Confidence is up, but will it lift the economy higher?

Looking at performance of the stock market over the last 12 months, one might assume that the economy is exploding upward. The rise has been driven mostly by a boost in consumer sentiment, which has taken off since the U.S. elections in November.

In 2017, consumer sentiment hit its highest level in more than 10 years!

Consumers represent 70 percent of the U.S. economy. Their confidence is crucial to future growth. Business spending is much smaller, but it is also much more volatile. So, when businesses are increasing their spending, the economy really has potential to move up. The good news is that optimism is also up for business executives.

Confidence data is nothing more than opinion polls. This is why they are referred to as soft data. Hard data represents real action. Typically, these go hand-in-hand: A change in one leads to a corresponding change in the other.

After inflation, consumer spending is up, but just by 2.8 percent.
The trend in the hard data does not match that of the soft data. The Federal Reserve does not seem concerned.

The Fed raised rates last December and March. Expectations are nearly 100 percent that it will raise them again in June–despite first quarter economic growth of 0.7 percent.

How does one reconcile the gap between opinion polls and actual improvement? What is likely to happen?

The U.S. economy is still improving. Unemployment is down to 4.4 percent. Corporate profits are up. Energy prices are down. Finally, global growth appears to be entering its first synchronized period of growth in two decades. According to BlackRock, European earnings are up nearly 20 percent in the last year.

Add to this good news the potential for positive surprises and it becomes more clear why a glass-is-half-full perspective is better.

  • Soft data could finally lift hard data
  • Increased global trade will help U.S. companies
  • Wages should rise with tight labor market
  • Deregulation could create more opportunities
  • Corporate tax reform may boost profits
  • Infrastructure spending could boost productivity

Any one of these surprises could help convert optimism into action. The timing is the greatest uncertainty, but that is no reason to be overly concerned. With so many positive economic changes occurring in the world right now, we believe there are plenty of opportunities
in 2017.

 

*Data from the Federal Reserve Bank of St. Louis. The S&P 500 index often represents the U.S. stock market. One cannot invest directly in an index. Investing involves risk, including potential loss of principal. The opinions and forecasts expressed are those of the author and may not actually come to pass. This information is subject to change at any time, based on market and other conditions, and should not be construed as a recommendation of any specific security or investment plan. SFS is not affiliated with any companies mentioned in this commentary.

2017 Predictions

Market movement since Election Day has been massive and investors see this as confirmation of just how good Republicans are going to be for the economy. How could so many investors be wrong? Actually, fairly easily.

Right or wrong, investors should be careful not to get carried away. There is a high amount of uncertainty and no way to know what the future will bring.

(1) Trump Rally
The big move in stocks in November and December has been an acceleration of the positive momentum already taking place in the economy. It has been characteristic of many presidential election years with a good economy.

It is completely normal to get excited, but don’t let it lead to overconfidence. Few things last forever and most years have their ups and downs.

It is not unusual to see inauguration day (Friday, January 20, 2017) mark a change for investors as they realize the new president does not have a magic wand.

(2) Dow 20K
The Dow stock index has been flirting with 20,000. It just could not quite get there in 2016. In 2017, I believe it will! And it will likely cross that mark many times.

The first time the Dow reached 10,000 came in March of 1999. Over the next 11 years, it crossed that level on 34 days until it surpassed it a final time in the summer of 2010.

It’s hard to fight gravity and it’s hard to turn a large ship. There is so much positive momentum right now that I expect it to continue. Unemployment is falling. Wages are rising. Confidence is climbing.

One unknown is the impact of policy changes on global trade, which may decline this year as the United States turns its focus inward.

(3) Fed Does Its Job
The Federal Reserve is likely to “take away the punch bowl just as the party is getting started.”

For two consecutive years I have accurately predicted that the Fed would be more cautious than its own forecast. This year, I am accepting the Fed’s forecast that it will raise rates 3 times in 2017.

Of course, no one knows with certainty because with each rate hike, I expect investors will become more concerned.

