by Asset Allocation Committee

The Trump victory has significant ramifications for the economy and markets.  The president-elect’s platform is somewhat ambiguous, which isn’t all that unusual; candidates want to build in some degree of flexibility that a detailed platform can reduce.  Despite this lack of clarity, there are elements that are emerging that offer a guide to the policy changes the new administration will likely implement.

We believe the key to Trump is his campaign slogan, “America First.”  Trump made it abundantly clear that he intends to conduct policy from the standpoint of whether it is best for America.  Although the term “America First” harkens back to an earlier movement,[1] Trump’s version appears broader, including both domestic and foreign policy.

So, what does an America First policy mean for the domestic economy?  Trump has promised both fiscal stimulation and trade restrictions.  The combination of these two policies contradicts the accepted economic orthodoxy since Reagan-Thatcher, which adopted globalization.  However, combining the two supercharges the domestic impact.  Why?  Because under conditions of globalization, some fiscal stimulus is lost to imports.

Globalization and deregulation began in earnest in 1978.  This chart shows the contribution to GDP from imports on a three-year average basis.

The pattern of imports clearly changes in the late 1970s, becoming a persistently larger drag on growth but also more volatile.  On average, from 1950 through 1977, imports reduced GDP by 31 bps.  From 1978 to the present, the average loss to imports nearly doubled, to 61 bps.  Trade restrictions will tend to add to real GDP; if Trump can reduce imports to the pre-1978 years, it would consistently add about 30 bps to GDP.  If fiscal stimulus adds 60 bps (the average that government spending alone added in Reagan’s first term), real GDP could rise nearly 1% per year.  This analysis does not include any rise in consumption that might coincide with changes in the income tax code or investment from reforms in corporate taxes.

Simply put, the combination of fiscal stimulus and import restrictions could lead to a sizeable boost to growth.  The downside to the policy is that it would certainly be inflationary.  One of the key elements to containing inflation over the past nearly four decades has been through globalization.  Trade impediments shift the aggregate supply curve toward the origin, meaning that price levels are higher at the same level of output.  But, in an economy that is struggling to boost price levels, the impact of higher inflation will be benign, at least for a while.

Higher inflation will raise interest rates.  We expect monetary policy to remain accommodative in the face of rising inflation due to political pressure on the Federal Reserve.  The dollar will likely rally because trade restrictions reduce the global supply of the U.S. currency, driving up the price.  The deflationary impact of a stronger dollar will be reduced because of fewer imports, although the imports that do arrive will be cheaper.

We will continue to monitor the progress of policy in the coming months.  But, in terms of asset allocation, our committee has started to address these changes and will be reacting in due course.

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[1] The earlier America First movement, led by Charles Lindbergh just before Pearl Harbor, was designed to keep the U.S. out of a European war.

by Asset Allocation Committee

With the elections coming next week, it seems like a good time to look at how markets have historically performed during election cycles.  We will compare the current election cycle against previous cycles.

The blue line in the chart above shows the indexed market return for the period 1928-2015.  To create this average cycle, we use the weekly returns of the S&P 500 Index starting with the first week of the election year through the end of the fourth year of the presidential term.  The weekly dataset begins in 1928.  The average gain in the first year of the cycle is about 6%.  By Q3 of the second year of the cycle, the average return of the S&P 500 is approximately 13%.  Equity markets move sideways to lower into late Q3 of the third year and then, on average, stage a strong rally into the last year before the election cycle begins anew.  The rally that begins in year three is a fairly well documented phenomena; politicians want to be re-elected and thus create policies that boost growth and, on average, lift equity prices as well.  We have added the S&P 500 performance for the current cycle, indexed to the first Friday close of 2016 (red line).  Although the market has been volatile, its performance has been close to average since the dip in Q1.

To further analyze the data, we break the historical data into four categories: incumbent Democrat president, incumbent Republican president, new Democrat president and new Republican president.  We define incumbent as a consistent party in power.  For example, this means we had a Democratic incumbent from 1936 through 1951, which encompassed both Roosevelt and Truman.  Similarly, we had an incumbent GOP from 1984 through 1991 which included Reagan’s second term and Bush’s only term.

