by Asset Allocation Committee

Last week, the Federal Reserve released its Financial Accounts of the United States, formerly called the Flow of Funds report.  It is a broad set of data that covers many aspects of the economy.  Here we present some key charts from the report.

This chart shows key private sector debt as a percentage of GDP.  We exclude the financial sector to avoid double counting.  We consider private sector debt more important to the economy for two reasons.  First, business sector investment is funded with debt and household sentiment is also tied to debt.  Leverage will boost growth, while deleveraging weighs on growth.  The other important factor is that private sector debt has different capacity constraints than public sector debt.  Private sector debt has to be serviced from income or revenue; the private sector cannot print its own money to service its debt.  The public sector can not only print money to service its debt, but it can use coercion to force compliance.  That is why government debt is a profoundly different risk to the economy; a large deficit is mostly an inflation risk, not a default risk.  When the private sector deleverages, it must either write down the debt (harming creditors) or create increased saving (harming debtors).  The current expansion is long in duration but growth has lagged previous growth periods in part because of deleveraging.  The above data suggests that the private sector has mostly stopped reducing debt relative to the economy but isn’t releveraging, which would tend to increase growth.

The other chart we closely watch is net saving by sector.

The chart on the left shows net saving by the four sectors of the economy—business, households (which represent the domestic private sector), government and the foreign sector.  They have been scaled to GDP.  Business saving is revenue less investment.  Household saving is income less consumption.  The government sector is the fiscal balance and foreign saving is the inverse of the current account.  For macroeconomic accounting, the four act like a balance sheet—the net sum always equals zero.  For the past few quarters, saving by sector has been mostly steady.  The combination of domestic private sector saving and foreign saving has been balancing the government’s deficit.  That is best observed on the chart on the right side.

One of the less discussed ramifications of the current tax bill is that it is expected to raise the government’s deficit; in other words, government dissaving must rise.  This must be offset by either rising domestic private sector saving or foreign saving (in other words, a rising trade deficit).  One of the other policy goals of the Trump administration is to lower the trade deficit but the tax bill may actually foster a wider deficit.  At the same time, if the administration meets that goal, domestic private sector inflation must rise.  If it is to come from the business sector, investment must fall without a significant rise in business revenue.  Of course, rising business investment is a key goal of the tax bill.  The other way saving could rise is from higher household saving, but that would likely come from lower consumption which would weaken growth.  That’s why getting a revenue-neutral tax bill was so important.  If the tax bill were revenue-neutral and simply improved efficiency through tax reform, investment could rise and perhaps be funded without a drop in business saving due to higher revenue.

Finally, net worth of households has reached a new record high.

Household net worth is now 673.0% of after-tax income, a new record.  The current level reflects rising equity markets and improved housing prices.  The chart does indicate that this number tends to fall rather abruptly during recessions.  As we noted in our 2018 Outlook, we do not expect a recession next year so this ratio probably has further to rise.

Overall, the Financial Accounts of the United States paints a picture of stability and slow healing.  Saving and debt are stabilizing and net worth is rising.  We will be watching how the tax bill affect this stability in the coming months.

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by Asset Allocation Committee

We have received a number of requests to update our S&P 500/Fed balance sheet model.

This chart shows the results from our S&P 500/Fed balance sheet model.  We have projected the model’s forecast using the expected path of balance sheet reduction.  It shows that the equity index tended to follow monetary policy from the end of the recession in mid-2009 until the election of President Trump.  Since the election, the index has far outperformed what the balance sheet model projects for fair value.

This model was always problematic, potentially a classic example of data mining.  The problem of data mining and the current discussion of “big data” get at the philosophical problem of “how do we know?”[1]  Our basic procedure when looking at correlations is to try to formulate a theoretical reason for why the correlation should exist.  Simply finding correlations, otherwise called data mining, is fraught with risk.  Some correlations are spurious—they develop almost by accident and fade over time.  Others are true as far as they go but can lead one to draw inappropriate conclusions.

This chart shows the relationship between ice cream consumption and drowning in 2006.  The relationship of these two variables is a common pedagogical tool when teaching statistics.  It is clear that a relationship exists between these two variables.  However, they share a common factor that is the likely cause of the correlation—summer!  If a policymaker neglected to take the seasonal factor into account, a case could be made for a tax on ice cream in a bid to reduce drownings.  It is almost certain such a policy would fail.

