by Asset Allocation Committee

The Federal Reserve is experiencing a crisis of sorts.  For years, policymakers have used the Phillips Curve as a guide to policy.  The Phillips Curve postulates that there is a tradeoff between inflation and unemployment. Essentially, to quell inflation policymakers need to raise rates to create unemployment.  The basic idea is that unemployment represents capacity; when the unemployment rate falls below some level, sometimes called the “natural rate of unemployment,” capacity constraints develop and inflation rises.  Theory has developed around the Phillips Curve.  For example, the Non-Accelerating Inflationary Rate of Unemployment (NAIRU) suggests an equilibrium unemployment rate; inflation falls above this rate, and inflation rises below this rate.

However, if NAIRU is natural, it doesn’t appear to be stable.

This chart shows the natural rate of unemployment, calculated by the Congressional Budget Office.  As is evident, it has increased and declined over time.

The lack of inflation given the low level of unemployment has led the FOMC to consider if another model might work better.  If the reaction of the economy to low unemployment has changed, then policymakers may need to keep rates lower for longer to avoid the risk of raising rates too soon or too much.  Doing either could needlessly shorten a business cycle.  If inflation reacts more slowly to falling capacity, it might make sense to use a different way to adjust the policy rate to inflation.  Currently, the FOMC uses a 2% target on core PCE inflation.  In other words, based on the yearly change in the core PCE index, the FOMC attempts to keep inflation around a yearly 2% change.  Although the Fed attempts to suggest 2% isn’t a ceiling, it is generally treated as one by the financial markets.

Of the current 17 members of the FOMC, nine are Ph.D. economists.  Of that group, five have advocated for a reexamination of inflation policy.  None of the non-Ph.D. members have advocated for a change.  Thus, the drive to make a change appears to be coming from the “technical” side of the shop.  At present, there are three ideas being explored to address the inflation policy issue.

1. Raise the inflation target: The official inflation target is relatively new. Although the Fed privately agreed to an inflation target in 1996, Chair Greenspan insisted it was to be kept secret.[1]   It wasn’t until 2012 that the FOMC made the 2% target official.[2]  The working definition of inflation control is a rate low and stable enough that inflation concerns are not part of the economic process.  In other words, if I am buying something, I neither accelerate the purchase (a reaction to higher expected prices) nor wait (a reaction to lower expected prices).  If the interest rate that creates equilibrium has fallen, one way to achieve that rate, on a real basis, is to simply tolerate higher inflation.
2. Use a moving average of the yearly change in inflation: The use of the core rate, the rate excluding food and energy, is designed to smooth out the changes that can be triggered by weather or geopolitical events. However, even items outside of food and energy can be affected by short-term events.  Changes in tax rates at the state and local level can raise prices for a short time.  In the past, price wars in mobile phone plans led to lower core prices.  If the goal is to control inflation over the medium term, a smoothed series might make more sense.[3]
3. Target the level of prices, not the rate of change: The FOMC uses the core PCE deflator as its policy tool. Instead of aiming for a 2% rate of change, the committee could target a level instead.  That way, if price levels were above trend for an extended period, monetary policy would be tightened until the index falls back to trend.  In the case of price levels being below trend, the Fed may move slowly to raise rates until prices return to trend.  The advantage of this model is that the FOMC would not have to react to a simple jump in prices after a period of low prices.

All three options have pluses and minuses.  Raising the inflation target is the easiest to understand.  But, there is concern that if the target appears flexible then inflation expectations could become unanchored.  The risk is that once the target is changed, the Fed could find itself facing political pressure to keep rates steady or cut them even with rising inflation to suit short-term political goals.  Moving average models will reduce the likelihood that the Fed would react quickly to inflation impulses and make the policy rate steadier.  However, by design, moving averages will tend to delay easing and tightening.  In the present circumstance, it appears attractive but it will tend to slow rate reductions going into an easing cycle.  Targeting the level of price is attractive in that it takes previous price levels into account, but it will be hard to explain to the public how it works and what to expect.  And, the calculated trend can be sensitive to initial conditions.  In other words, if you start your model in a high inflation period, it can affect the deviation from trend.

Here is one potential view of the second option.

Using the Mankiw Rule (which uses core CPI instead of core PCE), we take a five-year average of inflation on the model shown on the right.  The model on the right has better performance; during the 1990s, it did a better job of informing policymakers that rate changes were unnecessary and would have told the Bernanke Fed that policy was too tight going into the 2007-09 recession.  Interestingly enough, both versions suggest the Fed is currently too easy.

Here is another view using the employment/population ratio as a proxy for capacity.