As the chart shows, markets have had the best outcome when an incumbent Democrat wins.   A new Republican president tends to track an incumbent Democrat until the year after the election, then underperforms.  A new Democrat has historically been the worst outcome for the market (excluding the late 4^th year rally).  The current cycle is mostly following the incumbent Democrat/new Republican averages, suggesting that the equity market isn’t offering significant insights thus far.  However, it does imply that, regardless of the outcome on Tuesday, we will likely see a recovery into the New Year in that we will either have a new GOP president or an incumbent Democrat president.

Although most analysts are assuming a Clinton win based on polling, this analysis does suggest some equity market trepidation as we are currently underperforming both of the most probable outcomes.[1]  This underperformance could reflect the volatile nature of this election season or expectations of monetary policy tightening in December.  However, given the usual electoral pattern, we would not be surprised to see a stronger equity market into at least the first half of next year.

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[1] It is possible a third party could win, but highly improbable.  The most likely outcome is either an incumbent Democrat or a new Republican.

by Asset Allocation Committee

My weekend exercise is to take my dogs on long walks.  Both dogs seem to enjoy these walks and I use the time to listen to podcasts.  I recently listened to a long podcast that interviewed Sebastian Mallaby, a British journalist and senior fellow at the Council on Foreign Relations.  He has recently written a biography on Alan Greenspan, titled The Man Who Knew.  The FT Alphachat podcast[1] was an interview about that book.

Although I haven’t read the book yet (it’s on the list), a key takeaway from the podcast was that one of Greenspan’s attributes was that he was a savvy political operative.  He understood that the Federal Reserve operates in a political environment and that one of the Chair’s jobs is to manage the political system to maintain the central bank’s independence.  Mallaby suggested in the podcast that Greenspan was truly a “maestro” in managing the political situation.  However, as I listened, I wondered if managing the political situation meant that monetary policy was being framed to please the politically powerful.

This chart shows the Shiller Cyclically Adjusted Price Earnings ratio (CAPE).  We have placed a vertical line at December 1996 when Greenspan gave his famous “irrational exuberance” speech, raising questions about equity market valuations.  As the chart shows, the CAPE was approaching levels near the peak of the 1929 stock market bubble that was soon followed with a massive market crash.  Although Greenspan didn’t suggest that the Fed was about to change monetary policy to curb asset prices, equity markets around the world fell sharply on fears that Greenspan was about to use monetary policy to lower the stock market.  Greenspan faced heavy criticism for the speech.[2]  Being the consummate political operator, Greenspan’s Fed policy seemed to evolve into a form where asset market bubbles cannot be established in advance and the job of the central bank was to use monetary policy to repair the damage wrought to the real economy once the bubble collapses.

This chart overlays the Chicago FRB National Financial Conditions Index and the fed funds rate.  The index measures stress in the financial system.  The higher the reading, the greater the stress in the system.

The two series were closely correlated (85.1%) from 1973 through 1997, until the financial conditions index was created in 1998.  When fed funds rates rose, financial conditions deteriorated.  In some respects, financial conditions acted as a “force multiplier” for policy.  But, from 1998 to the present, the two series have become virtually independent.  After hearing Mallaby’s podcast, we suspect the FOMC may be trying to keep financial conditions calm, which could be construed as a reading under zero on the above chart.

This chart shows a model of household net worth regressed against nominal GDP.  Both series have been log-transformed.  Net worth was elevated into the early 1960s but steadily declined into the late 1970s.  It began to rise in 1995.  Note that since 1998, net worth has generally outpaced GDP except during recessions.

Currently, net worth relative to GDP is elevated.  It does appear that these increases in net worth that outpace the overall growth of the economy could be a function of monetary policy.  As investors become confident that the Federal Reserve will continue to suppress financial stress, it appears there is a tendency for asset prices to rise to lofty levels.  When valuations become unsustainable, often at the turn of the business cycle, it appears that sharp declines in net worth, caused by price declines in real and financial assets, leads to a fall in household net worth.

Mallaby’s research of Greenspan suggests he was inclined to allow asset prices to rise while striving to contain price inflation.  It is arguable that Greenspan’s policies with regard to financial system stress have been adopted by his successors.  If so, monetary policy is probably (although perhaps inadvertently) designed to aid asset prices.  As the last chart shows, net worth is elevated again at levels that have been difficult to sustain in the past.  We still believe that recessions are the primary triggers of market corrections and we closely monitor the economy for such events.  The current level of valuation makes this exercise even more critical.

