The Great Unwind
…..Dow record high close. Maria hits Puerto Rico. Earthquake in Mexico. The stock market is calm, too calm. The Fed holds rates steady for now but begins the Great Unwind. The mystery? Will it work?
Financial Review by Sinclair Noe for 09-20-2017
DOW + 41 = 22,412
SPX + 1 = 2508
NAS – 5 = 6456
RUT + 5 = 1445
10 Y + .03 = 2.28%
OIL + .81 = 50.29
GOLD – 10.20 = 1301.50
Dow and S&P hit record highs, again.
We start today with a couple of natural disasters. This morning Hurricane Maria hit Puerto Rico as a Category 4, but with wind gusts up to 190 MPH. There is serious damage, still being sorted out. Communications are down, power to the island is gone – the entire electric grid shredded – a total blackout. Buildings damaged and widespread flooding. People seeking help were told by authorities that they would have to sit tight until conditions improved. So far, there have been no reports of deaths in Puerto Rico, though there have been several reports in other parts of the Caribbean, including on the French island of Guadeloupe. Before striking Puerto Rico, Hurricane Maria’s eye clipped the edge of St. Croix in the U.S. Virgin Islands. Some 3,200 federal government staffers, National Guardsmen and other emergency personnel overseen by the Federal Emergency Management Agency were already in Puerto Rico, many of them dealing with the Irma response and recovery, when Maria approached.
Maria could worsen the many environmental calamities that already exist on the island, posing even greater threats to public health. In some ways, Puerto Rico will face familiar environmental threats caused by major hurricanes, but they’ll be compounded by the island’s financial and environmental woes. For instance, wastewater pumping systems failed in Texas and Florida after Hurricanes Harvey and Irma, causing major sewage spills. The same will likely happen in Puerto Rico, where most pumping stations run on electric power, but may be much worse due to the island’s “degraded and unsafe” electricity system. The local energy authority has already said it could take up to four months to restore power, likely resulting in prolonged sewage releases. Puerto Rico also has 23 Superfund sites, and flooding and landslides mean an increased risk of just spreading contamination.
Meanwhile, in Mexico City, rescue workers scramble to dig people out of the ruins of dozens of building which collapsed in yesterday’s earthquake. The death toll has climbed to at least 225 people, including 30 schoolchildren. All told, Mexico City officials counted 39 buildings entirely destroyed, and the city’s entire staff of emergency workers — about 50,000 people — was on duty along with other city workers who were supporting them. The city government reported that more than 50 people had been rescued from buildings across the city. The 7.1-magnitude earthquake struck Tuesday afternoon, 32 years to the day after the city’s last great earthquake, in 1985. That quake killed as many as 10,000 people. That event lead to better building codes, and that in turn means that the death toll from yesterday’s quake is not even worse.
The bull market that started in March 2009 seems to have gone on forever – the second longest in American history since 1900 and the third highest in percentage gains – and the past couple of weeks have seen record highs piled on top of record highs. It can’t last forever, but for now, realize that it is amazing. The stock market has been operating in an extremely rarefied world of heightened calm, one that is unlikely to continue. Stocks so far in 2017 are the steadiest they have been since 1965. The one thing we thought was a certainty about the market is that stocks fluctuate, but that isn’t happening – just small steady steps. Political turmoil has had little or no effect on the pervasive calm in the stock market. The VIX index, widely known as Wall Street’s gauge of fear, has remained very low, on a historical basis, despite recent spikes. Data from the Chicago Board Options Exchange shows that even when the VIX has risen this year, it has not even reached its average since 2004. The S&P 500 has not seen a 5% decline, from peak to trough, since June 28, 2016. That sell-off, 6.1 percent over several days, occurred after Britain’s surprise vote on June 23, 2016, to leave the European Union. And even that Brexit Blowoff was short-lived. Going all the way back to 1950, the current streak is the fourth longest in history without a 5 percent decline. The economic expansion in the United States is already the third longest since 1854. If there is no recession until June 2019, this will become the longest period without a recession. This is just a way of saying that maybe you shouldn’t get used to a steady diet of milk and cookies. This extremely calm and orderly progression of record highs is not the norm and will not last forever. Enjoy the show, just be aware of where the exits are located.
And that brings us to the steady hand on the tiller of monetary policy. No surprises in today’s FOMC announcement from the Federal Reserve. The Fed did exactly as promised – no rate hike at this meeting but we did get details on how they plan to shrink their balance sheet. The Fed announced today that the economy was in such whopping good shape that they plan to start selling off all the assets they accumulated as a result of three rounds of quantitative easing during the Great Recession. The Great Unwind begins in October – slowly at first, just $10 billion per month for the first three months, then slowly increasing. The Federal Reserve still plans to raise interest rates once more before year end, maybe in December. Although the Fed has not dramatically reassessed its current strategy, the central bank did scale back its estimates of how high interest rates will rise. The Fed remains on track to raise its benchmark fed funds rate three times in 2018, but it only pegged two further rates in 2019 instead of three. The bank also lowered its long-run target to 2.8%, the first time it’s fallen below 3%. Fed officials have been puzzled by the persistence of low inflation even as the unemployment rate fell in July to a 16-year low of 4.3%. Yet wages still aren’t rising as rapidly as conventional economic wisdom would suggest. Yellen said low inflation was a “mystery”.
But the biggest mystery is whether the Fed can tighten monetary policy without crashing the economy. For one day, at least, the dollar bulls were able to show their faces in public. It’s well known that the greenback has had an unexpectedly bad 2017, due at least in part to that mysteriously low inflation. The weak dollar has been a boon for stocks, and as stocks have climbed, slowly and steadily, that has been bullish for bonds because the more stock prices appreciate, the more investors need to buy bonds to prevent their equity weighting from rising too much or to hedge their equity risk. In other words, the gains in equities are feeding the bond rally, preventing bond markets from selling off even in a “risk on” environment. And a solid bond market is needed for the Fed to dump billions of dollars from their balance sheet. Let’s just hope the Great Unwind only happens on the Fed’s balance sheet and doesn’t spread to the rest of the market.
The Fed also repeated its view that unemployment is likely to end at 4.3% in 2017, fall slightly to 4.1% in the next year and then hold steady. The Fed’s forecasts imply the bank is unwilling to freeze interest rates in an experiment to see how low unemployment can go without stoking inflation. The Fed also has to contend with a murkier view of the U.S. economy in the aftermath of hurricanes Irma and Harvey. Yellen said the disruptions could hurt the economy in the third quarter, boost growth in the fourth quarter and raise inflation temporarily owing to higher gas prices. The path of growth, however, is unlikely to change. The bank projects roughly 2% economic growth over the next few years, keeping in line with Fed forecasts stretching back several years.
An extra note, at the press conference today, Fed Chair Janet Yellen said Wells Fargo may still face a penalty from the Federal Reserve for opening millions of unauthorized accounts. Yellen didn’t say what might happen to Wells Fargo, but she did say “We take our supervision responsibilities … very seriously”. Proving that even stodgy economists have a sense of humor.