2016 Review

“If you want to see the sunshine you have to weather the storm.” In its first 3 weeks, 2016 delivered investors more than a 10 percent loss–the worst start in 80 years. Our natural human instinct at such moments is to feel that it will continue, but predicting the markets is extremely difficult.

In a dramatic turnaround, the U.S. stock market rose in February and March–recording the best recovery in 83 years.

(1) Fed will move slowly. The Federal Reserve planned to raise rates 4 times in 2016. This aggressive forecast in combination with falling oil prices spooked investors. Then came the uncertainty of Brexit and the U.S. elections. By year end, the Fed raised rates just once (in December).

(2) Election years are not recession years. I expected the economy to grow and for the market to continue to rise as our bull market entered its 8th year.

This positive outlook proved beneficial in the early days of 2016 when the resolve of many investors was tested. The market turned positive and remained there for most of the year.

(3) United States grows and the dollar slows. A strong U.S. dollar is not as good as it sounds. Sure, it’s great for Americans traveling overseas, but it presents challenges for large U.S. companies and investors.

The year began with too much strength: From July 2014 to January 2016, our dollar rose against every major currency around the globe! It gained 20 percent versus the euro and 54 percent versus the Russian ruble!

Fortunately, the U.S. dollar spent 9 of the last 12 months below January 2016 levels. That gave investors more opportunity as we invested globally.

This international diversification helped a great deal until a great divide formed in November.

These investments have taken a break as U.S. stocks rose in November, but I believe the worldwide economy still looks positive and may offer benefits to investors again in 2017.

The Virtuous Cycle of Rising Prices

Imagine waking up tomorrow to discover gasoline prices have dropped in half. What if milk, eggs, and all your groceries cost less as well? Suddenly, your money would be worth more. Sounds great, right? It wouldn’t take long for the heavy weight of reality to hit you.

Consider how knowledge of tomorrow’s pricing might affect today’s behavior. Assuming no shortages, we would be crazy to buy today what would cost less in 24 hours. While falling prices (deflation) sound nice on the surface, they can have disastrous consequences.

Deflation's Destruction

Deflation has been present in most economic depressions in history, including the Great Depression. The initial causes may include productivity increases, oversupply of goods, or scarcity of money.
A rise in productivity has been occurring for centuries with greater education and technology. In fact, a U.S. worker today, on average, can produce twice as much as a worker in 1975 and 50 percent more than a worker in 1995! Outsourcing to cheaper foreign labor has a similar effect on productivity as technology.

Supply of goods fluctuates, especially with food and energy. For example, a drought in 2012 led to a rise in grain prices like corn, which made feed cattle more expensive in 2013, which led to higher dairy and beef prices in 2014 (see Price Changes table).

Price Changes

Scarcity of money is where the U.S. Federal Reserve (Fed) comes in. The Fed encourages low unemployment and low inflation by managing the money supply.

The Fed cannot control the weather in the Midwest, extract more oil from Saudi Arabia, or raise the minimum wage in China. But the Fed will do everything it can to avoid deflation. Since 2008, it has spent over three trillion dollars to stabilize falling prices.

Rising prices are normal in a healthy economy. The 50 year average for inflation is 4.1 percent. This reasonable rate encourages spending and creates a virtuous cycle of economic growth (see Inflation’s Value graphic).

Inflation's Value

All the current numbers in this cycle are good, but below average. Over the last twelve months inflation has been 1.7 percent, wage increases averaged 2.8 percent, and consumer spending grew 3.6 percent.
The most recent U.S. growth rate showed an increase of 4.2 percent. That is a great number. If it is followed by another increase in another category like wages the growth cycle could pick up speed. The result could help the current bull market continue.

Definitions

Escape Velocity: What Will Fuel Our Economic Breakout?

Escape Velocity is simply the speed required to escape gravity’s pull. An object on earth’s surface would need an initial speed of 6.96 miles per second (Mach 34) to get out of the gravitational range of the planet.

As we continue to recover from the 2008 recession the question looms; “What will it take to escape the unseen gravitational pull of what is called the new normal economy?”

