Sep 11, 2017

Economic Outlook September 2017

Federal Reserve Monetary Policy
The Federal Reserve is expected to begin shrinking their balance sheet when they meet September 20. This means the Fed will begin selling U.S. Treasury and agency bonds (or not repurchasing maturing bonds) that they acquired over the last nine years under the quantitative easing monetary policy, which was designed to stimulate the economy. Shrinking the balance sheet is another way of reducing liquidity in the economy similar to increasing the Fed Fund rate, which currently stands at 1.25 percent after four rate increases since December 2015. The initial reduction rate is expected to be about $6 billion per month.

The year-over-year inflation rate for July, the latest data available, was 1.7 percent – 0.1 percent lower than we expected. We don’t expect to see much deviation from this level when the August rate is announced Sept. 14.

Economic Activity
The economy grew at a 3 percent annualized rate in the second quarter this year. It was welcome news considering economic growth had been moving along at 2 to 2.5 percent for quite some time. It is too early to tell if the growth rate is sustainable. However, natural disaster recovery can boost the economy, much like government fiscal spending, so there may be a couple of quarters of good economic growth.

The labor force participation rate has stabilized around 63 percent. Total employment in the U.S. has reached 153 million people. Just before the start of the financial crisis, 146 million people were employed in the U.S. If we would return to a labor force participation rate of 66 percent, 160 million people would be employed, which would help support a sustainable 3 percent economic growth rate.

There’s always another side to the story when it comes to economics. Some not-so-good news:
  • Tax reform and fiscal spending expected by the markets have been delayed.
  • Tension with North Korea does not appear to be ending.
  • The Federal debt ceiling does not have a long-term solution, and state officials have mismanaged their pension promises almost as poorly as the federal government has mismanaged the Social Security program.
  • Consumer debt is at record-high levels.
  • The economy has had a run of growth that exceeds historical averages, but the market lacks economic models to accurately project the next downturn.

Fixed Income
If you purchase a two-year U.S. Treasury bond today, you would have an interest rate of 1.31 percent. If you buy a 10-year U.S. Treasury bond, you would earn 2.1 percent interest. The additional yield is not much incentive to buy longer bonds. Now consider the inflation rate (a measure of the rate a dollar’s purchasing power declines.) Deducting the 1.7 percent inflation rate from the interest yield on the two-year bond leaves you going backward with a real return of -0.39 percent. The real return on the 10-year bond is slightly positive at 0.40 percent. Of course, that is before taxes. After considering a 30 percent income-tax rate, you go backward at a rate of -0.23 percent on the 10-year bond.

At this point, you may wonder why anyone would invest in fixed income at all. The answer is principal preservation and diversification. Yes, the value of fixed income holdings go up and down in market value independent of interest payments, but the historical fluctuation is only a small portion compared to prospective stock fluctuation.

Stock Market
Over the last 12 months, Google earned $28.03 per share. With Google stock currently priced at $941, the company’s earnings were 3 percent of its stock price. At the same time, Amazon earned $4.03 per share. With Amazon stock currently priced at $965, the company’s earnings were 0.42 percent of the stock price. Another stock market darling, Netflix, earned $0.84 over the last year. Based on Netflix stock price of $174, the company earned 0.48 percent of its stock price, and yet the market rewarded it with 79 percent 12-month stock market appreciation.

By way of comparison, Ford earned $0.95 over the last 12 months, which was 8.3 percent of its stock price, currently trading at $11.36. This level of earnings is nearly three times the best ratio in the previous paragraph, but Ford saw a 4 percent market decline over the last 12 months. General Electric earned 3.3 percent of its stock price – about the same as Google. GE’s stock went down 18 percent over the last year compared to Google, which was up 18 percent. To complete the picture, Amazon’s paltry earnings were rewarded with 25 percent market appreciation over the last year.

Why do investors pay significantly more for earnings of one company compared to another? Should a stock’s price ultimately be supported by earnings? Call us old-fashioned, but we believe the answer is yes. The return on the S&P 500 through the end of August this year was 11.93 percent. The same 500 stocks giving each stock equal representation in the S&P 500 had a return of 8.76 percent. The same list of companies had a return gap of 3.17 percent because of capitalization weighting.

The discrepancy gets even wider if you are a disciplined investor looking to capture broader exposure to the stock market. The S&P 400 mid cap index is up 5.28 percent through the end of August this year, and the S&P 600 small cap index is up only 1.11 percent.

For 2016, the returns looked like this:
S&P 500 10.90 percent
S&P 500 E/W 14.01 percent
S&P 400 19.49 percent
S&P 600 24.78 percent

So far, the 2017 return structure is the complete opposite. In fact, over the last 10 years, the S&P 500 is the worst-performing index in the group.

Proper portfolio allocation often captures a broad cross-section of the market in its pursuit of meeting each investor’s investment, risk and income goals. Short-term progress can be quite different from longer-term perspectives.

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View previous Economic Outlook newsletters.