Financial Review

Thus Spake Powell

…Fed Chief Powell says rates are just below neutral. Stocks big rally. JOLTS shows quits improve. 3Q GDP unchanged at 3.5%. Investors lose faith in market cycle.

Financial Review by Sinclair Noe for 11-28-2018

DOW + 617 = 25,366
SPX + 61 = 2743
NAS + 208 = 7291
RUT + 37 = 1530
10 Y – .01 = 3.04%
OIL – 1.32 = 50.24
GOLD + 6.10 = 1221.70


There are several factors driving the stock market. You know the big issues: trade wars, tariffs, sanctions, emerging market debt, corporate debt, earnings, tax deals – all these issues can move the market.


Stock rallies across Asia spread to European indexes and US futures on Wednesday as investors took comfort from some reassuring words about trade by one of Trump’s closest advisors. Larry Kudlow said that the White House was having “a lot of communication with the Chinese government at all levels” ahead of Sunday’s highly anticipated meeting between Trump and his Chinese counterpart, Xi Jinping. Investors took Kudlow’s comments at face value, sending stocks higher around the globe. If a trade deal between the US and China can be reached, it would be a huge positive for stocks – but it seems premature.


The Federal Reserve still has some juice – and when Fed Chair Jerome Powell speaks, people listen. Today, Powell spoke before the Economic Club of New York. Three words resonated: “just below neutral”. The phrase “just below” neutral might seem innocuous. But those words from Powell sparked a wave of optimism among investors who took them to mean the central bank may be winding down its interest rate hikes.


The Fed chief’s remarks indicate the central bank won’t be raising its federal-funds rate nearly as many times in 2019 as the “dot plot” of Federal Open Market Committee members’ projections had implied. The median dot pointed to an additional three hikes of one-quarter percentage point each. (That’s after the quarter-point increase that’s still likely at next month’s FOMC meeting.)


Powell said, “Interest rates are still low by historical standards, and they remain just below the broad range of estimates of the level that would be neutral for the economy‑‑that is, neither speeding up nor slowing down growth.” In October, Powell suggested the Fed was a “long way” from neutral. This remark was seen by many investors as triggering the stock market volatility we’ve seen over the last few weeks as it suggested the Fed could be more aggressive than markets were forecasting in raising interest rates. Tweaking this language to say rates are “just below” neutral is what investors have latched onto as a sign Powell is tempering some hawkishness interpreted in his earlier remarks. Fed-funds futures similarly are now pricing in only two more quarter-point rate hikes, including December’s, with any certainty. The chance of four increases, to a target range of at least 3%-3.25% by the end of 2019 implied by the Fed’s dots, is given just an 8.6% probability, down from the already low 18.6% probability a month ago, according to the CME Fed Watch site.


Within moments of his remarks, stocks shot up, adding to an already positive session. Powell attempted to somewhat downplay the impact recent volatility may have had on his thinking about rates, saying, “It is important to distinguish between market volatility and events that threaten financial stability. Large, sustained declines in equity prices can put downward pressure on spending and confidence. From the financial stability perspective, however, today we do not see dangerous excesses in the stock market.”


In addition to delivering a few speeches, the Federal Reserve today published it first-ever financial stability report to warn primarily of the dangers lurking in corporate debt. The Fed said valuation pressures are generally elevated, with investors exhibiting a high tolerance for risk taking with business debt-related assets. It found that the debt owned by businesses relative to GDP is historically high, with signs of deteriorating credit standards.  The Fed report also found some good news in the financial system. Household borrowing has rose roughly in line with income, the nation’s largest banks are strongly capitalized and have more liquid assets, broker-dealer leverage is below pre-crisis levels, insurers have strengthened their financial position, and money market funds are less vulnerable to runs.


Powell’s speech also comes against the continued backdrop of Trump criticizing the Fed for not providing enough accommodation. But Powell’s remarks were not necessarily as dovish as market watchers might think. The message is that there is no preset path for interest rates and therefore the Fed might not necessarily tighten above neutral. This is a reassuring message from a market perspective because it removes concern of a Fed dead set on tightening up to a point where rates would intentionally slow down the economy.  However, the Fed could still tighten monetary policy in the face of a strong economy. And Powell portrayed a very robust economy, with unemployment near 50-year lows and inflation running right on target.