Slow economic growth has given Americans a feeling that the economy is destined to grow at 1 to 2 percent. The decades-long average prior to the 2008 recession was 3 to 4 percent.

Liftoff

Let us be clear. This article focuses on the economy, not the stock market. The market as measured by the S&P 500 formed a bottom 5 years ago. That index has reached around 50 all-time highs in the last 12 months. From January 1, 2009 to January 1, 2014 the S&P 500 went up over 100 percent.

Should it bother investors that the market has been making new highs? No, making new highs is normal for American stocks. Should we worry that five years is too long for a bull market? No, it is a healthy sign to have long periods of growth interrupted by smaller drops.

The question is “How long can the bull market in stocks last if the new normal continues?” Furthermore, what kind of rocket fuel will propel this economy beyond its current trajectory?

As the Federal Reserve stimulus winds down, something else will have to take its place. The U.S. economy needs to transition from a government-induced to a consumer-driven expansion.

Can consumers afford to spend any more? It has taken a long time, but unemployment levels are getting closer to pre-recession levels (currently 6.7 percent). Household debt payments are at an all time low as a percent of income, which is also really good. Unfortunately, the average income of American households is one economic measure showing no improvement over the last 5 years.

Household income may be the most important ingredient to current growth. It may improve soon. As unemployment numbers get stronger, the labor market will tighten. Employers will raise pay for their workers. When that begins to happen in the U.S. workforce, consumers will finally have more spending power to propel the economy.

While stock returns have been great in recent years, they cannot rise forever without better economic growth. The gravitational pull of the new normal is just too strong. Keep an eye on improving income in the United States. It may fuel the next breakout.

As the Sochi Olympics ended, many eyes turned to the other side of the Black Sea and the threat of war in Ukraine. With each successive turn of good or bad events, our U.S. stock markets1 seem to react in like manner. That begs the question, what impact do wars have on stock markets, and how should an individual react?

To see the impact of war, let’s first examine the most recent war that started on American soil. The impression that many people have is that the recession of the early 2000s started with the terror attacks on September 11, 2001. The reality is that stocks were already on a downward trend when September 11th happened. Yes stocks dropped sharply in the 10 days following that awful event, but once America grasped the reality of the situation, stocks rebounded, recovering the losses directly related to the shock of that event.2

There is a similar pattern for each conflict involving the United States. “In 14 shocks dating (back) to the attack on Pearl Harbor in December 1941, the median one-day decline has been 2.4%. The shocks, which also include the September 11th terror attacks and the 1962 Cuban missile crisis, lasted eight days, with total losses of 7.4%…The market recouped its losses 14 days later.”3

Similar patterns of decline occurred during several Middle Eastern conflicts such as Desert Storm in 1991, the Iraq War in 2003, and the Syrian Conflict in 2011. Leading up to each of these events, the market dropped, but recovery happened shortly thereafter.4
Mark Luschini, the Chief Investment Strategist for Janney Montgomery, put it this way, “It’s not that it’s welcome, but once it gets underway, you can quantify what the situation might look like. When you’re left in the dark about when it will start, what will be the result, it gives investors trepidation.”5

Short-term shocks to the system cause short-term consequences for the stock market and the economy. On the other hand, major periods of conflict can have more lasting effects on the economy and the stock market.

One of the most harmful economic effects of war is a supply shock. A major shock in the supply of goods or labor can severely impact economic productivity. Sources of these setbacks include economic sanctions, manufacturing destruction, infrastructure damage, etc. This has not been a factor of major concern within the United States as it has been a long time since there has been a war fought on American soil.

