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On March 16, Janet Yellen of the Federal Reserve scaled-back forecasts for multiple rate hikes this year, implying only two rate hikes from a prior expectation of four. This announcement was based upon the Fed’s nervousness of an overseas slowdown, and the steep stock market selloff early in the year. The market reacted favorably to her "dovish" commentary.

In a tumultuous and volatile quarter, stocks regained much of the ground they lost in the first 10 weeks of 2016. However, investors should note that certain members of the Federal Reserve board are not quite as accommodative as Mrs. Yellen.

This week, Boston Federal Reserve President Eric Rosengren said that the Fed is likely to raise interest rates this year before markets currently expect, as risks to the US economy from abroad are fading. Last week, Richmond Fed President Jeffrey Lacker said "inflation was likely to accelerate in coming years", while San Francisco Fed President John Williams said he would favor another interest rate hike now in April noting "very encouraging" progress in inflation. While Williams is not a voting member of the Fed, St. Louis Fed President James Bullard feels that there is a "credible case" to raise interest rates again in April, and Philadelphia Fed President Patrick Harker said the Fed should seriously consider raising rates in April.

The futures market now expects one additional rate hike this year, in September. The risk is that it arrives sooner than expected, and possibly as soon as April 27. The reason for this is that there are signs of inflation appearing in the US economy. The Fed enjoys looking at an economic inflation statistic called the Core PCE price index, ex-food and energy. The latest figure for this index came in at 1.68%, the highest year on year level of inflation since February 2013. As this index continues to rise closer to the Fed’s inflation objective of 2%, rate increases grow more likely.

The output gap, or difference between the actual output of the US economy and its potential output, is far narrower in the US that it is in Europe or Japan. It has been steadily narrowing since 2009. The growth in the US labor force has finally exceeded population growth. Combined with rising US wages, a low unemployment rate, and rising unit labor costs, the risk is now that the US will experience some inflationary wage growth.

Traditionally, when a business cycle extends into what is known as "late-cycle", it moves passed its peak rate of economic growth. In this phase of the business cycle, rising inflation can cause profit margins and earnings growth to decelerate. While input prices have remained subdued because of the collapse in commodities, this is not likely to be the case for much longer. Rising inventories relative to sales are another indication of the end of the business cycle. The following chart indicates that the inventory to sales ratio is at a seven year high.

Rising interest rates and tightness in the employment market are two other signs of a late stage business cycle. During this phase of the business cycle, stock returns are typically less reliable and assets that resist inflation tend to outperform. These might include Treasury Inflation Protected Securities, gold, commodities, and stocks related to commodities. In the near-term

there may be continued volatility in the global commodity markets. But as we move forward and commodities and oil establish a floor, there will be an increased focus on the risks of inflation. This view contradicts the widely held notion that world economies are headed for further deflation.

There are two geopolitical events on the horizon which could prove highly volatile. The first is the Brexit vote on June 23, when UK voters will have a direct referendum to decide on staying or leaving the European Union. At the time of this writing "Brexit" is 4% ahead of "Remain In", with 18% of UK voters undecided. The Brexit referendum could trigger another Scottish independence referendum as well, as most Scots wish to remain within the EU. While the economic impact of a Brexit is unclear, there is great uncertainty about its outcome. The Czech prime minister has already suggested that his government would begin discussions of leaving the EU if the UK voted to leave.

The second event is the Greek debt repayment schedule. Greece has massive debt repayments scheduled for 2016, particularly in the April-July period. Greece needs a new bailout in order to meet the July payments. In a leaked political transcript appearing on Wikileaks on April 2nd, IMF officials revealed that they were considering a “credit event” in Greece in order to force Germany into relieving Greece of a portion of its debt, and to simultaneously force Greece into pension reform. This would be an intentional plan to destabilize Europe, just around the time that the E.U.’s decision making capabilities could be impaired by the Brexit vote. At this point it is difficult to predict the outcome of this, but in the words of a recent Standard and Poor’s report, the chance of a Grexit in the long term remains high.

Stocks are not cheap at the moment. In fact the current forward P/E multiple of the S&P 500 is even higher than it was on January 1 of this year. The economic forces and fears which caused the January selloff remain intact:

1.) Fears that the Chinese communist government has persistently overstated its growth figures. Fears of further Yuan devaluations causing a "waterfall selloff" again in China.

2) Emerging market debt crises, particularly for oil-dependent countries.

3.) Falling profit margins in the US.

4) Falling earnings at U.S. corporates. Earnings of companies listed on the S&P 500 are forecast to have dropped 7.6% in the first three months of the year from the same period one year ago, according to S&P. That will mean the third straight quarter of weaker S&P 500 earnings. Energy companies have been the most impacted, but even stripped of energy companies, S&P 500 profits should be down some 3.3% since last year.

5.) Concern that the US dollar begins to rally again based on coming higher US rates, which will impact the profitability and volumes of US exports.

6.) Concern that the unprecedented, record levels of stock repurchases by US companies will cease due to higher rates. Corporate buybacks represent the single largest buyer of stocks over the past year, and they came to an end recently as blackout periods restrict companies from buying back shares in the months following a calendar quarter. Stock buybacks artificially make stock valuation seem lower than they actually are by inflating earnings-per-share, or the "E" in "PE". The stock buybacks of the first quarter seemed contradictory in the face of record outflows by retail and institutional investors out of stocks during the same period. More than $2 trillion of stock buybacks have taken place since 2009, serving to prop up the stock market. The growth rate of buybacks slow as profits decline, interest rates rise, or credit stress increases borrowing costs all three of these have begun to happen.

7.) The US bull market in stocks is already the third longest in US history. The Dow Jones Transportation Index tends to lead the S&P 500 Index. At the time of this writing, the Transportation index has been down on six consecutive days. Technically, stocks are trending lower: long term moving averages are trending down, and a three point bearish trendline has been established since last November. Caution is still advised from a technical standpoint, especially with oil now falling below $37 per barrel.

For the first quarter of 2016, the S&P 500 was up 0.2%, the Dow was up 1.49%, and the Nasdaq was down 2.74%.

Grant Rogers

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