by Asset Allocation Committee

With the elections about a month away, we are fielding an increasing number of questions about the market impact of the result. Although some market commentators are raising concerns about a Trump victory, so far, market data doesn’t seem to suggest a high level of correlation.

This chart shows Donald Trump’s average poll numbers on a weekly basis (using an inverted scale) along with the S&P 500 index on the same basis since the beginning of the year.  The weakness seen in the equity markets in Q1 did coincide with reasonably strong numbers for Trump, but most of that equity weakness probably had to do with monetary policy.  Note that as Trump’s poll numbers have improved, equities have also improved.  This could mean that (a) financial markets are not all that concerned about a Trump victory, (b) financial markets simply believe that there is no way Trump will win, or (c) the outcome of the election isn’t material, because the outcome of most elections are not material to the markets.  The correlation of the two series is a modest -1%, suggesting that the two are virtually uncorrelated.

Similar results are seen when comparing Trump’s poll numbers against the performance of gold and the 10-year Treasury yield.  So far, the most significant relationship is the Mexican peso.

The MXN/USD exchange rate is pesos per dollar, meaning the higher the reading on the above chart, the weaker the peso.  As Trump’s poll numbers have improved, the Mexican currency has weakened (the correlation is 54%).  This relationship makes sense.  Trump has promised to “build a wall” on the Mexican border and has called for a rewriting of the North American Free Trade Agreement (NAFTA).  A Trump win could be very disruptive to the Mexican economy and thus the peso has been very sensitive to the path of the election thus far.

We believe a Trump victory would be a bearish surprise to the financial markets.  Although he has promised many things, we suspect his priorities will start with immigration and then move to trade which is second on the list.  He has offered a large infrastructure spending package as well.  Although his tax policy has excited traditional supply-side Republicans, we doubt the tax policy is a high priority for Mr. Trump.  His policies would be potentially inflationary which could be bearish for both equities and debt.  Of course, proposing policy and getting measures through Congress are two different issues.  We have doubts he will be able to execute much of his platform.  But, the uncertainty alone could increase market turbulence.  Thus, as the election approaches we would expect increasing market volatility until the outcome is determined.

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by Asset Allocation Committee

Last week, the FOMC left rates unchanged, as expected.  The statement was rather hawkish but the accompanying information, such as the “dots” chart, was mostly dovish.

Note that three of the 17 members of the committee want to stand pat for the rest of the year and two want to raise rates only once next year.

This chart shows the average projected rate from the dots chart along with the projected fed funds rate from the Eurodollar futures market.  A couple interesting trends are emerging.  As we have seen for some time, the FOMC is steadily lowering its terminal rate, the policy rate where tightening ends.  They still hold out hope for a normalization in the long run, around 3%, but this expectation has been in the dots for some time.  It never actually seems to occur.  For this year, expectations are modest; on average, in fact, there is a chance that no hike will occur, even though the Eurodollar futures have one discounted.  However, the Eurodollar futures are also looking for a terminal fed funds rate of around 1.25% at its peak.  Simply put, the financial markets expect that the conditions that have led to low rates will continue well into 2019.

What would lead to rate normalization, which appears to be a rise to 3% for fed funds?  The most obvious catalyst would be a rise in inflation.  As long as the world remains awash in excess capacity, inflation will remain low (assuming trade remains open).  That’s why the presidential elections are important.  We expect Donald Trump to restrict trade, whereas Hillary Clinton will, for the most part, try to maintain the current trade structure.  For now, we expect that rates will rise, but expect a terminal rate of 1.25% for fed funds.

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by Asset Allocation Committee

Profit margins are off their highs but have started to improve.

This chart takes total S&P 500 operating earnings as a percentage of GDP.  Excluding the financial crisis, operating earnings have been running between 5% and 6% of GDP for most of the past decade and a half.  In the middle of last year, this percentage fell below 5% and has remained below that threshold for the past four quarters.  Falling energy prices appear to be the culprit for the drop in margins.

