When testifying to the Senate Banking Committee back in 1987, the newly-appointed Fed Chairman, Alan Greenspan, provided some insight into his views on communication: “Since becoming a central banker”, he said, “I have learned to mumble with great incoherence. If I seem unduly clear to you, you must have misunderstood what I said.” His successors have generally tried to be more open with regard to both their opinions and their intentions. However, there are times, when the Fed will want to communicate to financial markets without piquing the interest of either the general public or the administration.
Many years ago, I worked for the Office of Revenue and Tax Analysis at the State of Michigan and, from time to time, Saul Hymans and his colleagues from the University of Michigan would visit the state government in Lansing to discuss the latest output from their macro economic models of the U.S. and Michigan economies. As they started into their presentation, I was always eager to hear about their forecast. However, I was rather puzzled about how much time they devoted to the current quarter. I mean they had a big macroeconomic forecasting model – couldn’t we just skip the present and move on to the future?
This week will be full of market-moving economic data. We expect purchasing manager surveys and light-vehicle sales to indicate steady demand in November, as investors await Friday’s jobs report. Recent data on unemployment claims point to continued momentum and payroll growth should rebound from October’s meagre reading which was suppressed by both weather and strike activity. Markets will also be focused on wage growth, with futures still only assigning a 64% probability of a December Fed rate cut. That being said, any decision on a December rate cut will also depend on next week’s CPI report and, whether they admit it or not, the Fed’s own quiet assessment of the potential for the new Administration’s agenda to reignite inflation. It will likely be some months, therefore, before investors can more accurately assess the potential path for economic growth, corporate profits, inflation and interest rates. As we note in our year-ahead outlook, while we have emerged from a cyclical storm, we have entered a policy fog.
I’ve been running my own econometric model of the U.S. economy for almost 30 years now. The basic structure is simple. You start by forecasting the components of demand, that is to say, consumption, investment, trade and government spending. This gives you an initial projection of real GDP growth. You then feed this into labor market equations, along with some demographic assumptions, to forecast the growth in jobs, the unemployment rate and wage growth. All of this, along with assumptions about energy prices and the dollar, then drive forecasts of inflation. Given this outlook for growth and inflation, you make an assumption about the path for the federal funds rate and then run forecasts of other interest rates. With all of this in hand, you can forecast productivity, corporate profits, the federal budget deficit and household net worth. And then you go back to the start to see how all these changes impact your original demand forecast. You repeat the process until you arrive at a reasonably consistent solution.
The most urgent task facing investors in the wake of the 2024 elections is figuring out how much of the Trump agenda, as broadly outlined on the campaign trail, will be put into effect. A full and literal implementation across taxes, trade and immigration could have unwelcome consequences for the economy in both the short and long run. A more partial implementation, (which seemed to be anticipated by financial markets last week), could net out to be positive for stocks and negative for Treasuries in the short run. However, even this more restrained policy path would likely result in sharply-rising government debt and the potential, in some areas, for building economic and market risks. For this reason and because of the further run up in the U.S. equity valuations in the wake of the election, investors would be well advised to continue to rebalance portfolios both across asset classes and around the world.
The last few weeks have seen spectacular weather in New England, with warm temperatures and blue skies almost every day. By now, we would normally have stored the back-yard furniture inside to prevent it getting ruined over the winter. But instead, on weekend afternoons, Sari and I drowsily read our books in the sunshine with the still-loud chirping of the crickets letting us pretend that summer isn’t really over. Nor is there any harsh weather in the near-term forecast – it should be in the 70s on Thursday when the trick-or-treaters set off on their rounds. But the gentle rustle of falling leaves is providing its usual warning of colder days ahead and the need to be prepared.
Growing up in Dublin, I had a well-earned reputation as a child of very healthy appetite. At birthday parties, I’d always make sure, at the outset, to get my share of any cocktail sausages, cucumber sandwiches or Rice Krispie treats going around. When it came time for cake and ice cream, I made sure my plate was amply stocked. And I know my mother was filled with pride, (and the other young mothers equally filled with envy), as her little man waddled back up to the table in search of seconds. But even I had my limits. I vaguely recall a rather distressing incident on the car ride home from one of these parties. I won’t go into the sordid details – suffice to say that the upholstery in the back of the car neither looked nor smelt quite the same thereafter.
