Market Update

Posted on January 19, 2018 by Gemmer Asset

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Equity markets continued their winning ways this week with the S&P gaining +0.9% while small-cap equities advanced +0.3%. The international markets were also solid – the EAFE was up +0.8% and the EM index +1.9%. We are early in the early inning of fourth quarter earnings reports, but the most interesting aspect will be what companies do with the tax cut proceeds. There are two broad themes coming to light:


1) We are seeing firms raising pay and other compensation. As of a few days ago we’d compiled a list of 164 firms that are giving employees bonuses, pay raises, or greater 401K matching. For example, Jet Blue offered a $1K bonus to its 21K employees. Bank of America is also giving $1K to its 145K U.S. workers. Aflac, on the other hand, is increasing its 401K match. Wal-Mart raised its base wage for all hourly employees to $11, gave bonuses of up to $1K, and expanded maternity and parental leave. Part of this is almost certainly political. But the job market is getting tight and employees more in demand. This should definitely feed through into more wage inflation this year and support consumer spending. Maybe we also see modestly higher price inflation because much of this will be spent.


2) The other dynamic is what happens with repatriated earnings. Apple made a splash this week by announcing they will repatriate roughly $245bn, pay $38bn in taxes, and use some of the remaining funds to boost investment. They plan to increase their capital spending by more than $30bn over the next five years as well as increase their R&D fund. They claim they will add over 20K jobs as a direct result of this spending through hiring at their existing campuses and opening a new one. This is but one company, but the numbers are large. It will be interesting to see what other high-profile firms such as Alphabet, Amazon, Facebook, etc. choose to do in the weeks and months to come.


Bond yields pushed higher again this week with the 10-year adding another 9bps while the 2yr tacked on 6bps to close above 2% for the first time in a decade. As a result, intermediate-term bonds lost -0.8% for the week while long-term Treasuries were down -1.2%. High-yield was flat and bond loans were up +0.3%


As you can see below, the yield on the 10-year is challenging the high back in early 2017. Beyond that we are probably looking at 3% as the next level of resistance.




This latest move higher in yields has been accompanied by a repricing in future Fed policy. Over the last few weeks the market has gone from expecting just two quarter-point rate hikes this year to three. As you can see below, the odds of three hikes are now greater than 50%. While not shown, the market has put a small probability on four hikes.




On a Cliff Edge, or Much Ado About Nothing?


As I write this the countdown towards a government shutdown continues. Don’t you love these things – 7 hours, 43 minutes, 47 seconds before……..well, it’s not entirely clear.



Almost certainly in less than 8 hours another news cycle will begin. Yes, part of the government will shut down after midnight, but if you went by the headlines you’d think we are all about to plummet off some cliff. This is but one among many:




Where is this cliff and why are we standing so close to the edge?


Anyway, by way of background, the Republican-led House on Thursday passed a short-term funding bill that would avoid a shutdown for another four weeks. But Senate Democrats and a handful of Republican senators have signaled they may oppose the measure. In general, the Democrats want an extension of the Deferred action for Childhood Arrivals (DACA) immigration program which expires in March. Select Republicans worry about the impact of a stopgap measure on both the military and deficit. Because of Senate rules, such opposition would make it impossible to get through the chamber seeing as 60 votes are needed. With Graham, Paul, and Rounds coming out against the bill and McCain unavailable, Republicans in the Senate could need more than a dozen Democrats to vote for the extension.


What got us here?


Why are we in this situation again?


The problem stems from the failure of Congress to approve a 2018 budget before the fiscal year began on October 1, 2017. That forced Congress into approving what has become a series of temporary extensions of funding while negotiations for a larger deal continue in fits and starts.


Republicans have been pushing for a two-year agreement that will outline the spending parameters for the rest of this year plus all of the 2019 fiscal year, which begins October 1, 2018. But such a deal has proven elusive, falling victim to the usual disagreements between the parties over federal spending amounts and how dollars should be allocated. Republicans are pushing for an increase in military spending, while Democrats want that paired with a similar increase in non-military spending.


Immigration policy is also a major stumbling block in the negotiations. Democrats are saying they will refuse to support any government funding extension that does not include a solution for the immigration status of the so-called “Dreamers.” Last fall, President Donald Trump announced that he would end DACA, which protects young undocumented immigrants who are in school or the military, on March 5 if Congress does not pass broader immigration reforms. With that deadline now just weeks away, Democrats are pressuring Republicans for a solution and using the potential of a government shutdown as leverage.


What is impacted?


If no bill passes by midnight then the federal government will enter a partial shutdown affecting nonessential services, which would close national parks and cause services like the issuance of replacement Social Security cards to be halted.


Well, that sucks if you are waiting for a Social Security card, but is this really like teetering on a cliff edge?


Under a shutdown all essential services remain open. Social security checks still go out, as do Medicare payments (although Medicare can’t accept new applicants). Other programs that are affected include:


– Site inspections by the Environmental Protection Agency and Food and Drug Administration. These inspections are done for “sites that included hazardous waste, drinking water, and chemical facilities.”


– The Internal Revenue Service can’t do Social Security number or income verifications, possibly delaying things like loan applications. Additionally, any tax refunds outstanding would be delayed. Given the IRS’s scramble to manage the new GOP tax law, a shutdown would be especially damaging.


– The National Institute of Health would stop funding grants for research and the Department of Health and Human Services would stop sending welfare assistance to states.


The impact on Federal workers is pretty significant. Federal workers in essential services still go to work and get paid. For example, in preparation for a shutdown in 2015 the Department of Homeland Security said that 42,593 of the Coast Guard’s 49,304 on-board employees would remain on the job. For the Secret Service, 5,785 of the agency’s 6,507 employees were exempt from the shutdown that year.


But the number of employees in non-essential services who would be furloughed is significant. In 2013 this amounted to 850K of the 2.1 million federal employees. That’s a good-sized number.


Economic and Market Impact


What is the likely economic impact from a shutdown this weekend? We have a number of examples to study. Since 1974 there have been 18 government shutdowns. Most were short-lived. For example, of the eight during the Reagan administration, none lasted more than three days. The longest in recent memory were 1995 (21 days) and 2013 (16 days).


Goldman estimates that furloughs similar to those seen in 2013 would reduce GDP growth in the first quarter by 0.2% for each week the shutdown lasted. It is important to remember that this would be reversed the following quarter if the shutdown was to end. If the shutdown lasted several weeks, the effect might rise slightly as federal contractors and procurement could also begin to be affected. But in general, the economic impact is small and temporary.


Markets have tended to shrug off shutdowns. On average, the market has declined -0.6% during each of the last 18 previous shutdowns. In recent history, the experience is mixed. The 1995, 1995-96, and 2013 government shutdowns had a modest effect on financial markets (see the chart below). Stocks experienced a slight decline in the early days of the December 1995 and October 2013 episodes (roughly down -2%), but no real change around the November 1995 shutdowns.




Business Insider had a great table on all 18 events.




Hardly cliff plunging statistics. In other markets, the dollar weakened slightly in the three most recent cases. Treasury yields did not react meaningfully at the start of these shutdowns.


So, all in all, the shutdown stinks if you are furloughed, but it is tough to draw any broader conclusions. At least historically, shutdowns have come to a relatively quick end and the economic and market impact is modest to almost non-existent.


Even if the shutdown is short, we’ll be talking about increasing the debt limit in about four weeks. Of course, it will be increased. We have to finance the recent tax cuts after all. But I’m sure the headlines will have us falling over another proverbial precipice again right before the limit is raised.


Have a good weekend.


Charles Email Sig




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