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Second Quarter 2018 Forecast and Opinion

In the first quarter of 2018, we have begun to see what happens when the liquidity that has driven markets for the past ten years begins to dry up.
The Fed is raising interest rates while shrinking its balance sheet. The “Paul Ryan” tax cut has created a $1.3 trillion hole in the government’s finances, which means that $1 trillion or more of Treasury debt will be issued this year, and in coming years, twice the normal amount.
The unpredictable announcements made by the U.S. president concerning tariffs have raised concerns over a tit-for-tat trade war with our major economic partners. Wall Street recognizes that tariffs tend to be damaging to the economy, just as they were when imposed in 1934. While it may be true that China has never been fair in terms of free trade, tariffs will nevertheless have repercussions on the stock market. While tariffs would be worse for China than the U.S., both sides still lose.
If the stock market bump of 2017 was due to the Republican agenda, investors should be concerned about what happens if the Democrats sweep the congress in November of 2018. The question is posed in a politically agnostic fashion, but tax cuts, perceived changes in cultural attitudes toward business and profits, and lightening of regulations, particularly in the energy and financial sectors, could be reversed by a Democrat majority.
One element that has changed since January is that tax cuts have increased profits at U.S. corporations, meaning that stock valuations have been reduced to levels which are no longer as extreme as they were before the tax cuts. Having said that, tax cuts are now built in to profit forecasts, which will, going forward, have a high comparison basis. Expect corporate profit growth to be peaking now.
First quarter GDP growth forecasts have been lowered weekly by the Atlanta Fed, and are now only at a 2.3% annual growth forecast, down from a 5.4% forecast in February.
Stock buybacks, a major driver of upward stock prices in recent years, should continue apace (if not increase) after the Republican tax cuts. Normally, stock buybacks reflect low interest rates as companies borrow inexpensively to buy back their own shares. But rising interest rates are being offset by lower taxes, particularly lower taxes on repatriated offshore profits.
The Federal Reserve, increasingly confident that they will reach their 2% inflation target rate in the near future, is on track to deliver three interest rate hikes this year, one of which took place in January – the sixth interest rate increase since December of 2015. Keeping in mind that unwinding the Fed’s balance sheet is estimated to equal another 1% of tightening, and it becomes clear that the Fed is embarking on a contractionary policy course which will serve to lower asset prices. As the U.S. Treasury competes for investors’ money to cover record and “bigly” higher deficits, rates will have to move higher. It’s worth considering that the U.S. is neither in recession nor at war. If it were, we should expect U.S. deficits to move even higher, causing more Treasury issuance and even higher interest rates.
At the end of this year, the total cumulative amount of Fed tightening should reach 2.25%. Along with the estimated 1% of equivalent tightening caused by shrinking the Fed’s balance sheet and we’ll have 325 basis points (3.25%) of rate tightening.
Out of 13 Fed hiking cycles since WWII, 10 of them have put the economy in recession. Fed tightening slows growth, particularly when $1.9 trillion of investment grade and high yield debt is being re-financed over the next 36 months to pay for the stock buybacks of recent years.
Typical of slowdowns in growth are when the jobless rate begins to flatten out, which it has, at 4.1% over the last six months despite fiscal stimulus boosts. The volatility seen in the first quarter of 2018 is usually associated with market tops or market bottoms.
It’s interesting to note that ECRI, the Economics Cycle Research Institute, known for their hitherto bullish “Leading Economic Indicators” index is now predicting a global slowdown in growth. It is worth watching the yield spread between 2 year Treasury note and the 10 year Treasury bond. An expanding economy usually results in this spread widening. When the spread goes to zero, or even goes negative, a recession almost always results afterwards. Here is the chart of this spread over the last two decades:

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The S&P 500 Index fell 1.2% in the first quarter, and the Dow Industrial index fell 2.5%.

Grant Rogers

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