"Kee Points" with Jim Kee, Ph.D.

The Dow Jones Industrial and the S&P 500 finished at all-time highs yesterday, and to repeat there is no real significance in anything hitting new highs that have historically trended upwards over time (like US stock prices). If instead valuation levels were at an all-time high, which they are not, then that would be a whole other story! In the current environment, my sense is that the market rises and falls more or less in proportion to the odds of President Trump getting major tax/regulatory reform through. Washington expert Greg Valliere, who has been a guest speaker at numerous STMM events over the years, argues that there are “signs of life in the Republican Congress,” and that a crucial vote on a replacement form of Obamacare is possible before the July 4th recess. Tax reform is still very much alive for 2017 as well. One of the impediments to tax reform legislation has been the controversial Border Adjustment Tax, but according to Valliere, House Speaker Paul Ryan has indicated he might be willing to back away from or support delays in the Border Adjustment Tax (which he supports). This tax gives breaks to US companies that ship products abroad, and removes tax breaks from US companies that import goods from other countries. In absolute terms (sheer dollar amounts) the US is the largest importer and exporter among the developed countries. It is slightly behind China, which is considered “emerging,” although the European Union countries combined slightly exceed both. Looking at imports and exports as a percentage of GDP, Germany ranks the highest of the major developed countries (40% and 50% respectively), with the US among the lowest with both imports and exports less than 15% of GDP (HCWE). Top export destinations of the US are Canada, followed by Mexico, China, Japan, and then Germany. We import the most from China, then Mexico, Canada, Japan, and Germany (MIT’s OEC - Observatory of Economic Complexity).

Yield Curve: The flattening yield curve has also been in the headlines recently, meaning short-term rates are rising relative to long-term rates. I’ve talked in prior Kee Points about bullish versus bearish flattenings, so I won’t go into that here, but there is some concern that the current flattening is signaling slower economic growth going forward. I’ve seen that in some of the downward revisions in the various “nowcasting models” for the second quarter GDP, although all models see an acceleration from the first quarter. The yield curve has been distorted by central bank policies since the Great Recession, which reduces its reliability as a forecasting tool. Right now short-term rates are being influenced by Federal Reserve policies, while longer-term rates are being influenced by lower rates overseas (i.e. European Central Bank and Bank of Japan policies). Normally, if the fed raises short-term rates (i.e. the federal funds target rate) it would translate into higher longer-term rates, as long-term rates are in part a function of expected future short-term rates. But in the current environment of low to negative interest rates overseas, any increase in long-term rates here attracts foreign capital from abroad, driving them back down. I think that is the key dynamic behind today’s yield curve. Also quality spreads (the difference between the yields of high quality and low quality bonds) tend to anticipate growth accelerations and decelerations, and they have narrowed, which is not consistent with a major slowdown in economic growth.

Oil: Finally, oil prices are back in the headlines as crude oil (WTI) has fallen to $43 per barrel, which is down from around $54 per barrel at the beginning of the year (Brent crude being a couple of dollars higher). Supply and demand influence every market, and both are always at work in the oil market. You can’t really measure these forces directly, but you can infer them by looking at changes in prices and quantities over time. If the prices are lower and the quantities sold are not, it is a pretty good indication that supply increases are the primary driver. The Federal Reserve Bank of New York publishes a weekly “Oil Price Dynamics Report,” in which they attempt to decompose recent fluctuations in oil prices between demand factors and supply factors. Their current report reads, “Oil prices fell steadily owing to decreasing demand and increasing supply.” Demand growth has been far more dependent upon emerging economies than developed economies over the past 10 years, and developed economies are always moving towards lower energy intensity, or lower energy use per unit of output. On the supply side, many US shale firms that purchased $50 oil hedges continue to produce (which is expected to roll off by year’s end), and OPEC still struggles to police output restriction targets.