Daily Comment (November 29, 2018)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT]

Good morning!  Equities are consolidating this morning after a strong rally yesterday.  Here is what we are watching today:

Powell:  After spooking the financial markets in October, Fed Chair Powell gave a much more dovish speech yesterday.  There were two elements of this talk that boosted market sentiment.  First, he suggested that the current fed funds target was close to neutral[1], implying that the FOMC may be close to ending its tightening cycle or at least considering a pause.  In fact, a pause would be consistent with the notion of data dependence.  One element that Powell has brought to the Fed is the idea that even the best economic models are approximations and thus it’s wise not to be overly reliant on such models in making policy.  It is likely that only a non-economist, or perhaps a non-academic economist, could come to such a conclusion.  One could argue that Alan Greenspan conducted policy in a similar fashion.  Although Greenspan was a trained economist, he worked in the private sector and was never a professor.  His decision in the late 1990s to not raise rates when unemployment was low turned out to be correct.  However, we would argue he was right for the wrong reasons.  His argument for not raising rates was expectations of a productivity boom. Although productivity did rise, it was probably due more to fully utilizing capacity and not any “miracle.” Instead, inflation stayed low because of long-running trends in globalization and deregulation.  However, it is interesting that the primary proponent of raising rates was Janet Yellen, who was likely working off of Phillips Curve models.  So, having Powell in this position means the risk of policy overtightening due to adhering to an academic model has lessened.  The risk has been replaced with data dependence.  Operating policy on data dependence means, by definition, that policy will be reactive.  That’s not necessarily a bad thing but it’s important to know what risks one is taking.

The second supportive comment from Powell was that he didn’t see evidence of financial excess in the financial markets at this time.  We would agree with this perspective in most markets.  High yield is the one major sector where we would disagree.  Spreads remain very narrow; although they can remain at such levels for a long time, the risk/reward isn’t all that attractive.  Other areas, such as private equity, are frothy as well.  But, the major broad markets, stocks and bonds, are, if anything, a bit cheap.

Where do we go from here?  Although the financial markets appear to be holding that the Fed is now less of an issue, we do note that the official range of the potential neutral rate is between 2.50% to 3.50%.  That information is simply useless, because it implies one to five more hikes.  Our Mankiw Rule estimates of neutral range from 1.85% to 3.93%.  These model ranges are worthless by themselves.  Instead, these models all have independent variables that reflect potential measures of slack.  If you think the economy is running at full employment, fed funds should be closer to 4.00%.  If you think slack exists, the policy rate is probably already at neutral.  Our belief is that there is slack in the economy, which accounts for the continued low level of inflation.  Thus, we see little danger in at least pausing the pace of rate hikes.  The key point here, however, is that the Fed is making decisions under conditions of uncertainty.  When making such decisions, one must be aware that the potential for making mistakes is high and thus caution is warranted.  Powell seems to understand this better than the last two Chairs, which is probably a plus.

Further gains in equities in the short run will be dependent on this weekend’s G-20 meeting.  We do note that there will be a number of Fed speakers in the coming days and some dissent might be expressed.  But, for the most part, the focus will now shift to trade.

The G-20 and China talks: We expect some sort of short-term accommodation at this weekend’s meeting.  We look for the U.S. to delay implementing the tariff hike on China and postpone expanding tariffs on the rest of Chinese imports.  China will offer to buy some American goods—look for soybeans, oil and LNG purchases to resume.  But, this outcome is merely a reprieve.  It has become evident that the president (a) holds that trade is a mercantilist exercise, meaning that trade surpluses are good, deficits bad, and (b) China is a strategic competitor.  Simply put, the president views tariffs as a core position.[2]

Apparently, the president is returning to auto tariffs[3], specifically targeting Chinese vehicles.[4]   The U.S. is warning European nations to be wary of using Chinese 5G technology for security reasons.[5]   The strategic goals of the U.S. and China have diverged and are probably not reconcilable.[6]  We note that elite opinion is turning on China, meaning it isn’t just the White House that is viewing China as a strategic threat.[7]  We will likely see a deal this weekend, but it should only be seen as a truce; U.S. and China policy is likely to become increasingly hostile going forward.

Brexit update:  Both the government and the BOE gave their economic assessments of Brexit yesterday.  In all cases, leaving the EU is expected to harm the British economy, with a “hard Brexit” causing serious economic damage.[8]  Market reaction to these studies was barely noticeable, suggesting the financial markets expect policymakers to avoid the worst outcomes.  We tend to agree with this assessment, but worry that policymakers, seeing the lack of market turmoil, may misinterpret the reaction and think they don’t have to worry about a hard Brexit.  We do expect the May Brexit plan to fail in Parliament; it may pass with a second vote after May resigns, or we could have another referendum.  Hard Brexit, exiting without a deal, is still the least likely outcome, but that isn’t to say that outcome is impossible.

A sober note:U.S. life expectancy from birth fell a tenth of a year; it peaked at 78.9 years in 2014 and is now down to 78.6 years.[9]  Rapidly rising suicide rates[10] and drug overdoses are the primary culprits for the stalling of life expectancy.[11]  It is highly unusual for life expectancy to decline in an industrialized nation and what we are seeing in the U.S. may also reflect the economic fallout from the Great Financial Crisis.

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[1] https://www.ft.com/content/221b509e-f32d-11e8-ae55-df4bf40f9d0d?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[2] https://www.wsj.com/articles/bring-me-tariffshow-trump-and-xi-drove-their-countries-to-the-brink-of-a-trade-war-1543420440

[3] https://www.cnbc.com/2018/11/28/trump-says-auto-tariffs-being-studied-after-gm-restructuring-announcement.html and https://www.ft.com/content/571cd042-f32d-11e8-ae55-df4bf40f9d0d?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[4] https://www.reuters.com/article/us-usa-trade-china-autos/trump-administration-to-study-tools-to-raise-u-s-tariffs-on-chinese-autos-idUSKCN1NX2XL  Note China only exported 53k of cars to the U.S. last year.

[5] https://www.ft.com/content/6719b6b2-f33d-11e8-9623-d7f9881e729f

[6] https://www.ft.com/content/be50582a-f2e6-11e8-ae55-df4bf40f9d0d

[7] https://www.washingtonpost.com/opinions/chinas-ominous-plan-to-penetrate-and-sway-the-united-states/2018/11/28/bc245ece-f34b-11e8-aeea-b85fd44449f5_story.html?utm_term=.493f55b33445

[8] https://www.politico.eu/article/best-case-brexit-scenario-means-2-5-percent-hit-to-uk-growth-over-15-years/?utm_source=POLITICO.EU&utm_campaign=d371e174d1-EMAIL_CAMPAIGN_2018_11_29_05_34&utm_medium=email&utm_term=0_10959edeb5-d371e174d1-190334489 and https://www.nytimes.com/2018/11/28/world/europe/uk-brexit-economy.html?emc=edit_mbe_20181129&nl=morning-briefing-europe&nlid=567726720181129&te=1

[9] https://www.wsj.com/articles/u-s-life-expectancy-falls-further-1543467660

[10] https://www.wsj.com/articles/cdc-finds-rise-in-suicide-rates-across-the-u-s-1528417378

[11] https://www.wsj.com/articles/cocaine-meth-opioids-all-fuel-rise-in-drug-overdose-deaths-1537466455