• “Kee” Points with Jim Kee, Ph.D.

    • Government Funding
    • Debt and Unfunded Liabilities
    • The Weak Dollar?
    • Markets First
    • Emerging Markets

    Here are a few quick points to help make sense of what’s going on as we head into 2018:


    Government Funding

    There is a growing threat of a government shut-down, according to strategists like Greg Valliere, due to internal dissent in both parties as to what to support and not to support (e.g. defense, immigration) prior to the January 19 deadline (that’s the end of the temporary funding bill passed in December). I would reiterate that markets historically have not viewed government shutdowns as a crisis, and most strategists seem to think that 2018 will be the year of flexibility or compromise with respect to the Trump administration. That’s an interesting thesis, so we’ll see.


    Debt and Unfunded Liabilities

    I’ve talked before about the importance of comparing debt to total assets, and of comparing the annual cost of servicing that debt to annual income or GDP. Nothing there is alarming; it is the future unfunded liabilities (Medicare, Medicaid, and Social Security pretty much in that order) that are precarious. But there is a difference between outstanding debt versus future liabilities. Commitments on outstanding debt have to be paid in order to avoid default, which would cause repricing of outstanding debt (downward) and a whole lot of chaos. Future liabilities, however, are promises that can and will be “altered.” That can occur with means testing and other modifications, and does not involve default and the consequent potential for financial chaos. That may not sound fair or just, but it makes all of the difference in the world when it comes to assessing the impact of government commitments on the investment landscape.


    The Weak Dollar?

    The dollar has dropped to a three year low against a basket of major currencies, and the press seems to be struggling both with how to explain this and how to make it a bigger story than it is. Typically, exchange rates are determined by a lot of things that are impossible to measure while they are occurring, like relative growth rates between countries, and actual tightness versus looseness of central bank policies relative to each other. On that last point, an example is the Federal Reserve, which has raised short-term rates (i.e. the federal funds target rate) 5 times since 2015, and yet the actual federal funds rate, after adjusting for inflation, is still negative. Is that tight?

     

    Here’s how I see it: When the price of oil plunged in 2015 the dollar shot up sharply. Oil bottomed and the dollar peaked in 2016, then oil gradually rose (and the trade weighted dollar fell) until the beginning of this year, when oil rose sharply and the dollar fell through 2017. Currently, Brent crude is pushing (but hasn’t quite hit) $70 per barrel. It is tempting to describe this inverse behavior of the price oil and the dollar solely in global “petro dollar,” terms. And indeed, with the advent of fracking and the increase in production from Saudi Arabia, the price of oil fell dramatically, which should result in fewer dollars required to purchase oil (lower supply of dollars globally), as oil is generally purchased in contracts denominated in dollars. That would put upward pressure on the dollar, because the supply of dollars needed to buy oil is less, and reducing the supply of anything increases its price. But missing in this analysis is the “safe haven” role that the dollar also plays.


    You might recall that oil’s plunge was associated with a sense of panic by markets and the press, while its climb has been greeted with sighs of relief. When oil plunged, risky assets like stocks and high yield bonds flat-lined or sold off, then started back up as oil prices started back up. The dollar was clearly being moved during this period by its role as a safe-haven, with money bidding up the price dollar-denominated debt, lowering yields. 10-year Treasury rates more or less reflect this - they fell when oil prices fell, and rose as oil prices recovered.


    What Now?

    I’ve talked before about Robert Mundell’s notion that the dollar/euro exchange rate is perhaps the most important price in the world, particularly because other countries like China peg to the dollar to some extent. The euro was way too strong up to 2014 at $1.40 per euro, and then fell to almost $1.00, meaning the dollar was way too strong. It has since risen back to its current level above $1.20. Somewhere between $1.20 and $1.30 for the euro would be normal, meaning neither currency is too strong or too weak. There’s a lot of “guesstimate” in this sort of thing, but the bottom line is that I see the dollar’s movement as more a normalization than anything else.


    Markets First

    The Wall Street Journal over the weekend highlighted trade talks, infrastructure spending, and immigration policy as big domestic agenda items for 2018. Trade policy in particular has the potential to be most worrisome. On trade, the US has pulled out of the Trans-Pacific Partnership (about a year ago), and the Trump administration seems to want to “update” everything from NAFTA to the World Trade Organization. The UK is expected to spend the first half of 2018 negotiating what its trade status will look like vis-à-vis the European Union, and in China the ambitious Belt and Road initiatives to increase trade over land and sea will probably see resistance from involved countries (Financial Times). It would be nice to have a crystal ball for all of this, but we do have markets. In other words, it probably makes more sense to watch markets in order to gauge how positive these things are going (or not), rather than the other way around, i.e trying to anticipate the unknown and get ahead of markets. It’s not perfect, but most strategists, myself included, wake up to a headline and check markets in order to get a quick gauge of legitimacy versus sensationalism.