Public opinion supports the belief that war and its associated spending creates positive economic outcomes for the U.S. economy. This is mostly due to the higher GDP growth that was exhibited during conflict periods like World War II, the Korean War, the Vietnam War, and the Cold War. The only outliers have been the Iraq and the Afghanistan wars.6

8 Million

While war tends to generate some positive economic benefits, it is more of a mixed bag for stock markets. “During WWII stock markets did initially fall but recovered before its end, during the Korean War there were no major corrections while during the Vietnam War and afterwards stock markets remained flat from the end of 1964 until 1982.”7

Another typical impact of major conflicts is inflation. This is due to the increase in government spending through various financing methods. “While inflation may be good for reducing debt burdens, high inflation has many harmful effects, such as wealth redistribution and erosion of international competitiveness.”8

Short-term conflicts typically have a short-lived impact on the stock market. As such they shouldn’t change an individual’s investment philosophy or cause one to “abandon ship.”

A more prolonged conflict may cause an individual to take a more judicious approach by reevaluating his or her goals and making adjustments based on the current market environment. As always, it is prudent to seek advice from an experienced investment professional that can help you plan for and navigate your own voyage through our uncertain world.

*Research by SFS. Data is from the Federal Reserve Bank of St. Louis. Investing involves risk, including potential loss of principal. The S&P 500 index is often considered to represent the U.S. market. One cannot invest directly in an index Past performance does not guarantee future results. The opinions and forecasts expressed are those of the author and may not actually come to pass. This information is subject to change at any time, based on market and other conditions, and should not be construed as a recommendation of any specific security or investment plan.

The Federal Reserve Will Soon End its Easy Money Stimulus

When Lehman Brothers collapsed in 2008, all lending essential stopped. The U.S. Federal Reserve (Fed) feared that all five investment banks in this country would cease to exist. No one fully understood the financial calamity coming, but we were beginning to feel what the worst recession in 80 years would be like.

The Fed acted to stop the financial infrastructure from imploding. It believed cushioning the blow was necessary to help all Americans. It started the Troubled Asset Relief Program (TARP). It added to that program over the years with Quantitative Easing (QE) one, two, and three.

Recent years may not have felt like easy money to us, but there is likely no organization more profitable in recent years than the Fed.

The Fed doesn’t literally print money (a responsibility of the U.S. Treasury). It doesn’t have to. Money is created electronically by the Fed and infused into the financial system through open market actions. Its effectiveness is questionable. Its impact is global. And at some time soon it may be ending.

What Is the Fed’s Impact?

Currently, the Fed is spending roughly $85 billion each month to buy treasury bonds in order to keep long term interest rates at historically low levels. The goal is to encourage risk taking. The Fed wants banks to lend, businesses to hire, and consumers to borrow.

If you have purchased a home, refinanced a loan, or bought a car with debt, then you have benefited from these unprecedented efforts of the Fed.

All this money the Fed is creating seems to be working to a small degree. The U.S. stock market* is on track for its fourth positive year in the last five. If you have invested in stocks or bonds consistently during this time, you have probably benefited from the Fed’s actions. Experts have been debating how well the Fed’s historic efforts have worked. One theory is that each time the Fed spends, it has less positive impact than the previous effort. This would explain the lackluster growth in the economy.

Why Is the Fed Still Involved?

Simply stated, the benefits still appear to outweigh the risks.

Low interest rates are meant to be enablers for businesses and consumers to increase borrowing. If the debt gets out of hand, then we will be facing similar problems to those that got us into this mess.

If spending and demand increase too much, then inflation could rise to levels considered too high for a developed economy (greater than 4 percent). At that point, the Fed will have to react to try to slow down the economy even if it means job losses.

At this point, official inflation is tame and private debt levels do not appear inflated like in 2007.

As long as the risks appear low and unemployment is above 7 percent, the Fed is likely to keep spending.

What Will Happen When the Fed Slows Stimulus?

Interest rates will rise from the unusual levels where they currently are to a more natural rate determined by investors. We experienced a taste of what this will feel like this spring and summer. Rates on the 10 year treasury almost doubled in just a few months. Investors saw an increase in volatility.

Where Is the Silver Lining?

Don’t fight the Fed is a common phrase for investors. The Fed is powerful and it is working for what it believes is best for Americans. It plans to cut stimulus only after it determines that the U.S. economy is strong. If rates rise that should bring better yields for savers.