Financial Review

Accommodation Drop

…Fed hikes rates. The economy is strong, everything is rosy. Stocks drop. ECB says trade wars will hurt US. NAFTA circles the drain. Trump blames China.
Financial Review by Sinclair Noe for 09-26-2018

DOW – 106 = 26,385
SPX – 9 = 2905
NAS – 17 = 7990
RUT – 17 = 1691
10 Y – .04 = 3.06%
OIL – .24 = 72.04
GOLD – 6.70 = 1195.10


The Federal Reserve raised interest rates for the third time this year and signaled they will raise rates again in December. The Fed announced an increase in the target range for its benchmark interest rate of 25 basis points to 2%-2.25%, setting the Fed funds rate at its highest level since April 2008. All nine voting members of the FOMC voted in favor of the rate hike.


The most notable change in Wednesday’s statement was the removal of language indicating the Fed sees its policy as “accommodative.” In its August statement, the Fed said, “The stance of monetary policy remains accommodative, thereby supporting strong labor market conditions and a sustained return to 2 percent inflation.” The removal of this language indicates that Fed officials see their current interest rate policy as nearing the level that is estimated to sustain full employment while meeting the Fed’s 2% inflation target.


As it did in its August policy statement, the Fed described the economy as “strong” in at least three different areas, writing that information since the Fed’s August meeting shows, “the labor market has continued to strengthen and that economic activity has been rising at a strong rate.” The statement adds, “Job gains have been strong, on average, in recent months, and the unemployment rate has stayed low. Household spending and business fixed investment have grown strongly.” Economic strength showed up in the Fed’s projections for growth. Fed officials’ median forecast now calls for GDP growth to hit 3.1% in 2018, up from 2.8% in June’s projections and substantially higher than the Fed’s forecast for 2.5% GDP growth this year at the end of 2017.


The Fed’s latest dot plot also reveals that officials are split on the path of interest rate hikes next year and beyond. With 12 of 16 Fed officials forecasting another rate hike in 2018, December’s meeting will likely come and go without any fanfare. In 2019, however, four Fed officials expect two rate hikes, four Fed officials expect three rate hikes, and four Fed officials see four rate hikes as likely being appropriate. In 2020, the Fed’s median dot indicates one rate hike will likely be warranted before the range of outcomes widens significantly in 2021. The latest dot plots also shows the longer run interest rate estimated to sustain full employment and 2% inflation is likely somewhere between 2.5%-3%. Six Fed officials see 3% as the longer run neutral rate, with four officials pegging the neutral rate at 2.75%, and three officials seeing 2.5% as the longer run neutral rate. This forecast indicates that perhaps as soon as next year Fed policy will move to being restrictive, with benchmark rates set higher than what officials estimate will be required over the longer run.


In the press conference following the Fed rate hike announcement, Fed chair Jerome Powell seemed sanguine about the long-range forecast. It seems the Fed is looking at a low unemployment rate stretching into the distant horizon with anchored inflation expectations, solid and consistent growth bolstered by rising levels of capital expenditures and productivity. If the Fed is worried about the economy, Powell did not let on – rather, the data is just about perfect and a trend in place is more likely to continue that it is to reverse. So, the outlook is for a long steady flight with almost no turbulence and if the economy does touch down, it will be a soft landing.  Stocks were higher following the Fed’s announcement but then dropped after Powell’s press conference.


The European Central Bank is not quite so sanguine. Their concern is trade wars. In a research bulletin, ECB economists modeled a scenario in which the U.S. raises tariffs on all of its imports by 10 percentage points, and its trading partners retaliate with an equivalent tariff increase on their U.S. imports. Other countries don’t retaliate against each other in the model. The researchers found that the U.S. economy would shrink by around 2% in the first year compared with a situation in which nothing changes. That is because higher tariffs would reduce household incomes and hurt business confidence, weighing on private consumption and investment. That would more than offset a positive effect of tariffs–that consumers and businesses would likely switch to domestically produced goods, which would tend to boost the U.S. economy.


“An economy imposing a tariff which prompts retaliation by other countries is clearly worse off,” the researchers conclude, “living standards fall and jobs are lost.”


