Market Recap
It was a broadly lower week for most of the global equity indexes with the exception of the S&P 500. Large-caps were up +0.2%, but small-cap U.S., developed, and developing stocks were lower. About the only other major markets in the black for the week were Japan (+1.4%) and Germany (+0.5%). After all the angst about earnings in the third quarter, the reporting season hasn’t been too bad. The earnings beat rate is coming in at 63%, about in line with the averages (see chart below). While current 3rd quarter earnings should fall about -2%, this is far better than feared at the end of September.
In part this explains why October proved to be such a strong month. The S&P added +8.3% for the full month while Europe was up +10.2% and Japan +7.7%.
For the week oil prices managed to rally +3.9%, but the broad commodity index was down -0.2%. This was largely due to lower gold and metals prices. Gold lost -2.0% and copper was down -1.6%.
In the fixed income market yields ticked up 0.04% and intermediate-term bonds lost -0.5%. High-yield was down another -0.3%, bringing the YTD loss to -0.8%. Overall the fixed income market reacted very little to the Fed meeting on Wednesday.
Growth, Employment, and Wages
Before we get to the Fed lets touch on three economic reports that are likely to shape the Fed’s view over the next few months.
First up is 3rd quarter economic growth. Expectations were pretty low for this week’s report, and the actual number didn’t disappoint. Growth came in at +1.5%, down from +3.9% in the second quarter, as you can see below.
Breaking out the components is interesting:
Residential Investment = +6.1%
Equipment Investment = +5.3%
Personal Spending = +3.2%
Government Spending = +1.7%
Exports = Unchanged
Inventories = -1.44%
Most sectors outside inventories grew pretty well. The growth in consumer spending was solid. If you strip out the contraction in inventories GDP growth was +2.9%.
Inventories are awfully volatile, and growth in the 2nd quarter was flattered by inventory restocking. Economic growth in the U.S. is probably tracking in the middle of the last two numbers – say something in the mid-2% range.
Secondly, weekly unemployment claims continue to set records (in a good way). Thursday’s report showed weekly claims at 260,000 and the 4-week moving average at 259,250. This is the lowest level since….wait for it….drum roll please….1973.
If you dig deeper into the data and look at unemployment rates by levels of education you see a striking divergence. For those with a college degree unemployment is just 2.7%. However, for those with a high school diploma the rate is 8.4%. It’s probably fair to say that anyone with a high school or better level of education can get a job if they want one. For those without it is a different story.
Finally, wages bounced back from last quarter’s dismal report. The employment cost index showed that wages increased +0.6% in the third quarter (+2% year-over-year). This comes after a gain of just +0.2% in the second quarter, the smallest on record (see chart below).
So all in all the economic data of late is decent. Headline growth was soft but the consumer is driving things pretty well. Unemployment and jobless claims are still headed lower, and wage inflation isn’t falling off a cliff like we thought last quarter.
The Fed Sets the Stage for December
This poses a dilemma for the Fed. If you just look at the growth data the case for a hike looks pretty solid. But inflation remains tame. Friday’s core PCE report showed that prices increased by just +0.1% in September and are up +1.3% year-over-year. This is well short of the Fed’s +2% goal. The headline rate (includes food and energy) actually fell for the month. The chart below shows the core (blue line) and headline (red line) over the last 50 years. It is pretty stunning just how low inflation is compared to past years.
So when the Fed met on Tuesday and Wednesday they were faced with a quandary. Hike rates because the economy is doing reasonably well. Cut rates because disinflationary trends are strong. Or do nothing. Of course the last option won out and the Fed held its benchmark rate unchanged at 0%-0.25%, prolonging the wait for the first interest rate increase in nine years.
The statement outlining the decision said the US economy was expanding at a “moderate pace”, as consumer spending and business capital investment rose at “solid rates”. Many keyed on the fact that the Fed dropped their language used at the last meeting about overseas risks. The key part of the statement read as follows:
“To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining whether it will be appropriate to raise the target range at its next meeting, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.”
As Fed watcher Tim Duy notes:
“Bottom Line: December stays on the table. Very much so, in fact. Indeed, in all reality the only reason market participants have not gone all in on December is because they recognize that the Fed has repeatedly cried ‘wolf’ this year. Makes one distrustful of the Fed’s proclamations. At this juncture, my expectation is that only disappointing data prevents the Fed from moving in December.”
The Headwinds from the Dollar Could Increase
A more hawkish Fed poses its own problems for the economy beyond just interest rates increasing. We would actually argue that modestly higher rates will have little impact on growth. After all, cutting rates from over 5.25% to zero did little to spur growth largely because it had no impact on credit creation. When an economy has too much debt, lowering the cost of borrowing isn’t going to encourage people to rush out and borrow even more. Similarly, if people aren’t borrowing at record low rates, they are unlikely to cut back if rates go up a point or two.
The bigger impact from a hawkish Fed is the impact on the dollar. Last week the European Central Bank (ECB) sent a strong signal that they are likely to either increase or extend their ongoing quantitative easing program. The Bank of Japan isn’t sure what to do, but the odds of more quantitative easing are going up because Japan is on the cusp of dipping back into deflation, as you can see below.
The dollar rally of the last few months has been driven by the expectation of divergent central bank policy. This idea is alive and well. A hawkish Fed is bullish for the dollar, and a stronger dollar on its own constitutes a tightening in monetary conditions. So the Fed needs to step carefully. As BCA notes:
“Econometric models suggest that a 10% appreciation in the trade-weighted dollar reduces the level of real GDP by 50-to-100 basis points after two years. The Fed’s broad trade-weighted dollar index has increased by 18% since July 2014 (chart below). This implies that dollar strength alone will shave around 45-to-90 basis points from annualized growth over the next two years.”
As a result there are downside risks for both growth and bond yields over the next few months:
“…taken together, U.S. GDP growth is liable to drop below 2% next year, which will make it very difficult for the Fed to raise rates. Although Treasury yields are likely to move higher in the near term, we expect the 10-year yield to fall back below 2% before the end of the year.”
If they are right refinancing opportunities await!!
Have a good weekend.
