April 2017 – Monthly Commentary

April 2017

Last month the Commerce Department reported that the U.S. economy expanded at a 0.7% annualized rate, below consensus forecast of 1.0%.  Much was made in the media that such anemic growth is an indication that the economy is at risk of tipping into recession.  It seems like that proclamation is made this time every year.  At first glance the outcome was disappointing, but we caution readers not to place too much credence in the report for a number of reasons.  First, the initial report is an estimate that only captures a very small percentage of actual activity, with the balance based on assumptions.  Moreover, both the activity they have in hand and the activity that has yet to be tallied are subject to revisions.  Given the massive size of the U.S. economy, it takes a very long time to tally economic activity which means that GDP itself is revised numerous times before it is finalized.  Therefore, the first look at GDP is not much more than a hunch.

The second problem is the manner in which GDP is reported in the media.  The standard is sequentially, on an annualized basis.  That means that we’re comparing first quarter economic activity, which is usually dampened by cold, snowy weather with fourth quarter activity, which is packed full of holiday gift giving, entertaining, and feasting.  The two periods are not comparable from an economic perspective.  But, undeterred, the Commerce Department attempts to adjust the disparately differing periods by seasonally adjusting activity.  In essence they assume that economic activity is more robust in the first quarter than it actually is, then compare it to the fourth quarter.   That makes no sense whatsoever!  We think a more logical way of comparing the period is to compare activity to the same quarter of the previous year.  On that basis, Q1 GDP rose 1.9%, more than twice as fast the headline would suggest.

Looking past GDP, we have been pleasantly surprised by earnings for the first quarter.  Since the collapse in energy prices several years ago, aggregate earnings have been pulled lower as the bottom fell out of energy producer’s profits and the spillover effect that had on banks and lenders. At the time of this writing, 90% of companies in the S&P 500 have reported, and the average operating margin of the index has topped 10% for the first time since 2014.  Moreover, the percentage of companies beating their estimate was in excess of 73%, while the percentage of companies missing their estimate fell to 18.8%.  To be sure, CEO’s often play the game of low balling estimates so that they can claim a beat when they report.  Nonetheless, the estimated aggregated earnings, based on companies reporting to date is $28.09, up sharply from the $21.72 recorded in q1 2016.

On the back of the better than expected earnings and the S&P 500 setting all time record highs, the VIX index traded down to a level not seen since 2006.  The VIX is the weighted average implied volatility of a number of strike prices on the S&P 500 across several nearby expirations.  To clarify, implied volatility is a component of an option price that is an estimate of the annualized standard deviation of the underlying security.  In this case, the VIX is the implied volatility of the S&P 500.  Quite often the uninitiated refer to the VIX as the fear gauge.  While we are not fond of the term as it oversimplifies the information imbedded in implied volatility.  But in this current market environment we view the very low VIX as an indicator that investors are complacent about the downside risks to the stock market.  The message is that with the S&P 500 pushing to record highs and VIX trading close to record lows, now may be the time to protect portfolio gains with put options.

March 2017 – Monthly Commentary

March 2017

The Federal Reserve didn’t disappoint last month, delivering the third rate hike of this cycle, pushing the overnight Fed Funds rate to 0.90%.  However, at the post-meeting press conference Chair Yellen delivered a “wishy washy” assessment of the economy which did little to instill fear in the bond market.  In fact, instead of tightening policy, the move actually eased monetary conditions.  Since raising overnight rates on March 15th, prices of Treasury notes and bonds have risen on all maturities two years and longer.  Historically, a rate hike causes prices to fall.  Even more bizarre, on the afternoon of the announcement stock prices soared by nearly one percent.  Some dubbed the move a “buy the fact” short covering rally, which seems likely.  But, the rally fizzled as the Republican effort to repeal ObamaCare, a central tenant in President Trump’s campaign agenda, began to go awry.  The seemingly “half baked” Republican solution would cut government spending and many of the taxes associated with the current plan, but at the expense of millions of currently insured Americans.  In what had been thought to be a “slam dunk” for the President became an embarrassment as the Republicans were forced to withdraw the legislation.  Ironically, it was the conservative Republican bloc known as the Freedom Caucus that torpedoed the legislation.  Given the failure to amend ObamaCare and his inability to implement the much touted travel ban, investors have begun to question Trump’s ability to successfully reform the tax code.  The President would like to lower Corporate and personal tax rates, and lower taxes on repatriation of foreign-earned revenue.  The thought is that by cutting corporate taxes, business would see more revenue fall to the bottom line, and the anticipation of that added revenue has been one of the catalysts for the sharp rise in equity prices since the election.   With the probability of Trump tax reform being called into question, investors have been taking profits on what is arguably an overvalued stock market.  However, continued favorable economic data offset some of that worry, resulting in a roughly unchanged S&P 500 for the month.  As we begin earnings season anew, we anticipate that investors will scrutinize results closely to ascertain if the lofty price/earnings multiples are warranted.

Now that the Federal Reserve has begun to normalize interest rates in earnest, the next question is when the committee will begin to normalize their inflated balance sheet.  Prior to the crisis, their portfolio of Treasury and Mortgage-Backed notes and bonds was less than $800 Billion.  That amount has ballooned to $4.5 trillion since 2008.  As the Fed takes in proceeds from coupons and the repayment of maturing issues that it owns, the Fed’s open market desk reinvests those proceeds back into the market.  Historically, when the Fed wanted to raise interest rates, they did so by selling an amount of their Treasury holding into the market until supply and demand of overnight reserves rebalanced at their targeted interest rate.  In this rate cycle the Fed has changed the methodology.  Rather than selling securities and forcing the market to reprice, the Fed accomplishes the rate hike by crowding borrowers out.  We’ve previously written about the Fed’s Reverse Repurchase (RRP) facility, a program in which the Fed pays qualified institutional lenders an interest rate equal to the lower bound of the 25 basis point Fed Funds range.  After the latest rate hike, that rate stands at 0.75%.  Without that facility, the Fed would be helpless at raising interest rates given the vast amounts of liquid reserves in the system.  The U.S. T-Bill market is not large enough to absorb the liquidity and if the Fed simply suggested that they would like to see rates higher, nothing would happen.  However, now that the Fed is paying 75 basis points for a risk free U.S. Government investment, the risk free investor is incentivized to sell T-Bills and invest in the higher yielding Fed RRP.  Problem solved?  At least in the short term!  Longer term, however there are two problems.  First, the goal of raising rates is to drain the excess supply of money from the system.  The RRP operation doesn’t touch reserves so excess reserves are allowed to continue sloshing around in the system, keeping borrowing costs low and encouraging excess risk taking.  Secondly, in paying interest on reserves, the Fed incurs a cost and that cost rises as they raise rates.  All of this argues that the Fed should begin to normalize their balance sheet or, at the very least, end the reinvestment of coupons and maturities.  They have begun to publicly discuss doing exactly that, but the question remains as to whether they will have the temerity to act?