The Time Has Come

by Shawn Narancich, CFAExecutive Vice President of Research

Awaiting Lift-Off

Following last week’s solid jobs report, a clear plurality of investors now expect the Federal Reserve to raise short-term interest rates next week. But once the Fed has achieved lift-off, what then? Amid ongoing dollar strength and falling energy prices, corporate profits have stagnated this year and economic growth remains pedestrian, causing concern about more of the same in 2016, but with less monetary accommodation along the way. We expect the path of Fed rate tightening to be gradual because inflation remains nearly non-existent. Even excluding food and fuel prices, so called “core inflation” also remains notably below the Fed’s 2 percent objective.

Mission Partly Accomplished

What we do have, and what is leading to the end of zero interest rate policy, is a state of relatively full employment. Although the labor force participation rate remains near decade low levels, the Fed rightfully sees its full employment mandate as having been achieved. In turn, we have seen stirrings of labor cost inflation, both statistically and anecdotally. The employment cost index is finally nearing 3 percent after having spent a prolonged stretch below that mark. Real life examples include fast food restaurants like McDonald’s and retailers Wal-Mart and TJ Maxx having to boost wage rates to keep employees; the degree to which labor inflation takes hold more broadly will be important to gauge, as this combined with the productivity of labor determine what we believe to be the single most enduring predictor of consumer price inflation – unit labor costs.  Perhaps because of muted levels of capital spending later in the economic cycle, workers’ productivity has proven to be disappointing in recent quarters, increasing upward risk to this key measure. As the Yellen Fed achieves lift-off from zero percent interest rates, it will be closely tracking its labor force dashboard in helping to determine how fast and how high rates ultimately go.

OPEC Laissez-Faire

OPEC finished its latest and much anticipated meeting in Austria last Friday much like we expected, acceding to the current level of the 12-member cartel’s production, but apparently not making any plans to accommodate additional liftings from Iran once UN sanctions are lifted, as expected sometime early next year. While some thought OPEC would cut production, this outcome never seemed likely. Lead producer Saudi Arabia’s strategy has come into focus – keep oil prices low enough, long enough, to accommodate its recapture of market share and stimulate enough additional demand to tighten oil markets naturally. In essence, the cartel has ceased to act as one. By all accounts, the meeting was highly contentious and unusually long, the result of discord that saw members Venezuela, Nigeria and Ecuador argue unsuccessfully for reduced liftings.

Black Gold?

Oil prices fell on the news last Friday and have proceeded to breach late August support levels of $40/barrel. Not helping oil bulls’ cause is news this week that Iraqi production gains have boosted OPEC production to fresh three-year highs in November at the same time the El Nino weather phenomenon has warmed the Northern Hemisphere and squelched early season demand for heating oil, an important seasonal product of crude oil. These headwinds notwithstanding, we maintain our belief that oil markets will tighten as U.S. production continues to roll over, non-OPEC, ex-U.S. production stagnates, and oil demand again grows at a faster than anticipated clip. Barring a market share war within OPEC (one that would be fought with limited means given how little excess production capacity the cartel has), Saudi’s de facto strategy appears destined to succeed. We see modest levels of oversupply morphing into undersupply as 2016 progresses. After all, the following adage holds – the best cure for low oil prices is low oil prices.

Our Takeaways from the Week

• The long awaited Fed lift-off from zero interest rate policy is at hand
• Oil prices have fallen anew in the aftermath of OPEC’s highly anticipated meeting last week

Disclosures

Slow Ride

by Brad Houle, CFA Executive Vice President

I had a terrible first car - a 1978 Honda Wagon. It came equipped with vinyl seats, a manual choke, AM Radio and was a shade of brown that resembled a very well-worn Buster Brown shoe from that time. Growing up in Montana, the 1978 Honda wagon also did not like to start in below zero weather. It required stomping on the gas several times and pulling out the manual choke as far as it would go. The Wagon had all of 60 horsepower which made driving up a hill or passing another car a tenuous endeavor and frequently required putting the gas pedal all the way to the floor. There was no difference in the Honda's power if the pedal was depressed completely to the floor versus let off a little. The same could be said for the Federal funds rate being effectively zero or .25 percent. There is not much difference in the impact on economic growth.

