by Asset Allocation Committee

One of the relationships we persistently monitor is the expectations of 10-year Treasury yields compared to the actual level of yields.  To do this, at the beginning of each year, we plot the rate forecasts from the Philadelphia FRB’s Professional Forecaster Survey.  The record of the forecasters has not been stellar.

The blue line on the chart shows the level of yield; the other lines show the consensus forecasts.  The open boxes on the red lines are “misses” and the filled dots are “hits.”  The forecasters are wrong about 59% of the time.

What is interesting to us is not the error rates but the fact that the direction of the error is consistent; the forecasters expect higher rates.  We suspect a major part of this was due to forecasters overestimating inflation.  It has been our position that globalization and deregulation are responsible for low inflation, not monetary policy.  We had little faith in central bank ability to cause inflation and so we have tended to be more dovish on long-term rates in our asset allocation portfolios.

Still, we have noticed that the downtrend in rates has mostly ended in 2012, while rates have been rangebound for the past five years.  Clearly, the forecasters are looking for an upside “breakout” in yields that has failed to materialize…so far.

Our 10-year T-note yield model puts fair value at 2.10%; thus, current yields are a bit high.  The model uses fed funds, long-term inflation trends, the yen/dollar exchange rate, oil prices and the yield on German bonds.  What is troubling for us is that if we just use the first two variables of the model, the fair value yield jumps to 3.03%, which is in the neighborhood of the current Philadelphia FRB forecast.  Simply put, international factors appear to be holding down fair value yields.  A weaker yen, higher oil prices or rising German sovereign yields will likely have a negative effect on the fair value yield.  Of the three, German yields are probably the most critical.  If the Eurozone avoids financial and political problems, it appears the ECB is prepared to begin slowly withdrawing stimulus.  If that’s the case, the forecasters may have a chance of being right this year.

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by Asset Allocation Committee

For equity investors, there is always a concern about the major market declines; being able to reduce market exposure prior to crashes like the ones in 2000 or 2008 is always desirable.  Although large declines have occurred outside of economic recessions, they have become increasingly rare.  The last major market pullback absent a recession was the 1987 crash.  Thus, an indicator that can use high frequency economic data (data that is available on a weekly basis) and relate it to equities should have some value.

This chart shows one of our recent efforts.  The upper line is the monthly average for the S&P 500; the lower line is an indicator built of three economic numbers—initial claims, the CRB commodity index and the Conference Board’s Consumer Confidence data.  We have standardized[1] the economic data and created an indicator, shown on the bottom of the graph.  In general, a positive reading is generally bullish for equities.  We have placed vertical lines on the chart to indicate when the indicator turned negative with persistence.  These are usually periods of falling equities.

Although useful, it is clear that the indicator is somewhat “late” in that the equity decline is well underway by the time it becomes negative.  That would suggest that a momentum number based off the economic indicator might be helpful.

To achieve this, we calculated the 18-month change in the above indicator and set a “crash line” at -1.0.  The adjustment improves the indicator’s value, indicating an investor should reduce equity exposure sooner than the unchanged index would suggest.  At the same time, using a -1.0 reading eliminated the false exit signals.

There is an element of “data mining” here and we would not recommend using this indicator as a “precision instrument.”  However, it does show that these three standardized data points  are fairly good coincident indicators of the economy and, using an 18-month change and a filter, do offer reasonably good warnings when one should reduce exposure and when a market pullback is a mere correction.

We use the period since 1997 because it makes the data easier to observe.  But, we did look at data from 1980 and the performance is similar.  As we would expect, the indicator did not help at all during the 1987 crash, confirming that its usefulness is as a gauge of the interaction between equities and the economy, not as a pure market indicator.

What is it telling us now?  The economy is doing well enough that market declines will probably not be more than normal pullbacks.  Of course, this sort of indicator won’t necessarily be helpful if a geopolitical event triggers a major market decline.  But, the most common cause of bear markets in equities are recessions.  For now, that doesn’t appear to be on the horizon.

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[1] Standardizing entails subtracting the raw data by its average and dividing by its standard deviation.  The resulting number is then adjusted by how far it is from average and how far it is from its normal deviation.  Standardizing allows one to combine unlike indicators and essentially balance their relative effect.  In this case, the formula is Indicator = (standardized CRB + standardized Consumer Confidence) – standardized Initial Claims.  We subtract the claims data because lower claims indicates a stronger economy.  Subtracting that number thus allows the indicator to rise when economic data are improving and vice versa.

by Asset Allocation Committee

The FOMC did raise rates at the June meeting, which was fully expected.  The dots chart suggested that we would see one more hike this year and three next year.  In addition, the central bank gave some indication of how it would shrink its balance sheet.  Although the statement didn’t signal when the reduction would begin, Chair Yellen indicated in the press conference that it would begin before year’s end and seemed to hint it may start much sooner than the market expects.