    Emerging Markets

    China is expected to grow in the 6 percent range for 2018, while India (1/5 its size economically) is expected to grow in the 7 percent range. Raghuram Rajan, India’s former Central Bank Governor, recently made the profound point that India should hold off on any “chest thumping” (his words). Rajan stated that 7% growth for the next 15-20 years is what is needed to meaningfully lift the billions of people there to a higher standard of living. I thought that was a colorful point to end Kee Points on.


    I hope you will join us for one of our upcoming market update presentations. Please see the dates and times below. To reserve your space, please email the appropriate RSVP contact.


    Corpus Christi Market Update

    Wednesday, January 24, 2018

    Ortiz Center- Nueces Room

    11:30am-1:00pm

    RSVP to Joni Bedynek- jbedynek@stmmltd.com or 361-904-0551


    Austin Market Update

    Wednesday, January 31, 2018

    Austin Country Club- Ballroom

    11:30am-1:00pm

    RSVP to Kelli Stricklen- kstricklen@stmmltd.com or 512-342-2272


    Houston Market Update

    Wednesday, February 7, 2018

    River Oaks Country Club- Ballroom

    11:30am-1:00pm

    RSVP to Maribel Everett- meverett@stmmltd.com or 713-683-3818


    San Antonio Market Update

    Tuesday, February 13, 2018

    San Antonio Country Club- Ballroom

    5:30pm-7:00pm

    RSVP to stmmevents@stmmltd.com or 210-824-8916


    Dallas Market Update

    Thursday, February 22, 2018

    Fairmont Hotel- Parisian Room

    11:30am-1:00pm

    RSVP to Kelli Stricklen- kstricklen@stmmltd.com or 512-342-2272


  • “Kee” Points with Jim Kee, Ph.D.


    • Quick US Outlook
    • Investor Traps in 2018
    • Global Take
    • China


    Quick US Outlook

    2018 US outlook: Just to reiterate, I think the most interesting thing going forward for the US economy is the fact that you have tax cuts being implemented in an environment characterized by a decided shift in the regulatory tone (less rather than more). That should be good for growth. Since markets tend to be forward-looking, I think a lot of that has been priced-in, and I don’t really think anybody can get more precise than that. Interest rates are expected to rise gradually, mostly due to stronger growth and more fed rate hikes. Brent crude has risen to $67 per barrel, and I see interest rates and oil as having a common characteristic: they have a range that is considered “normal,” and a floor below which is (I call it) “uncertainty inducing.” I’d ball-park below $40 per barrel for oil and a 10-year treasury yield below 2% as the minimum of the normal range for oil and interest rates (the current 10-year treasury yield is 2.46%). The outlook for both of these in 2018 is above their “uncertainty-inducing” levels.


    Investor Traps in 2018

    2018 caveat: It has been a record 23 months since the last pull-back in US stocks, meaning a decline of 5% or more. And we’ve had 14 consecutive positive months in a row. That’s a concern, not because a downturn is eminent--you should expect the market to go up and down--but because what is considered a normal pullback is likely to feel more severe than it actually is compared to a normal pullback in a more placid market. That was a key point of a recent Wall Street Journal article by writer Jason Zweig. Investor panic, or overreaction, can in-turn lead investors right into the welcoming arms of product-pushers. That’s particularly true when stocks and bonds look pretty fully-valued. Product pushers tend to promise things that don’t really exist, like all of the market’s upside but protected downside; or they hype alternative types of investments (i.e. not stocks or bonds) with limited audited (or auditable) track records. On the bond or fixed-income side, product pushers allude to higher yields or income without higher risks, another thing that doesn’t really exist. So, I think one of the biggest risks to investors for 2018 won’t be markets, which again go up and down, but dubious strategies created to capitalize on investors’ reactions to markets. 


    Global Take

    2018 global: Outgoing Fed Chair Janet Yellen talked about the good current performance of the US economy, “not based upon, for example, an unsustainable buildup of debt.” She talked similarly of the global economy, describing the world as being in a “synchronized expansion,” a term which the press has proceeded to kind of drive into the ground. But that is what the data are showing. You can see it in the bottoming and upturn in global commodity prices (including oil), which has helped many of the commodity-based emerging markets. The last time the “big 4” (Europe, US, China, Japan) were hitting on all cylinders was in the 2000s, but the current global expansion is less robust than it was then, and it seems a little more sustainable. Growth for Japan (Bloomberg consensus) is expected to be positive but a bit below last year’s 1.7%. The growth rate for the EU (European Union) is expected to be in the 2%-2.5% range, while growth in the US is expected to be in the 2.5%-3% range.