On Thursday, the Federal Reserve left the Fed funds rate unchanged, citing global growth concerns. Ultimately, this move seems to be more about the messaging to the markets rather than actually being impactful to economic growth. The Fed does not want to further upset the applecart given recent volatility in world markets by appearing too hawkish and therefore causing financial market participants to fear the Fed will tighten too aggressively.

The Fed funds rate is important as it is one of the tools the Federal Reserve has to stimulate or slow down the economy. Should there be an external shock that requires intervention, with short term interest rates at or near zero, the Federal Reserve has no "dry powder" to stimulate the economy. As such, the Federal Reserve is highly motivated to normalize interest rate policy to allow more flexibility should a crisis arise that requires them coming to the rescue.

With all the hand wringing around when the first rate hike since 2006 will occur, it is also important to remember that a rate increase is good news. It means that the economy is strong enough that the Federal Reserve wants to make certain that it does not get overheated. The labor market has finally healed from the financial crisis and our economy continues to grow.

Our Takeaways for the Week:

• Domestically our consumption driven economy is doing well with a strong labor market and inflation that is well in hand.
• Internationally, the economic uncertainty in China and resulting turbulence in emerging markets has caused the Fed to remain on hold

Disclosures

Come Together

by Ralph Cole, CFA Executive Vice President of Research

Late last year we had a great chart that showed the Fed’s own expectations for tightening were ahead of the markets’ expectations for Fed tightening. We explained that as those two outlooks moved toward one another there would be volatility. On this past Wednesday, we experienced the positive aspect of that volatility.

Fed officials concluded two days of meetings in Washington and issued a statement regarding the economy and interest rates. While many were focused on the language used by the Fed, we were more focused on the Fed governors’ expectations for short-term interest rates in the coming year and the lowering of the theoretical “full employment rate”.

As part of Federal Open Market Committee (FOMC) meetings, each of the Fed Governors plots what they expect the Fed Funds rate to be at the end of 2015, 2016 and 2017. This chart has been referred to as “The Dot Chart”. The median expectations of the governors for Fed Funds at the end of 2015 actually came down from 1.125 percent to .625 percent. This means that the Fed Governors still expect to raise rates in 2015 (which we expect as well), but just not as quickly as they previously expected. This is more in line with what the market was hoping for; thus it was met with both a stock and bond market rally.

Untold Stories

Unemployment has been one of the most controversial topics of this economic expansion. The unemployment rate steadily moved down from 10 percent in 2009 to 5.5 percent in February. This rapid decline stood at odds with what many people felt they were experiencing in their own lives, and what was anecdotally highlighted in the media as well. What makes this more than a theoretical conversation is the unemployment rate’s effect on wages.

The most recent Federal Reserve study on employment came to the conclusion that the “full employment rate” for the U.S. economy was approximately 5.4 percent. The belief being that at 5.4 percent unemployment wages would start to rise or even accelerate. In the Fed’s statement today, they lowered the theoretical full employment rate for the United States to between 5.0 percent and 5.2 percent. Because we have not seen wages increase up to this point, they concluded that a lower level of employment would be needed to begin to pressure wages higher. This conclusion fits perfectly with the expectations of Fed Governors that the Fed Funds rate would not be increasing as much as previously expected. One company of note is Target, which announced this Thursday that they would be increasing wages for employees to at least $9/hour in April.

Takeaways for the Week:

• The Fed continues to signal that they will be raising rates later this year, but at a pace that agrees with the markets’ assessment of our economic situation
• Future Fed meetings and communications will cause increased volatility in the market

Disclosures

Onward and Upward

by Shawn Narancich, CFA Executive Vice President of Research

Investors attempted to divine the future of U.S. monetary policy following this week’s Fed meeting and watched with wide eyes as Alibaba became the largest ever U.S. IPO. For investment bankers underwriting shares of Alibaba, the timing of this $22 billion offering couldn’t have been better as U.S. stocks remain well bid amidst record levels of corporate profits and low inflation. Do record levels for U.S. stock prices and a feeding frenzy for the newly traded shares of Alibaba (trading up 36 percent in its debut) indicate speculation and excess, or is the S&P 500 at over 2,000 simply a marker on the path to further gains? Judging by the amount of retail investor cash on the sidelines and what appears to be an accelerating rate of economic growth domestically, we believe that equity valuations are reasonable. Our call is for stocks to track rising earnings and outperform bonds as the Fed pares its program of QE and ultimately starts raising interest rates next year.

