May 30, 2018
There is a new “buzz word” making its way through financial markets from the minutes of the Federal Reserve’s latest meeting. Specifically, the minutes of the Fed’s May meeting said, “A temporary period of inflation modestly above 2 percent would be consistent with the Committee’s symmetric inflation objective.” This added word “symmetric” sent Fedspeak gurus scrambling to dictionaries to decipher its meaning. In fact, the word “symmetric” was mentioned no fewer than nine times in the FOMC minutes!
Translated from Fedspeak, the Fed seems to be content to let inflation briefly run above its 2% target as the economy continues to recover. The use of this new “s” word may refer to their corroboration of the inflation rate from among several inflation measures. The Fed’s preferred inflation gauge, the core personal consumption expenditures (PCE) index, is currently at 1.9%, while the headline rate, including energy and food prices, is at 2.0%. Fed officials also described wage pressures as “moderate,” although it noted that there has been more pressure in industries where the labor supply is tightening. Fed officials see 2% inflation as a level that sustains economic growth without putting too much pressure on prices.
A view of the 10-year Breakeven Inflation Rate chart (below) gives a glimpse of what Fed officials read from the bond market. (The Breakeven Inflation Rate represents a measure of expected inflation derived from 10-Year Treasury Constant Maturity Securities and 10-Year Treasury Inflation-Indexed Constant. The latest value implies what market participants expect inflation to be in the next 10 years, on average.)
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary
There had been a measure of uncertainty that the Fed might be behind the inflation curve, however this latest fiscal policy statement should reassure equity markets that the Goldilocks economy remains robustly in place. The bond market found immediate solace in what was construed as the Fed’s sure-handedness on inflation, thus taking the 10-year T-Note yield down to 2.93% from 3.10%.
As the month of May comes to a close tomorrow, the stock market gets mixed reviews even though the major averages are set to finish a tad higher. From where I sit, I look at the varying geopolitical variables that are pulling and pushing on the market landscape – including fluid scenarios with de-nuking North Korea, putting some bite into the bark of averting a trade war with China, tightening the economic screws on Iran, the shelving of a NAFTA deal for the next Congress to tackle, and seeing the collapse of the economy of Venezuela, which just so happens to have the largest proven oil reserves in the world.
Yes, Venezuela has the largest proven oil reserves in the world, but many economists contend that years of economic mismanagement set the stage for the current disaster there. The damage was masked when oil prices were high, giving the government large resources. But when oil prices began a steep fall at the end of 2014, scarcities became common and food prices skyrocketed. Inflation could reach 2,300 percent this year, the International Monetary Fund warned in October 2017 (source: Bloomberg, October 10, 2017, “IMF Says Venezuela’s Inflation Rate May Rise Beyond 2,300% in 2018”). Children are dying from starvation in what resembles a sub-Saharan refugee camp. It’s tragic, and this past week’s undemocratic election of Nicolas Maduro, whose socialist government is shrouded in corruption, only perpetuates the crisis. Time will tell if Venezuela will move from banana republic with a lot of oil to first world status.
“Damn the Geopolitics, Full Speed Ahead” (For Global Growth)
The week leading up to the extended Memorial Day holiday weekend is typically upbeat for stocks. More confusion about the deal or no-deal with China and the initial delay of the North Korean summit hit stocks mid-week, but buyers stepped in supporting the market to where much of the losses had been pared. Then on Thursday, the meeting with Kim Jung Un was canceled, a temporary setback (it seems).
While the news of the canceled summit might cause the market to pause, the broader tone as of late has been improving, as evidenced by the market’s resilience to negative headlines. But then again, there has been a rotation of leadership that allowed the tech sector to regroup after getting de-FAANG-ed for much of the February-April timeframe. It was energy, railroads, and materials that took the lead while some past favorites (tech, financials, defense/aerospace, industrials) consolidated in earnings announcement season.
Heading into the last week of May, the FAANG stocks have reasserted themselves with only Alphabet trading off its all-time high. Several specialty retailers also provided some much-needed non-Amazon leadership in that sector, which helped fortify investor sentiment regarding consumer activity. So, despite the disappointing news surrounding North Korea, global economies continue to exhibit steady growth.
The International Monetary Fund’s April World Economic Outlook forecast cited a cyclical upswing fostered by structural change. The report stated, “The global economic upswing that began around mid-2016 has become broader and stronger. This new World Economic Outlook report projects advanced economies as a group will continue to expand above their potential growth rates this year and next before decelerating, while growth in emerging market and developing economies will rise before leveling off.”
World growth strengthened in 2017 to 3.8%, with a notable rebound in global trade driven by an investment recovery in advanced economies, continued strong growth in emerging Asia, a notable upswing in emerging Europe, and signs of recovery in several commodity exporters.
The IMF expects to see global growth of 3.9% to 4.0% this year and maybe next, supported by strong momentum, favorable market sentiment, accommodative financial conditions, and the domestic and international repercussions of expansionary fiscal policy in the United States. The partial recovery in commodity prices should also allow conditions for commodity exporters to gradually improve.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
Against this bullish macro-economic backdrop, the primary bull trend should remain intact while still being subject to seasonality issues and geopolitical disruptions, such as what occurred recently, and the inevitable toxic brew the mid-term elections are sure to bring. The market is entering somewhat of a quiet period where first-quarter earnings season has concluded with the Fed’s FOMC meeting slated for June 13 that is highly expected to result in a quarter-point hike in the Fed Funds Rate to a range of 1.75%-2.00%.
Aside from M&A news, it is my view that there won’t be a lot of high-profile catalysts to drive the major averages to new highs, with maybe the exception of the Russell 2000, which achieved a new all-time high last week. The rotation to small-cap stocks is a direct result of the strong move up for the dollar and how small caps are finally catching up with the other indexes after lagging for all of 2017 and early 2018.
However, if market participants feel the Fed is willing to give the economic expansion more rope on inflation, we could see growth accelerate. Then there well could be a ‘symmetric’ move by all the major averages to new highs in what would be a classic summer rally into second-quarter earnings season.
Hot stocks and cold beer. Ah yes!