On Tuesday, the Commerce Department will publish international trade data for August. The numbers will, undoubtedly, show a deficit – the U.S. has run a trade deficit every year since 1975. This, in turn, implies that the U.S. dollar exchange rate is too high – we buy everyone else’s stuff because it’s cheap; they don’t want to buy ours because it’s expensive. That being said, even as Americans have sent dollars overseas to buy goods and services, these dollars have returned to buy U.S. stocks and bonds, fueling a booming stock market and allowing the federal government to borrow relatively cheaply.
I have a habit, or so my wife tells me, of staring intently, for minutes at a time, into an open refrigerator, in search of one particular item. When she can no longer stand it, or when the binging of the refrigerator alarm informs the world that its contents are now thawing, she gently asks me what I am looking for and points it out, sitting, as it always is, right in front of my nose. I had a similar feeling of sheepish embarrassment last week, when I reflected on the impact of the extraordinary surge in wealth on the economic and financial environment. I spend a significant chunk of my life looking at stock indices and home prices. And yet, throughout this year, while agonizing about tenths of a percent in the unemployment rate or the inflation rate and how the Fed might interpret them, I have neglected to consider fully how burgeoning stock market and housing wealth has changed both the economic environment and the position of investors.
On Thursday, the Bureau of Economic Analysis, commonly known as the BEA, will release revised data on the national income and product accounts going back to the start of 2019. This is an annual process, usually only mildly interesting to economists and ignored by everyone else. However, this year it’s more important since it could help clarify the trajectory of the economy at a critical time for both political and monetary policy choices. It’s also important because it could help resolve at least some of a yawning discrepancy between the estimates of output produced and income received in the American economy.
Cutting short-term interest rates from a peak is a little like hauling a piano down a flight of stairs. The operation is best done slowly and with care. The Federal Reserve will probably show some awareness of this in their actions and communications this week. That being said, one of the greatest identifiable dangers to the economy and markets today is that the Fed, by acting too aggressively or talking too negatively, increases the risk of the economy falling into recession.
On Wednesday of next week, the Federal Reserve will almost certainly embark on its long-anticipated easing cycle. However, whether the first cut in the federal funds rate is 25 or 50 basis points is still very much in doubt. This is a crucial question for the economy and financial markets since a 50 basis point cut might well do more harm than good if businesses, consumers and investors saw it as a signal that the Fed is worried about recession. The most important issue for the Fed as they debate this decision is the strength of the U.S. labor market. It is quite clear that job growth has slowed over the past year as the post-covid rebound has faded. But is the labor market stalling, or just slowing to a more gradual pace?
The U.S. working age population is growing relatively slowly. The Bureau of Labor Statistics estimates that the U.S. population aged 18 to 64 grew by less than 0.1% over the past year.
Every August, for more than 40 years now, the Federal Reserve has held a retreat in Jackson Hole, Wyoming. It has become an important venue for Fed communications and investors this week will be focused on Jerome Powell’s speech, to be delivered at 10:00AM eastern time (or 8:00AM Wyoming time) on Friday. The topic of this year’s conference is “Reassessing the Effectiveness and Transmission of Monetary Policy”, a subject that is well worth careful reconsideration. This, no doubt, will be the focus of Chairman Powell’s remarks.
The last two weeks have provided a vivid reminder of how sensitive markets can be to small changes in the macro-economic outlook. With a nudge down in oil prices, the Fed’s 2% inflation goal suddenly seems achievable within a matter of months. With a slight weakening in the labor market, the unemployment rate has shifted to a trajectory that has foreshadowed recession in the past. In response, the 10-year Treasury yield fell from 4.29% on July 24th, to 3.78% on August 5th while the VIX index, a measure of stock market volatility, more than doubled over the same period, with stock prices falling sharply by the close of business last Monday.
