• "Kee" Points with Jim Kee, Ph.D.


    • What’s baked-in for the US Economy?
    • What’s baked-in for the world Economy?


    What’s baked-in for the US Economy?

    Is the Fed done raising rates, or at least done through 2019? The market seems to think so, as measured by the Chicago Mercantile Exchange’s “CME FedWatch Tool,” which calculates the probabilities of a rate high above the current 2.25%-2.50% target range using Fed Funds futures contract prices. A few research houses and Federal Reserve Branch Bank Presidents expect perhaps one hike this year, and a few others even expect rate cuts to begin, but I’d say consensus is for no rate hikes in 2019. In fact, there is some interesting (e.g. Stifel) research out there suggesting that, when one accounts for the 30-year downward trend in interest rates, the Fed is already at “neutral,” or the rate at which it is not distorting rates and markets. And I think the Fed is paying attention to this research. As I have mentioned previously, economic downturns typically don’t occur until after the Fed stops raising rates, and the maximum negative impact occurs over a year after the last hike. That relationship historically has been waning (i.e. getting weaker over time), but then again the current rate hike regime, which began at the end of 2015, is following an unprecedented seven years of zero percent rates. That could make the economy more sensitive to a given level of rate hikes. So the correct answer to the question, “What will be the impact on the economy this year of the rate hikes we’ve already had?” (i.e. “What’s already baked-in for 2019?”) is, “We don’t really know, we just have to watch the data.”


     

    What’s baked-in for the global economy? 

    This theme of ambiguity, for want of a better term, describes the outlook for the global economy as well. Global data has slowed since last summer, at least in the world’s largest economies like Germany, China, and Japan. A lot of this has been caused by ongoing uncertainty over global trade agreements (including tariffs), a headwind in 2018 that I think could turn into a tailwind in 2019. But there is something missing from the global trade discussion, and that is global capital flows. Free trade has both winners and losers, but generally the winners gain more than the losers lose. Obviously (?), a country is better off if its trading partner is large and wealthy than if it is small and poor (who in San Antonio drives past HEB to go grocery shopping in a small town with a single convenience store?). When an economy collapses or just enters into recession, some of the gains from trade are lost because that country imports and exports less. The volume of trade declines, just as would occur under a trade war. But there is an off-setting effect, which is that capital in the declining country(s) tends to flow towards the countries where opportunities are higher. And capital in those better-off countries that was slated to move abroad stays at home. This is a positive off-set for those stronger economies, and probably mitigates some of the negative impacts of the lost gains from trade. It might not fully offset them, but research does indicate that big downturns in one economy generally don’t result in downturns for all economies (HCWE Economics). That is, “contagion” effects are offset somewhat by capital flows. Now, measuring “capital” and “capital flows” is difficult (but fascinating), a topic for another day. The conclusion is that, as in the first paragraph, the answer to the question of how impacted the global economy will be from trade conflict that has already occurred is, “We don’t really know, we just have to watch the data.” 




  • "Kee" Points with Jim Kee, Ph.D.


    • Quick 2019 Outlook
    • A Challenging First Quarter


    2019 Outlook

    A good way to think about the stock market going forward is that it prices what is known, and that the gains or losses for the year tend to reflect that balance of negative and positive shocks that will occur over the ensuing 12 months. In that sense, I’m a little more optimistic for 2019 than 2018, largely because valuation levels (i.e. expectations) are lower than they were at the beginning of 2018, and I think that the negative shocks that were headwinds in 2018 could become positive shocks - tailwinds - for 2019. For example, the trade war ratcheted up in 2018 (that was the biggest negative shock), but trade resolution seems the better bet this year. China (and Europe for that matter) has experienced slowing growth, and that increases the odds of coming to the table more open to negotiations (Milken Institute; Knowledge@Wharton). A positive outcome in the US/China negotiations would be for China to agree to purchase more US goods, and to cede some ground on intellectual property rights. And the Federal Reserve was resistant to altering its course as global growth slowed in 2018, but it has signaled a much more cautious tone moving into 2019.


    A Challenging First Quarter

    But, the first quarter could be somewhat challenging, and that could well manifest itself in continued stock market volatility. Tariff hikes (from 10% to 25%) were suspended for 90 days beginning on January 1, so there will no doubt be a lot of back and forth on trade during the quarter. And some clarity on Brexit will have to occur before the March 29 deadline, which might include a plea by British Prime Minister Theresa May for an extension that would have to be agreed upon by EU authorities. First quarter numbers are typically low anyway, and the impacts of the government shutdown should help ensure that to be the case this year as well. Current forecasts like the Atlanta Fed’s GDPNow are estimating first quarter growth at 2.7%. But a recession for 2019 does not seem to be in the cards, just a slower rate of expansion in the US (closer to 2% than last year’s 3.1%), with global growth expected to be in the 3%-3.5% range. The government funding that ended the shutdown is only good through February 15th, at which point another shutdown could occur unless an agreement is reached between the President and Congress. Trump has threatened to declare a national emergency in order to fund “the wall,” a move with little broad-based support and of questionable legal legitimacy. My hunch, based upon no facts other than a re-reading of his first book, The Art of the Deal (1987), is that I wouldn’t put it past him. Finally, an interesting fact on the current, tight labor market (unemployment rate=3.9%) is that most of the hiring taking place now is in small businesses rather than corporations, a reversal of the trend during most of this expansion.


  • "Kee" Points with Jim Kee, Ph.D.