In this report, we want to examine two concerns we have about the path of policy tightening.  The first concern is the level of the policy rate.  To measure the impact of the policy rate, we use the Mankiw Rule.  The Mankiw Rule models attempt to determine the neutral rate for fed funds, which is a rate that is neither accommodative nor stimulative.  Mankiw’s model is a variation of the Taylor Rule.  The latter measures the neutral rate using core CPI and the difference between GDP and potential GDP, which is an estimate of slack in the economy.  Potential GDP cannot be directly observed, only estimated.  To overcome this problem with potential GDP, Mankiw used the unemployment rate as a proxy for economic slack.  We have created four versions of the rule, one that follows the original construction by using the unemployment rate as a measure of slack, a second that uses the employment/population ratio, a third using involuntary part-time workers as a percentage of the total labor force and a fourth using yearly wage growth for non-supervisory workers.

Using the unemployment rate, the neutral rate is estimated at 3.08%.  Using the employment/population ratio, the neutral rate is 0.75%.  Using involuntary part-time employment, the neutral rate is 2.31%.  Using wage growth for non-supervisory workers, the neutral rate is 1.08%.

The labor data has been mixed during this recovery.  The unemployment rate has fallen sharply, but other measures, most notably the employment/population ratio, have fallen much more slowly.

If the relationship between the unemployment rate and the employment/population ratio that existed from 1980 through 2010 had remained the same, the current unemployment rate would be closer to 7.5%.  Using the above Mankiw Rule with a 7.5% unemployment rate and the current core inflation rate would generate a neutral policy rate of -0.61%!  In other words, not only would the FOMC not be tightening, but cutting the balance sheet wouldn’t be considered either.

The conventional wisdom is that the employment/population ratio is being affected by retirements and thus the labor market slack isn’t as great as that indicator would suggest.  However, we note that wage growth is much more consistent with the employment/population ratio than the unemployment rate.  Thus, there is a legitimate worry that the Fed may overtighten and put the economy at risk.  Currently, the financial markets only expect one more tightening over the next two years; if the dots plot is the path of policy, the odds of a recession will rise.

If the employment/population ratio is the accurate measure of slack, we are already 37 bps above neutral.  Policy would be tight at 100 bps.  Thus, we are two to three hikes from putting the economy at risk.  Of course, the ratio could improve or inflation could rise, but without those events occurring, the risk to the economy from tighter monetary policy is rising.

The second concern is the balance sheet.  The actual effect of QE on the economy is difficult to determine.  We tend to think that the most likely impact was that the balance sheet expansion confirmed that the Fed was determined to execute an easy policy even with the policy rate at zero.  The level of the balance sheet appears to have had a strong effect on investor sentiment.

This chart forecasts the S&P 500 by using the size of the balance sheet.  From 2009 into late last year, this equity index closely followed the balance sheet.  After the election, equities shifted focus toward expectations of tax reform and fiscal expansion.

We have extended the forecast generated from the balance sheet using the FOMC’s stated plan for reducing the balance sheet and assuming the reduction begins in September.  The Fed intends to start slowly, only $10 bn per month, reaching $50 bn after a year.  It is obvious that the balance sheet could become a headwind by 2018.  This above chart isn’t our forecast for equities but it does suggest that the combination of rate hikes and balance sheet reductions is signaling that monetary policy will tend to become a headwind for equities.  If the Trump administration fails to move forward with tax reform or infrastructure spending, equity markets will be vulnerable to a correction.

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by Asset Allocation Committee

Last week, the Federal Reserve published its Financial Accounts of the United States report, more commonly called the “Flow of Funds” data.  The report offers a plethora of insights into the economy.  This week we want to examine the household debt situation.

In Q1, household debt reached $15.1 trillion, up 3.4% from the previous year.

Although the growth in liabilities is positive for consumption, note that the current growth rate is well below the 9.8% average from 1946 through 2006.  As we will show below, deleveraging continues but the pace has slowed dramatically.  Still, part of the reason for sluggish growth is that households are simply not borrowing as quickly as what we have seen in the postwar period.

As noted, deleveraging has continued but the pace has slowed to a crawl.

Household debt (non-profit debt is not meaningful) is down to 78.2% of GDP after peaking at 97.7%.  It is virtually impossible to determine the “correct” or sustainable level of debt, but a solid case can be made that any reading above 60% is probably not manageable over the long run.  Of course, there are three ways this ratio can decline, falling levels of debt, rising real GDP relative to debt or rising inflation relative to debt.  The lack of inflation has probably prevented an even larger drop in this ratio.

Low interest rates have reduced the servicing costs.

This chart shows household debt service costs as a percentage of after-tax income.  Debt service costs rose steadily from 1993 into 2007.  The combination of falling interest rates and the level of debt has led to a sharp drop in debt service costs.  At these levels of debt service, one would expect that households would be encouraged to expand their debt levels.  However, the “hangover” from the debt crisis has not yet diminished.

As long as households are reluctant to borrow, economic growth will remain slow and inflation low.  This combination should lead to moderate policy tightening from the FOMC and an extended business cycle.  If borrowing were to increase, these conditions might change but, for the foreseeable future, we expect borrowing to remain sluggish and economic growth to remain weak as well.

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