Under the same scenario, China’s economy would grow slightly faster in the first year, according to the ECB. While the U.S. would import fewer goods from China, that would be more than offset by increased Chinese trade with other countries, where the nation’s exporters could gain market share at the expense of more costly U.S. exports. European exporters might also gain from such a trade conflict, although that would depend on how easily a country could substitute between imported products from different countries.


Meanwhile, a trilateral NAFTA agreement is slipping away. US trade negotiators are on the verge of blowing through their self-imposed Sept. 30 deadline for reaching a breakthrough with Canada. Major sticking points still divide the countries — including over access to Canada’s dairy market and the fate of a dispute resolution process — and officials on both sides acknowledge they aren’t close to resolving them. There is a possible two-way deal between the US and Mexico but that faces political opposition. Business and labor groups likewise are largely united in demanding that policymakers keep all three countries in the fold. And it’s not clear the Trump team could fast-track congressional approval for a Mexico-only deal. The administration is seeking to rely on trade promotion authority to submit an agreement for an up-or-down vote on Capitol Hill. When it invoked that process at the start of NAFTA talks last year, the administration pledged to include both neighboring countries in the final package. Some trade experts say a two-way agreement wouldn’t qualify. Meanwhile, the possible deal with Mexico has a deadline of November 30 – that’s when Mexican President Enrique Peña Nieto steps down from office and hands over power to his successor Andrés Manuel López Obrador. After November, negotiators would be starting from scratch with a new Mexican administration. That, in turn, means it is unlikely the US Congress will sign off on anything to do with NAFTA this year; which means there is no real incentive for Canada to agree to any terms in the near future.


Meanwhile, we are in a trade war with China and there are no talks scheduled and after today’s activities at the UN, there probably won’t be any talks scheduled for a while. Trump accused China of seeking to interfere in US congressional elections in November, using his chairmanship of the UN security council to spring a surprise on his fellow world leaders. But administration officials – who also appeared to have been taken unaware by the allegation – were able to give few supporting details, and the unexpected move did little to obscure Trump’s isolation at the UN over his Iran policies.


At the start of this morning’s meeting – whose ostensible purpose was to discuss the proliferation of weapons of mass destruction – Trump said: “China has been attempting to interfere in our upcoming 2018 election.” Trump did not mention Russia, which US intelligence agencies say interfered in Trump’s favour during the 2016 presidential elections – and see as the prime outside threat to the 2018 midterm vote in November. Trump has long rejected that conclusion, and instead portrayed himself as a victim of election meddling, this time from Beijing. This week, the state-controlled China Daily paid for a four-page advertising section in Iowa newspaper the Des Moines Register to highlight the impact of Trump’s trade policies on the state’s soybean farmers, who are finding it harder to sell to China because of Beijing’s retaliation for US tariffs.


Brett Kavanaugh’s already troubled Supreme Court nomination was shaken further, as a third woman accused the federal judge of sexual misconduct on the eve of a Senate Judiciary Committee hearing. The new claim, more lurid than the others, was revealed by Michael Avenatti, the attorney representing Stormy Daniels, the porn actor and director who says she had an affair with President Trump. The growing scope and number of claims could make it harder for the Senate to push forward and for the White House to continue to resist calls for the FBI to conduct an investigation into the allegations. At Thursday’s hearing, the nominee is expected to testify, as is Christine Blasey Ford, who says Kavanaugh attempted to rape her at a party in high school. Republicans on the Judiciary Committee on Tuesday announced they had hired Rachel Mitchell, a sex-crimes prosecutor from Maricopa County to conduct questioning on their behalf; apparently because the senators did not think they could ask questions without coming off as insensitive buffoons. I have no idea how tomorrow’s hearing will play out. Maybe Kavanaugh will be exonerated or possibly denounced, but I’m pretty sure there will be a heavy price to pay for this nomination, one way or the other.


After consecutive quarters of near-record profit growth, companies are starting to lower expectations. With third-quarter earnings right around the corner, S&P 500 companies are cutting their outlooks at levels not seen since the first quarter of 2016, when corporate America was in a profits recession. In all, 98 companies have offered guidance — 74 have provided a negative outlook, meaning they expect earnings to come in below Wall Street estimates, while just 24 have been positive.


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