Today the Fed released the minutes from their October meeting. It made some interesting reading for some. In essence, the Fed is worried about the current level of stock prices and is concerned about the low level of inflation and its persistence in remaining low.
What the Fed did not talk about was how inflation can rise using their model. You see, with low productivity and little spending by way of capex but with borrowings to pay for increased dividends and share buy backs, it’s a wonder that share prices are not higher.
The Fed did not use its fabulous dot plot graph to show was the increase rate of price increases in the stock market. Given that earnings have improved and YOY have shown an increase, earnings growth has been lacklustre when compared to other periods. Yet the equity market has had a significant year by way of performance.
What the Fed did not discuss was its role in creating the bubble (perhaps) that they created. It’s great to say that the Fed is concerned about the stock market and low inflation. However, they are the main driver. With rates so low it’s an easy decision for a CEO to use whatever mechanism he can to drive his share price higher. However, at some point this lack of innovation will hurt the U.S.
Easy money is the heart of what is driving the U.S. equity market. Whilst bonds are low, and utilities have replaced bonds as the interest stream, then there is no alternative other than buy equities. And this is the problem. Too much money, low productivity and little capex.
So, the Fed is indulging in wishful thinking if its monetary policy is too loose and its very cheap money is propelling an illusion. Let’s not forget that whilst rates remain low all those financial models such as the dividend discount model and the various Merton models all point to higher equity prices. Unfortunately, the growth in earnings is not necessarily commensurate with current prices.
On the 15th of December, the Fed will most likely hike rates by about 25bp. The probability is around 93%. The curve will yawn and probably flatten a little further and equity markets will rally. What is interesting though are the number of large pension funds that are looking to reallocate out equity and move back to bonds. The California Public Employee’s Retirement System is one such pension fund.
It is wishful thinking on the Fed’s part that inflation will rise anytime soon and rise quickly. Yellen has said so herself. On Tuesday she said, “very uncertain” and is open to the possibility that prices (inflation) could remain low for years to come.
The Fed is looking to wage inflation, but in a period where technology is making many jobs redundant and spawning opportunities as waiters there will be little wage inflation. The multiplier comes from increasing productivity and employing people in high value jobs. Not employing people to wait on tables or sweep streets or stack shelves. Unfortunately, this is where a lot of growth has occurred. Many are taking jobs for the sake of taking a job. It’s a necessity.
How did the market react to the minutes? Pretty much as expected ahead of a holiday weekend. It was neutral. What concerned many was how they were going to get away out of NY or out of the cities and head off to wherever they were meeting up with family and friends. Thanksgiving is a big deal in the U.S. and for most they were looking to a break. The share market volumes were down about 20% for this time of the year and slid lower as the day passed. The slide in pricing had more to do with squaring of positions.
One highlight of the day was John Deere. The tractor maker reported an upbeat quarterly earnings report and issued a strong profit forecast. The shares rose 4.2%.
Bonds rallied on the day. The yield curve widened slightly as the front end rallied at a slightly better pace than longer maturities. The rally all happened in a fairly thin market.
Next week Trump will meet with Congressional leaders to discuss the tax package. There was good news for the GOP as one of their own dissenters for the repeal of Obamacare, Lisa Murkowski, is likely to support the current tax bill package before the Senate. She was won over with a provision to allow oil drilling in an environmentally sensitive area, the Alaskan Arctic National Wildlife Refuge.
So, the wishful thinking over the weekend will be for the GOP to finally have a win and get their tax bill through. For the Fed to finally see some inflation. For Financials to see a steep yield curve and for bond traders to have another great year in 2018.
And for equity traders to have another stunning year where the Dow rises 18% and for the GOP to pass some legislation. That the U.S. economy can grow at 3% when it is already at full employment and the Fed is in a tightening phase. All wishful thinking and I wonder how much comes true over the next year.
Equities: The S&P 500 fell 0.08%. The Dow fell 0.27%. The Stoxx 600 fell 0.3%.
Currencies: The Bloomberg Dollar Spot Index fell 0.6%. The euro rose 0.6%.
Bonds: the 2-year rallied to close at 1.73. The U.S. 10-year closed at 2.32% a slight fall in yield. The 30-year closed at 2.74 % in 2 bp. The 2/10 closed at 59, the 2/30 at 101.6 bp and the 10/30 closed at 42 bp. The European 10-year benchmark closes were, gilts closed at 1.27%, bunds at 0.349% and OAT’s 0.503%.
Commodities: Gold rose about 0.9% and WTI rose 2.0%. As the oil price rises more wells in the U.S. are being turned on and this week an additional 9 wells have come back onstream.
Aussie Market Today.
Aussie bonds will continue to go their own way today. The U.S. appeared to be doing some book squaring today and that’s a possibility in Australia as well. The U.S. won’t be around to provide direction until Monday for Australia. I expect the Aussie bond market to be quiet and a little towards the offer. No great movements expected and the market to remain thin and quiet.
Geopolitical tensions are still a concern although tensions appear to have been cowed for the moment.
Demand for solid investment grade credits look likely to continue as the hunt for higher yielding assets continues to gather pace.