Aug 6, 2018

Economic Outlook August 2018

In this month's Economic Outlook, Chief Investment Officer Greg Sweeney gives perspectives on Federal Reserve policies, expectations for interest rates and inflation, and what's going on in national and global markets.

Federal Reserve Monetary Policy

The Federal funds rate remains at 2 percent. The market expects it to increase another 25 basis points to 2.25 percent at the September 26 meeting. The concern is the Fed will raise interest rates at the expense of inverting the yield curve. (An inverted yield curve is where short-term interest rates are higher than longer-term interest rates.) We feel the Fed has its sights on reaching a Fed funds rate that is equal to or a bit above the headline inflation rate. A Fed funds rate below the inflation rate is considered “free money,” since inflation erodes the purchasing power of a dollar at a faster rate than the interest rate charged on money borrowed at the Fed funds rate.

Inflation

The most recent year-over-year inflation rate is 2.9 percent. Look for inflation to hit 3 percent when the information is released August 10. We expect this to be the peak in the inflation rate for the next couple of months. Inflation is expected to spike higher, but reality continues to defy that expectation.

Economic Activity

Growth in the second quarter of this year was 4.2 percent, which supports continued economic growth. Looking at regions around the globe, we see some industrial activity in Europe and Asia slowing down, while the U.S. continues to report solid gains. Capacity utilization in the U.S. has risen nicely from 75 percent in November 2016 to 78 percent today, and there is still room for it to move higher without becoming a source of inflation.

The Fed is raising interest rates and reversing its quantitative easing programs, thereby reducing the monetary policy boosts these programs provided to the economy in the past. Tax cuts are a form of fiscal policy aimed at boosting the economy, and they seem to be gaining influence in replacing the effects of monetary policy as those programs are removed.

Payroll gains have averaged 215,000 people a month in 2018. Companies are still looking for employees, and unemployment claims are the lowest they have been since 1970. Wage growth has been tame.

Fixed Income

The “term premium” is the extra yield intended to compensate investors for the uncertainty of investing money in longer-term maturity bonds. The term premium between 2-year Treasury bonds and 10-year Treasury bonds is only 32 basis points, or 0.32 percent. This is the market’s way of indicating there is not very much uncertainty about the future. In other words, the market does not expect inflation outside of a reasonable range or longer-term interest rates to move meaningfully higher.

In addition to a low-term premium, we see bond volatility at the lowest level in many years. This also supports the idea that investors are comfortable with current bond market levels.

Real yields (the yield left after adjusting for inflation) on bonds remain a challenge. At current interest rates, the 10-year Treasury bond yield barely keeps pace with inflation, making its real yield close to zero.

Stock Market

As the second-quarter earnings season advances, 85 percent of the companies reporting have beaten the earnings estimates expected by analysts. This is the highest portion of earnings-beating estimates in a very long time. It is odd that these favorable results fail to support further increases in the stock market as the earnings have been announced.

Fidelity announced that it will offer two stock index funds that have zero management fees. With the proliferation of passive investing (where investors put investment dollars in an index regardless of the valuations of each stock included in the index), we are beginning to wonder if individual company valuations play a diminishing role in the world of investing as they become overwhelmed by cash flow from passive strategies.

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View previous Economic Outlook newsletters.