The moving average model gave clearer signals; it would have told policymakers to ease sooner in 2001 (a recession year) and would have signaled to the Bernanke Fed to begin easing sooner than it did before the 2007-09 recession.  Both suggest the neutral rate is below the current rate but the moving average model suggests policy is tighter than the unadjusted inflation model.  Essentially, these views show that the real issue remains the measure of slack, but adjusting the inflation indicator might mitigate the uncertainty surrounding the capacity issue.

Here is one potential view of the third option.

The chart on the left shows the core PCE index, log transformed, regressed against a time trend.  In general, price levels vary to trend.  The chart on the right compares the detrended index to the fed funds target.  Note that the cycles in policy tended to move with price levels except for the current one.  This model would have kept the FOMC from tightening at all in this cycle.

Under current conditions, this reassessment of inflation policy will likely lead to an end of tightening.  Essentially, the considered adjustments will probably discourage further rate hikes by reducing the policy level of inflation.  However, this assessment still depends on the proper measure of slack in the economy, which, so far, has not been resolved by the FOMC.  Nevertheless, we think the proper assessment of this change is dovish for policy.

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[1] https://economia.icaew.com/opinion/april-2015/the-federal-reserves-battle-with-price-stability

[2] https://www.federalreserve.gov/monetarypolicy/files/FOMC_LongerRunGoals.pdf

[3] The Bank of England has a sort of smoothing process where it targets a 2% rate with a 1% variance.  If inflation rises or falls outside this band, the bank must explain to the Exchequer why this occurred and what it will do about it.  Thus, if the variance is due to a one-off situation, the bank may do nothing.

by Asset Allocation Committee

Our cyclical position on foreign investing remains with a zero allocation; although the committee has not been negative on foreign, our work suggested that the risk/reward compared to small and mid-cap stocks warranted putting more assets in those areas.  However, we are continuing to pay close attention to foreign as an area that may be attractive in the future.

In the past, we have noted that relative performance between foreign developed and U.S. equities is sensitive to the dollar.  In general, during periods of dollar strength, U.S. equities tend to outperform (assuming both are denominated in dollars, which is the case for a U.S. investor).

The blue line on the chart shows the ratio of performance between EAFE and the U.S., rebased to 1970.  When this line is rising, foreign stocks are outperforming.  The red line shows the JPM Dollar Index.  Note that a rising dollar tends to favor U.S. outperformance, while dollar weakness helps foreign market performance.   Although the dollar has remained strong, both on a purchasing power parity basis and a cycle basis, the dollar is extended and should begin to depreciate later this year.

However, in this business cycle, U.S. stocks have generally outperformed even during periods of dollar weakness.  This has led us to look for other factors that might account for this discrepancy.  It appears that the growth/value variation explains at least part of this divergence.

As in the first chart, the blue line shows the relative equity performance.  The red line shows the Russell 3000 Growth/Value divergence; a rising line suggests growth outperformance.  Growth stocks have outperformed in this bull market but are showing signs they may finally be starting to give way to value.  The primary driver of growth/value is the P/E ratio.  Significant multiple expansion isn’t all that likely, although a return to the 18x+ area would not be surprising.

Why would the growth/value divergence affect foreign stocks?  The most likely reason is index construction.  U.S. indices will tend to have a greater weighting toward technology due to the size of that industry in the U.S. economy.  Foreign nations, for the most part, have less dominant tech industries.  With technology being considered a growth sector, a period of strong technology performance would tend to lead to outperformance by growth.  If foreign equity indices have less technology, they would likely underperform.  Consequently, when the growth/value balance shifts to the latter, we would anticipate foreign outperformance.  The table below provides a comparison of sector exposures.

Overall, we continue to monitor the relative performance of foreign compared to other asset classes.  If our risk/reward estimates change later this year, we could consider a return to international.

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by Asset Allocation Committee

In 2017, we introduced an indicator of the basic health of the economy and added it to the many charts we monitor to gauge market conditions.  The indicator is constructed with commodity prices, initial claims and consumer confidence.  The thesis behind this indicator is that these three components should offer a simple and clear picture of the economy; in other words, rising initial claims coupled with falling commodity prices and consumer confidence is a warning that a downturn may be imminent.  The opposite condition should support further economic recovery.  In this report, we will update the indicator with January data.

This chart shows the results of the indicator and the S&P 500 since 1995.  The updated chart shows that the economy did slip late last year.  We have placed vertical lines at certain points when the indicator fell below zero.  Although it works fairly well as a signal that equities are turning lower, there is a lag.  In other words, by the time this indicator suggests the economy is in trouble, the recession is likely near or underway and the equity markets have already begun their decline.

To make the indicator more sensitive, we took the 18-month change and put the signal threshold at -1.0.  This provides an earlier bearish signal and also eliminates the false positives that the zero threshold generates.  Notwithstanding, we will pay close attention when the 18-month change approaches zero as it did in January.

