BLOG

Third Quarter 2017 Forecast and Opinion July 7, 2017

Midway through 2017, the optimism that fueled the stock market higher after the Trump election has not yet materialized into better economic data. So far the economy is growing at an anemic 2% as it did during the Obama presidency. Job growth, investment spending growth, consumer spending growth are slower in the first six months of this year relative to 2016. Even the Federal Reserve officials have begun warning that the stock market is overvalued. The Fed has notably shifted from a dovish stance to a more hawkish one over the past month. signaling higher rates, which represent a tightening of financial conditions.


• In the words of Vice Chairman Stanley Fischer in June 28th: "P/E ratios are near the top of historical levels… High asset prices may lead to future stability risks… The corporate sector is notably leveraged".
• Fed Chairwoman Janet Yellen: “Valuation pressures across a range of assets and several indicators of investor risk appetite have increased further since mid-February...The Committee currently expects to begin implementing the balance sheet normalization program this year provided that the economy evolves broadly as anticipated”.
• San Francisco Fed President John Williams: "the stock market rally still seems to be running very much on fumes… We are seeing… Excess risk-taking in the financial system with very low rates. As we move interest rates back to more normal, I think that people will pull back on that".


The IMF cut its 2017 U.S. GDP forecast to 2.1% from 2.3%, and its 2018 forecast to 2.1% from 2.5% previously. It said that it could no longer assume that the Trump administration will be able to deliver pledged tax cuts and higher infrastructure spending, citing that “we have removed the assumed fiscal stimulus from our forecast”. The IMF now assumes that U.S. GDP growth will begin declining in 2019, and will eventually fall to only 1.7% growth by 2022.
If we look at the following three charts, it is easy to see which one does not "fit in":

temp-post-image

In this chart we observe that economic conditions have been worsening since March, as the stock market climbed.

temp-post-image

In this chart, we observe how the bond market seems to be anticipating a recession, even as the stock market rises. The spread between the 2 year Treasury yield and the 10 year Treasury yield is getting narrower, or “flatter”, which is predicting a slowdown in the economy.

temp-post-image

In this chart, we observe how the Fed’s printing of money through quantitative easing has boosted asset prices in lockstep. The Fed is now winding down its stimulative policies, beginning in September of this year.
Complacency is at an all-time high in the stock market, at a time when stock valuations are nearing all-time highs as well. This chart takes S&P P/E ratios and compares them to the volatility index. As can be observed, this level has not been seen before in 25 years:

temp-post-image
(Source: Bloomberg, State Street)

Second quarter earnings are expected to rise by 7-9% overall within the S&P 500. The earnings season both in the U.S. and in Europe has been strong. There is no doubt that there has been an upswing in global growth, and 48% of the sales of S&P 500 companies are exports, which have seen a pickup in demand. The run up in stocks, however, may have been driven by the $1.1 trillion dollars’ worth of assets bought by the Federal Reserve this year. If the stock market is drunk on liquidity, beware the Fed taking away the punch bowl. Up to now, the Fed is, in a sense, still pursuing quantitative easing by replacing the bonds that they have bought when they mature, thus maintaining the size of their balance sheet. It currently owns $4.4 trillion worth of treasury and agency mortgage bonds.
Beginning in September, The Fed will begin gradually shrinking its balance sheet, starting at $10bn a month and rising in steps each quarter until reaching $50bn a month. This will represent a decrease in liquidity of $600 billion per year, until the Fed decides that its balance sheet is at the right level. The impact of this tightening will be felt globally. What’s more is that there is renewed speculation that the European Central Bank may be debating putting an end to its program of its asset purchases as well.


The dilemma Central banks face is that they have no ammunition if there is another recession. In the case of a bad recession, interest rates are typically cut by around 5% in order to “prime the pump” of the economy. If there were a recession now, there would only be room for 4 rate cuts of 25 basis points each, and certainly no room for more quantitative easing. The tightening of financial conditions that the Fed intends comes at a time when banks must boost their loss absorbing capital under banking regulations. This too will impact money creation in the global economy.

Grant Rogers

Global Disclaimer: This report has been prepared by Metis Capital Management LLC. This report is for distribution only under such circumstances as may be permitted by applicable law. It has no regard to the specific investment objectives, financial situation or particular needs of any specific recipient. It is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. No representation or warranty, either express or implied, is provided in relation to the accuracy, completeness or reliability of the information contained herein, nor is it intended to be a complete statement or summary of the securities, markets or developments referred to in the report. The report should not be regarded by recipients as a substitute for the exercise of their own judgment. Any opinions expressed in this report are subject to change without notice. The analysis contained herein is based on numerous assumptions. Different assumptions could result in materially different results. The analyst responsible for the preparation of this report may interact with trading desk personnel, sales personnel, other analysts, journalists, and other constituencies for the purpose of gathering, synthesizing and interpreting market information. Metis Capital Management LLC is under no obligation to update or keep current the information contained herein. The securities described herein may not be eligible for sale in all jurisdictions or to certain categories of investors. Options, derivative products and futures are not suitable for all investors, and trading in these instruments is considered risky. Mortgage and asset-backed securities may involve a high degree of risk and may be highly volatile in response to fluctuations in interest rates and other market conditions. Past performance is not necessarily indicative of future results. Foreign currency rates of exchange may adversely affect the value, price or income of any security or related instrument mentioned in this report. Metis Capital Management LLC accepts no liability for any loss or damage arising out of the use of all or any part of this report. Certain of the information contained in this presentation is based upon forward-looking statements, information and opinions, including descriptions of anticipated market changes and expectations of future activity. Metis believes that such statements, information, and opinions are based upon reasonable estimates and assumptions. However, forward-looking statements, information and opinions are inherently uncertain and actual events or results may differ materially from those reflected in the forward-looking statements. Therefore, undue reliance should not be placed on such forward-looking statements, information and opinions.

CONTACT US

keep in touch

METIS CAPITAL MANAGEMENT LLC

411 Theodore Fremd Avenue, Suite 206 South,
Rye, NY 10580
Phone. 914-315-6850

Click to Login to your account.

Click to Login to your account.