    • Quick Take
    • Asset Class Performance Lessons


    Quick Take

    With U.S. and developed-world stock market indices up strongly this year (so far), my quick take is that the market cares a great deal about U.S./China relations, which seem to be making progress, and very little about Donald Trump/Nancy Pelosi relations, which do not. However, that could change with time. I have mentioned previously that markets tend to shrug off government shutdowns, because they usually just result in rescheduled or delayed spending. But a prolonged shutdown can have a negative impact to the extent it interferes with the wealth-creating activities of production and exchange. This can happen in a variety of ways because many industries rely on government agencies for approvals, permits, loans, and other regulatory activities (i.e. airport security) that are a regular part of business. Former SEC commissioner Joseph Grundfest used the analogy of holding one’s breath - you can do it for a little while without any damage, but at some point the effects dobecome damaging. That is the sand-in-the gears argument for ending prolonged shutdowns, and I agree with it. Globally, the IMF has downgraded its expectations for growth (albeit from 3.7% to 3.5%), citing trade concerns and their impact on global activity, particularly Europe. “The bad news,” writes Asian Times economist David Goldman, “has a name and an address, which is Germany.” That made me chuckle. Germany grew about 1.5% in 2018, and is a big exporter highly sensitive to global trade. The sooner we see progress on trade policy and on the government shutdown the better!

     


    Asset Class Performance Lessons

    I just received one of those “investor’s periodic tables” from one of our data providers, Crandall, Pierce & Co., which shows the multi-year performance of different asset classes. Before the 2008 global financial crisis, quantitative analysis indicated that if you had to choose just a single asset allocation, you would be better off choosing 100% value (no growth), and mostly small cap (Financial Times). In fact, one innovative researcher argued that taking the best of both of those worlds - small cap value - and putting all of your equity exposure in that, would allow you to allocate a majority of the portfolio to bonds and still earn the overall return of the market (with the juiced-up small cap value allocation) but with much less risk. Well, looking at the past ten years, guess which U.S. equity class (large cap, mid cap, small cap, value, growth) did the worst? Yep, small cap value. Did anything do worse than small cap value? Yes, international stocks including emerging market stocks. Anything worse than those two? Yes, hedge funds. Worse than hedge funds? Yes, commodities did worse than hedge funds. Now, if you go back ten years many strategists were advocating a strong allocation to commodities because they had done so well after China joined the World Trade Organization in 2002 (i.e. the “commodities” super-cycle). Hedge funds were also hot. Burton Malkiel, the famed academic author of “A Random Walk Down Wall Street,” advocated a 50% allocation to international stocks, the majority (30%) to emerging markets (although Matthews India, which he advocated, did extremely well). Another (Larry Swedroe) advocated small cap, value, and emerging markets exposure with no pure growth (Kiplinger). The point here, really, is one that Jeanie Wyatt made in her recent quarterly letter. You cannot time these asset classes and you should not try. By maintaining exposure to growth and value, small cap andlarge cap (and mid cap), and even international, you should – over a full cycle – experience the broad market gains with less volatility.


  • "Kee" Points with Jim Kee, Ph.D.


    • Uncertainty at the Moment
    • China

     

    Uncertainty at the Moment

    The partial government shut-down that began on December 22nd has just exceeded the previous record holder, which was the December 15, 1995-January 6, 1996 shut-down that took place under President Bill Clinton. The current shut-down has occurred because of disagreements between Democrat and Republican leadership on border Wall funding. I don’t think the core constituents of each party are as gung-ho on this issue as their leaders are, but right now there are no obvious signs of a pending compromise. One exception could be in modifications to the Obama-era’s Deferred Action for Childhood Arrivals (DACA) program, which President Trump cancelled in 2017. Democrats have tended to favor deals that help young, even undocumented, immigrants (i.e. “Dreamers”) become citizens, and they have formerly offered border Wall funding in exchange for creating a path to citizenship for these young immigrants (WSJ). If there is a way through this impact I think it will involve a compromise that helps Dreamers gain citizenship (a concession on Trump’s part) in exchange for Wall funding (a concession on the Democrat’s side).

      

    China

    There are plenty of other uncertainties out there, like the on-going votes and debates over the conditions of Britain’s exit from the EU (scheduled for March 29th). Global data indicate slowing growth in the Eurozone, Japan, China, and even the U.S. Of these, China is perhaps the biggest concern, with trade (exports and imports) and manufacturing data indicating that the trade “spat” between the U.S. and China is starting to take a toll on the Chinese economy. The Chinese are expected to lower their GDP growth target from the current 6.5% growth rate to 6%, which is still pretty good for an economy that is almost as large as the United States. Thinking big picture though, I continue to feel that the following quote from consulting firm McKinsey & Co, which I used in our 2013 Market Update, has been the best guide for thinking about China:


    “While many economists now project that China’s average annual economic growth will fall to between 5 and 7 percent a year during the next decade, I expect it to slow even more, perhaps to 3 to 4 percent a year. In modern history, no country that has experienced an investment-driven growth “miracle” has avoided a slowdown (such as Japan’s after 1990) that surprised even the pessimists, and it is hard to find good reasons to think China will be an exception.”


    That seems to describe what we’ve been seeing since 2013. In the end, I see both the U.S. and China being more interested in getting a trade deal done this year than they were last year, and that would be a positive catalyst for stocks. Looking across the S&P 500 forecasts for 2019 by the top banks (Bank of America, Goldman Sachs, Citi, etc…13 in all), it appears that this “compromise over conflict” is a consensus expectation (although compromise was expected of Trump in 2018 as well). The average expectation for the S&P 500 is 3056 by year’s end, which is about 18% above today’s 2582 level (sounds a little rosy). Credit Suisse is the most bullish, with +30% upside (3350) expected by year’s end, while Morgan Stanley is the most bearish, with +6.5% upside (2750) expected by year’s end.


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