    China

    China continues to slow, though official numbers still report GDP growth around 6.8%. At the same time, different regions in China (e.g. Inner Mongolia) continue to confess that they have fabricated economic data(!). Research outfit Gavekal points out that China is engaged in “three key battles,” which are (1) reducing financial risk/debt, (2) reducing poverty and unemployment, 3) reducing pollution. And they continue to want to focus more on the quality of growth (domestic consumption) rather than the quantity of growth (heavy industry/construction and exports). I like thinking of China in old and new economy terms, with the best investments in the newer, consumer/tech sectors.


  • “Kee” Points with Jim Kee, Ph.D.

    President Trump signed the Republican tax cut bill into law on Friday, and he also signed a continuing resolution that will keep the government open through January 19th.

     

    What’s exciting about the tax cut is that it is occurring in a deregulatory environment: In prior Kee Points I have talked about business tax reductions as offering a far higher growth “bang for the buck” than individual rates at this point, and that appears to be where a lot of the net rate reductions occur. Economists often talk about how the “rate effect,” or the change in tax rates, is the most important aspect of tax reform for economic growth. Deductions, rebates, etc., might be important for other reasons, but not for growth [for those with real economics training or coursework, the assertion is, “the first-order incidence of price or excise effects over income effects; income effects sum to zero”].


    Back in 2011, in an interview with The Economist magazine, economist Robert Mundell argued that the “secret to growth (the name of the interview) for the United States was to cut the 35% corporate tax rate, which Mundell said should be brought down to 20% and ideally to 15%. During the subsequent Presidential election the following year (2012), both parties ran on a corporate tax rate cut (Wall Street Journal). Mundell focused on corporate rates because he felt that individual rates had already come down, at least by historical standards, and might be close to a “political equilibrium.” That’s a pretty profound insight, and it describes exactly what we just saw with the passage of the new tax law. The corporate rate was cut pretty dramatically; individual rates just a tad.


    Also, at the beginning of the year, Raghram Rajan (former head of India’s Central Bank) pointed out that, as quoted in the January Kee Points, “The mere replacement of zealous regulatory personnel with more hands-off regulatory personnel would positively impact growth even with zero actual regulatory changes.” Within 10 days of taking office, President Trump issued Executive Order 13771, the order to reduce two existing regulations for each new one issued. That has been thus far achieved according to the Office of Information and Regulatory Affairs (WSJ). Some skepticism here is warranted, but the change in tone towards less regulatory growth is undeniable.


    Putting the two together, any given growth incentive from tax reform will be more powerful under a hands-off regulatory environment than under a hands-on regulatory environment, for better or for worse. So it is the combination of the two that, in my opinion, makes the next few years more exciting to watch from a growth perspective.


    Also, in last week’s Kee Points I mentioned that I intended to bullet-point some of the major line-items of the new tax law, but I would remind everyone that they should see their own accountant or CPA about how this tax reform will impact their own situation. With that said, here are a few highlights:


    • The 35% corporate income tax rate will be permanently reduced to 21% effective January 1, 2018.
    • Lower tax rates on corporate income earned overseas and brought back to the US.
    • 100% expensing of qualifying business investments made between September 27, 2017 and before January 1, 2023 (after which a gradual phasing down occurs).
    • Seven income brackets with rates at 10%, 12%, 22%, 24%, 32%, 35%, and 37%.
    • Mortgage interest tax deduction limited to $750,000 (and ending deductibility of interest on home equity lines of credit). That’s on new mortgages, not existing ones.
    • Estate tax retained but exclusion is doubled (from just over $5 million to approximately $11 million).
    • State and local tax deductions capped at $10,000.


  • “Kee” Points with Jim Kee, Ph.D.


    • Tax Cuts Look Likely to Pass
    • Quick 2018 Outlook
    • Notes on Sentiment
    • Inflation Not Baked in the Cake


    Tax Cuts Look Likely to Pass

    Voting is expected this week on the final version of tax reform which, among other things, will lower corporate rates, individual rates, and rates on pass-through businesses. It will also affect non-profits and housing by modifying deductions. Several items could impact municipal bonds, particularly the removal of tax-exempt status that allows municipalities to refinance at lower rates. Lowering corporate tax rates also reduces demand for municipal bonds by corporations, banks, and insurance companies. On Friday, the House and the Senate signed off on a conference report resolving differences in their respective tax bills, and the 503 page report obviously contains the inevitable minutia of negotiations and compromises. Assuming the bill passes this week, I will try to bullet point the main implications for individuals (rates, exemptions, health care), businesses (corporate, pass-through, overseas earnings, etc.), non-profits, and municipalities in next week’s Kee Points.