Fed Semantics

All of which brings us to the details surrounding Yellen & Co.’s Fed meeting this week. Investors expected QE to be trimmed again, but the question for many investors surrounded the language with which Yellen would describe the timeframe between QE termination and the onset of rate increases. Juxtaposed against another benign inflation reading reported earlier this week (1.7 percent on the CPI), considerable time was retained as the Fed’s operative phrase. And why not? Commodity prices are dropping thanks to the stronger dollar and weaker growth from China, while unit labor costs are well contained at +2 percent. Recognizing that the Fed operates under a dual mandate to limit inflation to 2 percent and promote full employment, the error of estimate seems to be lower in deciding how fast the Fed raises interest rates, acknowledging that the 6.1 percent level of unemployment most likely overstates the degree of labor market tightness because labor force participation is so low. So is the market for Fed Funds futures correct in undershooting the FOMC committee’s collective prediction that short-term rates will rise to 1 3/8 percent by the end of next year? Only time will tell, but we believe that the Fed remains dependent on the tenor of incoming economic data to determine how fast rates will normalize.

Approaching Quarter End

With the Fed meeting behind us, a spattering of odd lot earnings reports this week from the disparate ranks of Fed Ex (good numbers, stock up), General Mills (bad numbers, stock down), and Oracle (disappointing numbers, stock down) has investors beginning to consider what could become of the next earnings parade that will start in just a few short weeks. We see puts and takes. Inasmuch as the U.S. economy is outperforming other regions at the same time the trade-weighted dollar has surged, U.S.-centric companies stand a better chance of meeting and/or exceeding estimates. In contrast, larger multi-nationals could struggle with currency translation and economic headwinds from a moribund European economy and slowing growth in China.

Our Takeaways from the Week

• Stocks remain well bid as investors come to grips with the prospects for Fed tightening next year

• Third quarter earnings season is right around the corner amidst currency headwinds for multi-national corporations

Disclosures

Motion Simulating Progress

by Ralph Cole, CFA Executive Vice President of Research

Talk, Talk, Talk

It seems that every time you turn around, the Fed is trying to communicate information to the capital markets or to Congress. This week, Janet Yellen made a trip to Congress to speak to the Joint Economic Committee where she gave a very balanced view of the economy and of possible future Fed actions.

Chairwoman Yellen said that the U.S. economy paused in the first quarter, but appeared to be gaining steam in the current quarter. This view dovetails perfectly with our own views at Ferguson Wellman. The questions from Congressional members centered on job growth, unemployment and the labor participation rate. As we watch testimony of this type, it is interesting to observe the new Fed Chair sidestep the clearly partisan questions and get to the heart of what the Fed is tasked to do and what duties are tasked to Congress. This inculcation occurs every time the Fed Chair is invited to give testimony. The Fed has a dual mandate ― maximum employment and stable prices. This slower than usual recovery has placed an increased focus on employment, and what the definition of “full” employment actually is. Congress and the markets want to identify the exact unemployment rate at which the Fed will begin raising rates, which we think is foolhardy. The Fed Chairwoman explained the importance of not reading too much into any one data series, and any one data point. Rather, it will depend on a number of factors.

Here in our office we are turning our focus toward wage-related inflation. Increasing wages are often a precursor to overall inflation for the economy, and just like the Fed, we will be looking for acceleration at the margin for a number of indicators, not any one indicator.

What’s Going On

What has surprised us has been the movement of rates going lower in the face of better growth. Many explanations have been floating around and we suspect it is a combination of slower growth in the first quarter of the year and low rates around the world, making the yield on the 10-Year U.S. Treasury look appealing. We continue to believe that an improving labor market and positive GDP growth will move rates higher in the coming months.

Our Takeaways from the Week

• While Chairwoman Yellen is adept at dealing with Congress, we hope that the Fed can reduce their commentary in the future which we believe will reduce overall volatility in the fixed income markets
• Strong first quarter earnings for the S&P 500 continue to support higher stock prices in the future

Disclosures

Sympathy for the Weatherman

by Ralph Cole, CFA Executive Vice President of Research

Sweater Weather

As economic and market forecasters, we have a great deal in common with meteorologists. We know forecasting daily moves in the stock market is a fools game, but that over longer  time horizons, our forecasting accuracy improves greatly. Weathermen face the difficult task during snow storms of forecasting snowfalls and temperatures minute-to-minute, and hour-to-hour – to which we say... “No thanks!”