We live at a time when extreme voices get the most attention and so it is tempting, following a string of weak economic numbers, to yell the word “recession”. However, a balanced assessment of demand and supply suggests that we are, thus far, merely transitioning to slower growth. A slower growth path is a more vulnerable one, particularly because excessive monetary ease is more likely to weaken than strengthen the economy in the short run. Nevertheless, barring some outside shock, the baseline scenario should be a slowdown scenario, even as volatile markets remind investors of the importance of diversifying and paying attention to valuations. The mood on the economy has changed quite quickly. The economic headline from just 12 days ago was that real GDP growth had, yet again, surprised to the upside, coming in at a robust 2.8% for second quarter, well above the 2.1% consensus expectation. Since then, however, we have seen higher-than-expected weekly unemployment claims and weak readings on construction, durable goods orders, home sales and manufacturing activity. This was topped off, on Friday, by a softer-than-expected employment report, both in terms of payroll job gains and the unemployment rate.
My wife, Sari, and I love old movies and one of our favorites is the Long, Long Trailer, staring Lucille Ball and Desi Arnaz. Desi and Lucy are newly-weds who decide, instead of buying a house, to purchase a trailer home which they hitch onto the back of their car and set off on their adventures. Soon, without any idea of how to drive such a contraption, they find themselves ascending into the Sierra Nevada mountains, driving up steep, narrow and twisty mountain roads. Unbeknownst to Desi, Lucy decided to collect rocks as souvenirs along the way which she hid all over the trailer, adding extra weight to an already dangerously unwieldy vehicle. The funniest part is watching them making small talk, pretending nothing is going on, as their car engine roars, gears squeal and little rocks spit out from their tires, over the cliffs and out into the abyss below. The contrast between the nonchalance of their conversation and the terror in their eyes is priceless and it only increases as they head over the peak and begin to descend. The most dangerous time, both for oversized trailers and central bankers, is when you begin to descend from a peak. Recent data suggest the Fed should, finally, begin to cut rates in September. This operation could work out OK. However, it is a delicate one and, particularly, when both markets and portfolios appear to be overconcentrated, it is important that investors take what steps they can to maintain or regain balance in their portfolios.
Despite a slightly higher-than-expected payroll job gain, the June employment report was on the soft side, with downward revisions to payroll gains from prior months, a drop in temporary employment and only modest gains in wages. However, the weakest aspect of the report was the unemployment rate, which edged up from 4.0% to 4.1%. This, in itself, wouldn’t be particularly notable were it not for the fact that the unemployment rate has now risen steadily over the past 14 months from a 54-year low of 3.4% set in April of last year.
The play, entitled “Steadily She Slows”, has, from a dramatic perspective, turned out to be a dud. It started with such a promising prologue of pandemic, recession, recovery, political upheaval, war and inflation. However, it has since settled into a drawn-out, repetitious script, wherein the lead actor, consumption, hogs the center stage and the supporting cast, in the form of investment spending, government spending and trade, has very little impact on the plot. The promoters, on cable news shows and social media feeds, do their very best to gin up public interest by prophesying catastrophic collapse into recession or reignited and blazing inflation. But still the play drones on, unloved by all, except, of course, the investors, who are profiting handsomely from its extended run.
As a young lad growing up in South Dublin, I received certain geography lessons on where I could, or could not, safely roam. In particular, I was warned not to stray north of O’Connell Street. I remember debating my mother on the issue, once when I wanted to go to a movie at a theatre near Parnell Square. I can’t remember exactly what I said, but I probably claimed that bad things didn’t happen on the North Side quite as frequently as South Side mothers thought they did. But my mother held her ground on this occasion…someone might or might not get beaten up in Parnell Square that afternoon. But if her son wasn’t there, it wouldn’t be him. After almost every speech, someone asks me about risks – what keeps me up at night. And today, with a soft-landing economy and the stock market near record highs, it does seem like a good time to review risks. But it’s important to recognize the most obvious point about market risk. The risk to you, as an investor, isn’t simply the danger of some negative event – it is the product of the probability of that event and your exposure to it. How you are positioned says a great deal about how worried you should be about any risk.