    Quick 2018 Outlook

    Most strategists expect positive returns for stocks next year, with the average and median forecasts of ten firms reported by Barron’s (Goldman Sachs, Citigroup, etc.) being in the 6%-7% range. People can’t really predict above or below average markets, of course, because that requires the ability to forecast heretofore unknown events that aren’t already priced-in or incorporated into current prices. But remember that prices lead quantities, and the expectations of higher future growth in the economy and earnings (“quantities”) from tax/regulatory reform should be anticipated somewhat by stocks and bond markets (“prices”). I think that’s what we are seeing, so I think the near-consensus “stronger growth, disappointing returns” (Black Rock) outlook for 2018 is the right expectation.


    Notes on Sentiment

    So far this holiday season consumer spending in general and retail spending in particular has been well ahead of expectations, which is consistent with extremely high business and consumer confidence readings. Confidence data can be both backward and forward looking, depending upon the circumstances. Under current circumstances, I would say confidence data has anticipated consumer spending, which is consistent with how most people think about consumer sentiment or confidence measures and subsequent spending decisions. But they can also be contrarian indicators in times of macroeconomic shocks. For example, after the 9/11 attacks on the World Trade Center towers, consumer sentiment readings were about the lowest on record. That led to a very dismal outlook for the retail sector by Wall Street analysts. But the following months’ bounce in retail spending were among the strongest on record. Keep this in mind anytime someone tries to read too much into confidence surveys or measures.


    For example, the November reading of small business optimism from the National Federation of Independent Business (NFIB) registered the second-highest reading in its 44 year history. There are eight components to the survey-based index, and the strongest gains came in the “Expected Better Business Conditions” component and the “Sales Expectations” component. Other surveys corroborate this, as the University of Michigan Consumer Sentiment Survey recently surpassed its prior 2007 peak for the first time since the expansion began. The NFIB listed expectations of lower taxes as a common component of feedback from survey participants. That suggests that stronger hiring and investment is in anticipation of lower taxes, so the notion that things are improving so a tax cut isn’t needed is a bit disingenuous.


    Inflation Not Baked in the Cake

    Does growth lead to an “overheating” economy? The notion that growth “causes” inflation is among the most misleading notions in all economics. Towards the end of the high inflation 1970s, economist Robert Mundell, who later won the Nobel Prize, questioned this thinking by asserting that, for a given stock of money, more output would put downward, not upward pressure on prices. That’s because each unit of money would trade for more goods and services, which is disinflationary, not inflationary. Mundell’s prescription, controversial at the time, was to encourage production by reducing taxes and regulatory burdens. Other Nobel Laureates at the time argued the opposite, and were on record asserting that the Reagan tax cuts, if enacted, would lead to high or even hyperinflation by the late 1980s. Mundell was right, output and capital spending rose dramatically during the 1980s as inflation fell, just as real output and capital spending declined in the 1970s, as inflation rose. Part of this success in bringing down the inflation of the 1970s had to do with then Fed Chair Paul Volker’s massively tight monetary policies in the early 1980s (raising short rates dramatically), which induced a deep recession (some count it as two) early on and was believed by Volker and others to be necessary to “break” inflation. Economists advising the administration at the time protested this, arguing that a gradual tightening would have accomplished the same goal with less stress to the economy. We will never know, because the massive tightening was the course that was chosen, not the more modest approach. But the point is that whether or not growth is ultimately inflationary or not depends upon the actions taken by the central bank and the deftness (or lack thereof) of controlling the excess reserves of the banking system.


    At the risk of oversimplifying, whether or not strong growth will lead to inflation depends to a large degree on the actions and organization of the monetary system or central bank. Specifically, the ability of the central bank (the Federal Reserve in the US) to manage the excess reserves of the banking system as the economy grows is the key to controlling inflation in an expanding economy. The Fed can control the level of excess reserves held versus loaned out (potentially leading to inflation) by paying interest on reserves as well by buying and selling securities (called “open market operations”) to target interest rates in general. Currently the excess reserves of the banking system are extremely high, a product of the asset purchase programs (i.e. quantitative or credit easing) of the Federal Reserve. That adds a level of complexity to the central bank’s task, a fact pointed out by former US Senator (and PhD economist) Phil Gramm and Texas A&M economist Thomas Savings last week in their Wall Street Journal article, “A Booming Economy Will Challenge the Fed.” The authors expect the US economy to return to its normal 3% growth path (as do I, but we’ll see), and argue that it is quite possible, but not certain, for this to occur with broad price stability:


    “If the Fed could find just the right mix of selling more assets and lower the rate it pays on excess reserves, it could theoretically end up reducing its balance sheet and reducing bank reserves without either slowing economic growth or igniting inflation.”


    So don’t believe anyone who tells you that high future inflation is already baked in the cake.


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