The East Coast has been battered by several snow storms over the past month, and this has had a negative impact on high frequency economic data. The reason that this has such a large effect on government data is because the Northeast megalopolis that spans from Washington D.C. to Boston is responsible for 20 percent of the nation's GDP. Largely due to poor weather conditions, retail sales in the month of January were down .4 percent. Similarly, industrial production also came in weak for the month of January, down 1.4 percent.

We believe the current slight weakness in economic data is a blip on the Doppler radar, and economic growth should accelerate as, literally, the snow thaws.

Welcome to the Jungle

One of Janet Yellen’s first duties as Federal Reserve Chairwoman was the semi-annual report to Congress. Timing of the report was helpful to both Congress and the markets because both senate and house leaders are trying to determine and understand the likely pace of tapering to expect in 2014. More specifically, what indicators will the Fed be relying upon, and are there any hard and fast rules governing the pace of tapering? As any good Fed Chairwoman would do, Janet left answers to all of those questions up in the air. Yes, she would like to continue tapering at this pace, but she is not tied to a $10 billion monthly reduction. Yes the Fed will be monitoring the unemployment rate, but it is not the only indicator they will be considering.

Despite the lack of specifics in her answers, the Fed Chairwoman’s performance was received very positively by the markets and as of this posting the S&P 500 was up 2.4 percent for the week.

Takeaways for the Week

• Despite several weak near-term economic statistics, the economy continues to expand at a reasonable pace
• The new Fed Chairwoman assured Congress and the markets that she will be a steady hand at the helm of the Fed

Disclosures

Reeling in the New Year

by Jason Norris, CFA Senior Vice President of Research

With 2013 coming to a close, one of the most frequent questions we have received is, “What’s the encore?”  The S&P 500 rose over 32 percent, the best return since 1997. Will 2014 result in profit taking or will there be continued follow through as investors deploy their cash?

A year ago, investors were looking at a lot of uncertainty with the pending government sequestration, increasing taxes (as you recall, the payroll tax was increased to 6.2 percent), as well as international questions with Europe and a possible slowdown in China. Those fears, at least by market perception, were put to bed as the Federal Reserve continued to hold interest rates down with their bond buying program. As the U.S. economy showed steady gains and the Fed signaled the end to quantitative easing, investors chased stocks higher and exited bond positions. In the last six months of 2013, over $175 billion left bond mutual funds but only $75 billion found its way into equity funds. We believe there is still a lot of cash to be deployed in 2014.

Against the Wind

2014 will be the advent of the Janet Yellen tenure at the Fed, a mid-term election, as well as the conclusion of QE3. We continue see slow improvement in economic data for the U.S. economy. Unemployment claims are trending lower (after a volatile month due to the holidays). Manufacturing data remains healthy, as reflected by this week’s PMI reading of 57 (a score of 50 or above signals strength). The U.S. consumer remained engaged into the end of the year as retail sales rose over four percent (primarily driven by double digit on line sales growth). Finally, the housing market is improving with prices rising and inventories falling.

What could derail the expansion? Rising rates. As the Fed unwinds its bond buying, we believe rates will continue to trend higher. Will these higher rates be a meaningful headwind to growth and equity returns? We don’t believe so. However, we will be monitoring closely.

Back for More

This brings us back to the first question: what does 2014 have in store after such a strong 2013? Looking at historic returns, equities revert to their averages. Since 1928, there have been 17 periods when stocks returned over 30 percent. The following year, equities averaged an 11 percent return and were positive two-thirds of the time (in line with historic annual returns). Therefore, this year, equity returns are going to be contingent on corporate profit growth and market valuation, which we believe are both constructive.

We hope you all have a healthy and prosperous 2014 and we look forward to seeing our clients and friends at one of our many Investment Outlook presentations over the next six weeks.

Our Takeaways for the Week:

• The retail investor remains skeptical of equities
• The U.S. economy continues to show steady improvement

 Disclosures