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":


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


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.


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:

(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

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