With the unemployment rate currently at 3.7% and the economy continuing to create in excess of 200,000 jobs per month, the headline data about the labor market suggests things are very good for American workers right now. In September, 3.6 million people quit their jobs, just below the record high 3.65 million job quitters we saw in August. The overall quits rate for the private sector in September held at 2.4% for the third month in a row, matching a 17-year high. In October, average hourly earnings for all employees rose 3.1% and for non-supervisory workers’ wages rose 3.2% over last year. These were the highest readings since the spring of 2009, when wages were on the way down as the post-crisis recession deepened. Quits are seen a positive economic indicator, with the thinking being that folks won’t leave a job unless they are reasonably confident they could easily get another one.


The first revision to third quarter gross domestic product resulted in no revision. Third quarter GDP growth came in at 3.5%, unchanged from the preliminary estimate. Business profits, meanwhile, surged to new heights. Adjusted corporate earnings before taxes rose 3.4% in the third quarter. More notably, profits in the past 12 months have climbed at a heady 10.3% clip, the fastest increase since 2012. Although the increase in GDP was unchanged, the revised report shows marked changes in how well some segments of the economy performed. Households and state and local governments spent less than originally reported, for one thing. And business investment was not as weak as initially believed. Consumer spending, the main engine of the economy, rose at a 3.6% pace instead of 4%. It turns out that Americans actually reduced spending on new cars and trucks instead of spending more. The increase in state and local government spending was trimmed to 2% from 3.2%. Businesses investment, meanwhile, was somewhat stronger than initially reported. Investment in equipment climbed 3.5% vs. virtually no increase in the preliminary estimate. And spending on structures such as office buildings and drilling rigs fell just 1.7% instead of 8%. The production of unsold goods, or inventories, was also stronger. They rose at a revised $86.6 billion annual rate vs. an initial $76.3 billion. Inventories add to GDP. Exports fell at a slightly bigger 4.4% annual clip. The increase in imports was little changed at 9.2%. A bigger trade deficit subtracts from GDP. The rate of inflation was marked down a notch to a 1.5%. Fourth quarter GDP growth is expected to be closer to 2.7%.


Investors are starting to lose some of their faith in this market cycle. In November, 44% of fund managers said they think global economic growth will decelerate in the next 12 months; in October, 38% of fund managers thought the same. These are both the highest readings since November 2008. But in this latest survey, a slight increase in the number of investors looking for a deceleration in the world economy was overshadowed by a clear step-up in bearish views on the S&P 500. In November, 30% of investors said they thought that U.S. stocks have already peaked, roughly double the 16% of investors who thought stocks had peaked last month. A third of investors polled by Bank of America throwing in the towel on higher stock prices this cycle doesn’t show outright capitulation, but the continued choppiness for the market after a brutal October has clearly increased concerns that the market’s best days are behind investors. And this data indicates a creeping anxiety among investors about the overall direction of the market, which for the last few years has been clearly up and to the right. Overall, fund managers surveyed by BAML still see the market rising before the end of this cycle — BAML’s survey shows investors think the S&P’s eventual peak this cycle will be 3,056, a roughly 12% advance from current levels. So, a gloomier view of the economy does not indicate an outright rolling over of investor sentiment. But continued tepid optimism for a modest rise in stock prices along with a doubling in the number of market participants that think we’re not going anywhere but down makes clear that investor confidence continues to bleed out of the market. And indicates there is still plenty of room for the situation in financial markets to get much worse.


At least 84 farm operations in Minnesota, Montana, North Dakota, South Dakota, and parts of northwestern Wisconsin filed for bankruptcy in the 12 months that ended in June, according to a new analysis from the Minneapolis Federal Reserve, more than twice the level seen over the same period in 2014. The strain of low commodity prices on farmers and ranchers has been compounded by tariffs. Farming margins have been squeezed for some time, so the tariffs are just salt on the wound. Falling prices have also exerted pressure on farming finances throughout the rest of the Midwest, with more than half of respondents in a Kansas City Federal Reserve survey reporting lower farm income than a year ago.

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