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[1] http://ftalphaville.ft.com/2016/10/21/2177678/podcast-our-chat-with-sebastian-mallaby-on-alan-greenspan/

[2] http://www.wsj.com/articles/SB95774078783030219

by Asset Allocation Committee

The dollar has been strengthening over the past few weeks; we believe much of this appreciation is due to expectations of tighter monetary policy.  Fed funds futures suggest that there is a 60+% chance of a rate hike at the December FOMC meeting.  Although the FOMC is divided and there are prominent doves that oppose any tightening, the consensus on the committee seems to be leaning toward a 25 bps increase.  However, we also suspect that the next hike (following December) will be delayed for several months.  In other words, to placate the doves on the FOMC, Chair Yellen will need to promise a very slow path; to satisfy the hawks, she will need to raise rates in December.

There are at least four different ways to value currencies—relative inflation, relative interest rates, trade performance and relative productivity.  As a general rule, if any of the four performed consistently, the other three wouldn’t exist.  Of the four, relative inflation, so-called “purchasing power parity,” is the oldest.  Although most of the time it doesn’t give strong signals, it does tend to indicate when a currency pair is at an extreme.

This chart shows the purchasing power parity relationship between the dollar and the D-mark.  We use the legacy German currency and calculate its currency value based on its conversion rate at the time the euro was introduced.  We do this for two reasons; first, we have a consistent inflation history with Germany, and second, Germany is the dominant economy in the Eurozone, meaning the comparison with Germany is likely representative for the leading nations in the Eurozone.  In our opinion, parity models are only useful at extremes.  When the relationship becomes more than one standard error from parity, it tends to signal a problem with valuation.  Currently, the dollar is overvalued by more than one standard error.  There have only been two other periods when the dollar was stronger based on this measure.  And, we note that this degree of overvaluation has been in place since January 2015, indicating it has been overvalued for a rather long time.

It appears that this deviation from fair value is due to divergent monetary policy.  The spread between German and U.S. three-month LIBOR rates has widened in favor of the U.S.

These charts show the same data in two forms, a simple line graph and a scatter plot.  In 2014, as the markets began to discount future FOMC tightening, the LIBOR rate began to rise modestly.  At the same time, German rates fell sharply as the ECB tried to address deflation and weak economic growth; in fact, German three-month LIBOR remains in negative territory.

Although interest rate differentials are favoring the U.S., it is interesting to note that the explanatory power of interest rate differentials in the purchasing power parity model is modest at best.  In other words, in relation to the past 36 years, the current spread in interest rates should not be having this degree of impact.  The current spread is having an expanded impact mostly due to the current level of low rates.[1]

Complicating matters is that the U.S. three-month LIBOR rate has been rising due to changes in U.S. money market regulation.  There has been a sustained exodus of liquidity out of institutional prime money market funds and this has led to higher three-month LIBOR rates.  We doubt this level of LIBOR will be sustained over time, and so the U.S. side of the interest rate spread should ease.  In addition, German LIBOR rates have been negative for the past few months.  We doubt the ECB will maintain negative rates much longer and instead use QE for monetary stimulus.  Thus, we would expect the spread to narrow in the coming weeks.

In addition, there has been a marked change in market expectations toward FOMC monetary policy.

This chart shows the spread between the fed funds target and the two-year deferred Eurodollar futures contract.  The latter shows the market’s projection for future three-month LIBOR rates.  For much of the past two years, Eurodollar futures were projecting a terminal rate for fed funds of 1.50%; that has now declined to around 75 bps.  Simply put, the financial markets expect perhaps one or two more rate hikes over the next two years.  If this is all we get, we would expect the rate differentials between Germany and the U.S. to steadily contract.

It is worth noting that the current strength of the dollar appears based on the policy spread in 2014-15.  If so, once the market adjusts to a lower terminal fed funds target, we would expect some dollar weakness to develop.  In the second half of next year, a USD/EUR of 1.25 (a USD/DMK of 0.6410) would be likely.  A weaker dollar would be supportive for equities and commodities and bearish for debt and foreign equity markets, although this weakness would be partially offset by stronger foreign currencies.  In addition, emerging equities usually strengthen relative to developed markets when the dollar weakens.  Thus, in our asset allocation models, we have been slowly adding commodities and emerging equities to portfolios.  If the dollar weakens in 2017, we would likely build on these initial positions.

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[1] Since 1970, the average spread between the U.S. and Germany is 69 bps, suggesting the current spread of 119 bps is rather wide.  However the standard deviation is 235 bps, meaning the current spread is within the normal range.