What does the indicator say now?  The economy has weakened but is not yet at a point where an investor should become defensive.  Breaking below the red line would be our signal to expect a broader downturn.  Most likely, we are going through a period similar to what we experienced in 2016.  If so, and the economic data begins to improve, then we should see equities turn higher in the coming months.

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by Asset Allocation Committee

The pullback in equities in Q4 coincided with a sharp drop in long-duration Treasury yields.  However, the recovery seen in early 2019 has not led to a rise in yields.

This chart shows the S&P 500 (left axis) and the 10-year T-note yield (right axis).  Note that yields and the equity markets tended to rise together in the first three quarters of 2018.  More importantly, they tracked each other in the fourth quarter; as equity values fell, yields also declined.  However, as equities have recovered since late December, yields have not rebounded into the range where they were when the S&P was around 2700.

In part, yields are currently running below fair value.

This chart shows our bond model; the core variables are fed funds and the 15-year average of CPI.[1]  In addition to these variables, we add the JPY/USD exchange rate, crude oil prices, German 10-year sovereign yields and the Federal deficit/GDP ratio.  The market would not be “rich” in this model until yields approach 2.17% but they are modestly below fair value after being above fair value for most of last year.

There are thee variables that account for the decline in the 10-year T-note yield, fed funds, German sovereign 10-year yields and oil prices.  In October, the 10-year T-note yield was running around 3.15%.  That level had discounted oil prices at $60 per barrel, German yields at 20 bps and a terminal fed funds rate of 3.25%.  The decline in the fed funds estimate to 2.50% accounted for 30 bps in the decline in yield, while the remaining 3 bps to fair value came from the decline in oil prices to $55 per barrel and German 10-year sovereign yield declines to 14 bps.

The “undershoot” to 2.70, below the fair value of 2.87%, could be achieved with a fed funds of 2.12%.  Given that the actual target is the mid-point between the upper and lower bound of the fed funds target (the announced rate is actually the upper bound), this would imply a rate cut.  Or, a decline in inflation expectations to 1.8% from 2.1% could also account for the undershoot, assuming no change in fed funds.

We suspect the primary reason for the slide is that inflation expectations have probably fallen.  This is because there isn’t much in the data to support the FOMC cutting rates.

This chart compares the fed funds target to the implied three-month LIBOR rate from the two-year deferred Eurodollar futures contract.  History shows that policymakers tend to stop raising rates when the spread between these two rates invert.  As the spread line shows, the spread is near inversion which is consistent with a policy pause but would not be consistent with rate declines.  Policy cuts would be in order if the implied yield were to fall further, but that evidence doesn’t exist for now.

If inflation expectations are leading to the undershoot, then stronger economic growth could trigger a rise in inflation fears.   We would not be surprised to see a modest rise in yields in the coming weeks, but a rise beyond 3.00% on the 10-year T-note yield would likely require a return to policy tightening by the FOMC.  We would not expect such a shift until later this year, if then.

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[1] Which is a proxy for inflation expectations.

by Asset Allocation Committee

Gold is considered by some to be a commodity, but we treat it as a non-liability-backed currency.  In other words, gold isn’t created because someone makes a loan.  Instead, it is created by mining.  In addition, most commodities are consumed but much of the gold refined through the ages still exists.  In other words, gold may be “lost” but it is rarely consumed.  Even in jewelry, it can return to its bullion state with modest effort.

Instead, gold provides one of the three functions of money.  It is rarely used as a medium of exchange and we don’t price things in ounces of gold, so it isn’t a numeraire.  But, it does act as a store of value.  Thus, gold demand tends to rise during periods of monetary instability.  Monetary instability is partially described as rapid increases in the money supply, currency depreciation and negative real interest rates.  When any of these three events occur, they tend to be supportive for gold prices.  In other words, gold prices tend to react to excessive money growth, dollar weakness and falling real short-term interest rates.

Our gold model uses the central bank balance sheets of the Federal Reserve and the European Central Bank, the two most frequently used currencies for foreign reserves.  We also add the EUR/USD exchange rate as a proxy for the dollar and the real two-year T-note yield.

The model’s current fair value is $1,414, suggesting the current price is undervalued.  We have seen the fair value decline recently.  This is due to the explanatory variables adjusting in a bearish fashion; the Fed’s balance sheet is contracting, short-term real interest rates have increased and the dollar has strengthened.  However, even taking these issues into account, gold prices still appear cheap.  If our expectations of dollar weakness this year come to pass, the fair value for gold will likely rise.  However, given the level of undervaluation, gold should have further upside potential in the coming months.

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