.
HSBC built on this point on Friday:
“Rather than using the blunt instrument of policy rates to head through the exit from ultra-accommodative monetary policy, central banks have recognised the value of letting the currency test the ground first. The tactic has been to move the market conversation towards that of exit. This is sufficient to get the currency strengthening, instigating a tightening but through a channel which can be easily reversed without the kind of jolt that a policy interest rate reversal would entail. This is not about direct FX intervention but it is about getting the currency to do the dirty work, at least initially. If all goes well, then the central bank can raise rates.”
We are seeing this now. The ECB is using the currency to see how robust underlying growth is in the eurozone. If a stronger euro leads to slower growth then the ECB can choose to do nothing. Conversely, if growth remains decent they can begin to rein things in.
It’s a similar story in the U.S. The weaker dollar should bump up growth in the months to come, aided in no small part by the recent fall in yields. For example, typical mortgage rates are priced off longer-term Treasuries and not the Fed Funds rate. As you can see below, average 30-year rates are down roughly 50bps this year.
On a $500K mortgage this works out to a savings of roughly $160/month or $1,920 a year. Nothing to sneeze at. Bank Credit Analyst, at least, thinks this sets the stage for a turnaround in the dollar in the second half of 2018.
“The easing in (the dollar and long-term interest rates) since the start of the year should boost real GDP growth over the next few quarters. This could cause the unemployment rate to fall to 3.5% by next summer, leaving it below its 2000 lows and more than a full point below most estimates of (full employment). If this were to happen, it would prompt the Fed to turn up the hawkish rhetoric.”
But first we need a Fed that actually has people on the board who can make decisions!! Even if we don’t see the dollar bump soon, the more important point is that the easing in financial conditions through both the currency depreciation and the fall in yields means growth should do just fine beyond the near term impact of the hurricanes.
Harbor Capital Appreciation Proxy Vote
Just a heads up that Harbor Funds (the manager of Harbor Capital Appreciation) may be reaching out to owners of the fund regarding a pending proxy vote. Please click here to see the full description, but essentially the vote covers 2 issues:
• A vote on electing trustees to the board.
• Allowing Harbor to amend their investment restrictions on borrowing and lending to other funds within the Harbor Fund family.
You shouldn’t in any way feel obligated to vote on this proxy, but if so inclined, we recommend voting “yes”. We apologize for any inconvenience this may cause, but unfortunately, we have no control over this outreach.
Have a good weekend.
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