We have concluded that the most likely reason the Fed’s balance sheet was related to the S&P 500 was because it showed that the U.S. central bank still had effective tools to stimulate economic growth.  In other words, QE was mostly a confidence builder.  It appears that Trump’s promises of deregulation and tax cuts have replaced QE in supporting investor confidence and thus, the relationship has broken down between the Federal Reserve’s balance sheet and the S&P 500.

However, we would be remiss if we didn’t examine another element of the balance sheet relationship.  With globalized financial markets, it is also possible that the behavior of foreign central banks affects U.S. equities as well.  Combining the exchange rate-adjusted balance sheets of the European Central Bank (ECB), the Bank of Japan (BOJ) and the Federal Reserve, with projections based on policy guidance, yields the following model.

The BOJ’s balance sheet path is more difficult to project because Japan is now fixing the 10-year JGB interest rate and adjusting the balance sheet accordingly.  We have developed a projection but with less confidence than our estimates for the Fed and the ECB.  We are also assuming mostly steady exchange rates.  This model shows that the rise in the S&P 500 can be explained by the combined effects of balance sheet expansion from the Federal Reserve, the BOJ and the ECB.  It also suggests the upside is likely limited because the ECB will begin tapering next year and is projected to stop expanding its balance sheet by the end of Q3 2018.

Thus, one possibility is that continued balance sheet expansion by the BOJ and ECB has supported equities, offsetting the lack of Federal Reserve expansion.  If this is the case, then ECB tapering and the end of its expansion and the uncertainty surrounding BOJ expansion may become significant headwinds next year.  However, as noted above, we believe QE was mostly a confidence booster; there is little evidence it had much of an impact on the economy.  At present, tax cuts and deregulation have lifted investor sentiment and supported higher equity prices.  However, we will be watching to see whether the slow end of unconventional monetary policy abroad has an impact on equities next year.

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[1] We discussed this issue at length in the summer of 2016.  See WGRs, Thinking about Thinking: Part 1, 8/15/16; and Part II, 8/22/16.

by Asset Allocation Committee

Given the length of the current expansion, there is growing concern about the economy’s ability to avoid recession.  So far, none of our indicators suggests the economy is near a downturn.  Of all the indicators we monitor, the yield curve is the most reliable; however, there are potentially dozens of iterations of “the yield curve.”  The two-year/10-year T-note spread is used in the leading economic indicators.

The indicator is quite reliable with no real false positives.  This is monthly data through October; currently, the spread is around 65 bps, meaning it is approaching inversion but still above zero, meaning the economy is probably still on pace to avoid recession over the next year.

Other calculations of the yield curve offer other insights.  The spread between the implied three-month LIBOR rate from the Eurodollar futures market, two-year deferred, relative to fed funds offers insights into monetary policy.  The Eurodollar futures market is where unhedged interest rate swaps are offset, so a rising implied rate on the deferred contracts suggests increased hedging activity and fears of rising rates.  When those implied rates stop rising, it can offer a signal to policymakers that they have moved rates enough.

The lower two lines on the chart show the implied three-month LIBOR rate and the fed funds target.  The upper line is the spread between the two rates.  The important insight from this analysis is that the FOMC stops raising rates when the spread inverts.  Chair Greenspan was able to prevent two recessions, one in 1994 and another in 1998, by rapidly cutting rates when the implied rate fell below the fed funds target.  Although the FOMC did move rapidly in 2000, the rate cuts were not aggressive enough to prevent a recession.  At the same time, the 2001 recession was rather mild.  In the 2004-06 tightening cycle, the FOMC did stop raising rates once the spread inverted; however, the central bank kept rates elevated despite the inversion.  As financial conditions deteriorated, the Federal Reserve moved to cut rates aggressively but this action was not enough to prevent the Global Financial Crisis.

So, what does this chart tell us now?  As long as the spread isn’t inverted, the FOMC will probably continue to raise rates.  Note the reaction of implied LIBOR rates in 2016 after the December 2015 rate hike.  As the implied LIBOR rate fell, the FOMC, which had been signaling higher rates for 2016, held rates steady until December and only raised rates as the implied LIBOR rate rose as well.  Overall, this pattern suggests that the current spread will support a December rate hike.  However, next year’s rate moves should follow the implied LIBOR rate.  If that rate fails to rise with policy tightening, we would expect the FOMC to slow the pace of increases next year.

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