We have a model for this series that is critical to our forecasts for S&P earnings.  It includes unit labor costs, net exports as a percentage of GDP, LIBOR, fed funds, national income accounts profits as a percentage of GDP, a national corporate cash flow estimate from the Financial Accounts of the U.S.,[1] the EUR/USD exchange rate and oil prices.  Based on these variables (and the forecasts coming from the Philadelphia FRB’s Survey of Professional Forecasters), we estimate S&P 500 earnings as a percentage of GDP.

Here is our updated model.

By Q1 2017, margins should rise back to 5%.  Given the current divisor, S&P earnings for this year are expected at $107.09, and $113.89 for 2017.[2]  These are much lower than what is being discussed in the financial press, mostly due to the wide divergence between Thomson-Reuters and S&P’s earnings numbers.[3]

The key to the forecast is that the dollar will gradually weaken as the terminal rate is lowered for fed funds and as oil prices recover to $52 by mid-2017.  If the dollar unexpectedly strengthens, which would also lower oil prices, we would need to adjust our forecasts lower.  Of course, this also means that earnings will exceed our current estimates if the dollar weakens more than we expect (EUR/USD > $1.14) and/or oil prices rise more than forecast.  The actual recovery in margins is a welcome sign for earnings, although we believe that most of this good news is already reflected in current prices.  However, the good news is that, barring a recession, we should avoid a major market correction.

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[1] Also known as the Flow of Funds report.

[2] This change reduces our estimate for 2016 from $107.82, but increases our forecast for 2017 from $109.32.

[3] We analyzed this issue in the AAW from 7/15/2016.

by Asset Allocation Committee

Since the beginning of September, 10-year T-note yields have risen from a low of 1.52% to a high of 1.75%.  This backup in yields is as issue we are monitoring carefully because we have favored long-duration assets for some time.  We analyze long-dated interest rates by starting with a fair value assessment of the 10-year T-note yield.

This is our full T-note model.  It uses the effective fed funds rate, the 15-year average of inflation (a proxy for inflation expectations), the yen/dollar exchange rate, oil prices and the yield on German bonds.  The current fair value rate is 1.71%, suggesting that the long end is a bit overvalued at current yields.  A hike of 25 bps in the effective fed funds rate would raise the fair value yield to 1.88%, assuming no change in the other variables.  Thus, the recent rise in yields is due, in part, to concerns about the potential for tightening monetary policy.

Deeper examination shows that foreign factors are keeping yields low.  Eliminating the yen/dollar exchange rate, oil prices (which are set globally) and German bond yields creates a model using only domestic factors.  Namely, using just inflation expectations and fed funds boosts the fair value by 100 bps.

By focusing on domestic factors, the 10-year T-note is deeply overvalued.  In fact, a comparison of the models shows that international factors have played a key role in lowering yields over the past two years.

As we assess the prospects for the three international variables, we expect oil prices will likely be rangebound.  Over the next year, we look for the average price of oil to hold around $50 per barrel.  In the near term, however, seasonal factors will likely weigh on oil prices and support lower T-note yields.  Barring helicopter money in Japan, the JPY will likely drift higher against the dollar which will also bring lower T-note yields.  The key factor will probably be German yields.  German yields ticked higher after the ECB refused to adjust policy last week.  But, worries about the upcoming Italian referendum, expected to be held as early as October, and the rising likelihood that the ECB will eventually boost stimulus should lower German bond yields.  Thus, for now, we believe the case for long-duration fixed income remains in place.

Longer term, we continue to closely monitor the expansion of populism.  Populist policies will tend to eventually lift inflation and will most likely end the long decline in interest rates.  For now, the establishment continues to hold sway but we would expect that somewhere in the next four to eight years, or perhaps sooner, inflation will return and we will need to position portfolios for such an environment.

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