Fed Still on Gradual Normalization Course

The word “inflation” appears 106 times in the minutes of the latest FOMC meeting, held March 20-21 and released on April 11. By contrast, the word “unemployment” appears 45 times. Does this suggest that Fed officials are increasingly concerned about a rebound in inflationary pressures given that the jobless rate was at a cyclical low of 4.1% during March? There were still 6.6 million unemployed workers, according to the Bureau of Labor Statistics (BLS). However, the latest data, also from the BLS, showed that there were 6.1 million job openings during February. That implies that virtually all the remaining unemployment can be described as “frictional,” resulting from geographic and skills mismatches.

Actually, Fed officials have been rooting for inflation to rise to their 2.0% target for the yearly percent change in the personal consumption expenditures deflator. They first publicly announced this target at the start of 2012. Yet much to their chagrin, they have failed ever since then to boost inflation on a sustainable basis to 2.0% despite their ultra-easy monetary policies following the Great Recession.

Nevertheless, the FOMC started to normalize monetary policy, first by ending quantitative easing at the end of October 2014, then by gradually raising the federal funds rate in 25-basis-point baby steps—starting from around zero at the end of 2015 to 1.50%-1.75% at the March meeting.

They are likely to remain on this gradual course through next year, since the latest economic projections of the FOMC participants show median inflation expectations of 1.9% this year and 2.0% next year. Anticipating finally accomplishing their mission of hitting their inflation target, the committee’s median projections for the federal funds rate are 2.1% at the end of this year and 2.9% at the end of next year.

Financial markets started to fret about a more aggressive normalization of monetary policy on February 2, when January’s employment report showed a higher-than-expected 2.9% gain in wages, as measured by average hourly earnings for all workers. That’s a bit ironic given that during Janet Yellen’s first press conference as Fed chair during March 2014, she suggested that the Fed’s easing-does-it policies would bring wage inflation back up to a range of 3.0%-4.0%.

Four years later, following last month’s FOMC meeting, Fed Chair Jerome Powell signaled in his first press conference that monetary normalization would remain on a gradual course. March’s wage inflation rate eased to 2.7%. The minutes released last week sent a message to financial market participants to chill out about inflation.

The message seemed to be a response to the observation in the minutes that “a steep” albeit temporary “decline in equity prices and an associated rise in measures of volatility” resulted from market participants’ reaction to “incoming economic data released in early February—particularly data on average hourly earnings—as raising concerns about the prospects for higher inflation and higher interest rates.”

FOMC participants do expect that inflation will rise as “transitory” factors that had weighed on inflation last year dissipate this year. Furthermore, the stronger economic growth is expected to push inflation up toward the FOMC’s 2.0% objective, according to the minutes. But such an increase is not expected to change the FOMC’s gradual course of raising interest rates. Nor would a temporarily overshoot of the inflation target: “A few participants suggested that a modest inflation overshoot might help push up longer-term inflation expectations and anchor them at a level consistent with” the FOMC’s 2.0% objective.

If inflation should rise much faster than expected and stay consistently above 2.0%, however, then the FOMC might decide to raise rates at a “slightly” faster pace over the next few years. One risk to inflation discussed in the minutes could come from fiscal stimulus. Depending on the timing and magnitude of the effects of fiscal stimulus, it could push output above its potential and further tighten resource utilization.

Fed policy isn’t likely to veer much from the current course of normalization. President Donald Trump seemed to signal his endorsement of this course by promoting Fed Governor Powell to replace Yellen. The President just announced his intention to nominate Richard Clarida for the No. 2 position of Fed vice chairman. He is widely viewed as a solid economist, with experience in the financial industry. Trump also plans to nominate Kansas State Bank Commissioner Michelle Bowman as a Fed governor, representing the interests of community banks. Meanwhile, the Federal Reserve Bank of New York recently named John Williams as its next president. He had the same position at the Federal Reserve Bank of San Francisco. The new Fed team is shaping up to be one of pragmatic centrists with few, if any, obvious dissenters.

So far, Chairman Powell hasn’t been fazed by the volatility of the stock market. He and his colleagues could be thrown off course if inflation makes a major comeback. That would force them to raise interest rates faster and higher, which certainly would worsen the outlook for the federal deficit. That would push bond yields much higher and cause serious concerns for stock investors.

The key will be inflation. While Fed officials continue to believe that it is a monetary phenomenon, they may come around to recognize, and even to appreciate, that there are other forces such as global competition and technological innovations keeping a lid on inflation. If so, then the Fed’s current game plan will be realized. (For more on the Fed and inflation, see Chapter 9 in my new book, Predicting the Markets: A Professional Autobiography.)

Real GDP Growth: Hard To Get Back to Old Normal

In a 4/6 speech, newly appointed Fed Vice Chairman John Williams matter-of-factly stated: “Last year real gross domestic product, or GDP, increased 2.6 percent. This is a solid performance. Importantly, it’s above the trend growth rate, which I peg at about 1¾ percent.”

I was surprised by his comment that the trend in real GDP is only 1.75%. That certainly is at odds with the predictions of President Donald Trump and his supply-side advisers, who believe that their policies will boost real GDP growth up to the old normal of 3.0% and even 4.0%. I have been expecting more of the same, i.e., 2.0%-2.5%.

Williams referenced a 10/11/16 FRBSF Economic Letter titled “What Is the New Normal for U.S. Growth?” by John Fernald. Sure enough, the article starts by stating: “Estimates suggest the new normal for U.S. GDP growth has dropped to between 1½ and 1¾%, noticeably slower than the typical postwar pace.” The article explains the reasoning behind this lackluster outlook for real GDP as follows:

“This estimate is based on trends in demographics, education, and productivity. The aging and retirement of the baby boom generation is expected to hold down employment growth relative to population growth. Further, educational attainment has plateaued, reducing the contribution of labor quality to productivity growth. The slower forecast for overall GDP growth assumes that, apart from these effects, productivity growth is relatively normal, if modest—in line with its pace for most of the period since 1973.” Here’s more:

(1) Labor force growth. “[T]he population is now growing relatively slowly, and census projections expect that slow pace to continue. Second, these projections also suggest the working-age population will grow more slowly than the overall population, reflecting the aging of baby boomers. Of course, some of those older individuals will continue to work. Hence, the Congressional Budget Office (CBO) projects the labor force will grow about ½% per year … over the next decade—a little faster than the working-age population, but substantially slower than in the second half of the 20th century.”

(2) Productivity growth. The article is much more pessimistic (or perhaps realistic) about the outlook for productivity growth than are today’s supply-siders. Fernald concedes: “The major source of uncertainty about the future concerns productivity growth rather than demographics. Historically, changes in trend productivity growth have been unpredictable and large.” Nevertheless, he estimates that the new normal trend growth rate in real GDP is 1.6%, implying that productivity won’t grow much faster than 1.0%.

(3) Information technology. But won’t the IT revolution boost productivity? It hasn’t been doing so in recent years. Fernald observes: “Starting around 1995, productivity growth was again exceptional for eight or nine years. Considerable research highlighted how businesses throughout the economy used information technology (IT) to transform what and how they produced. After 2004, the low-hanging fruit of IT had been plucked.”

Again, he concedes: “Looking ahead, another wave of the IT revolution from machine learning and robots could boost productivity growth. ... But, until such a development occurs, the most likely outcome is a continuation of slow productivity growth.”

For more on technology and productivity, see Chapter 3 of my new book, Predicting the Markets: A Professional Autobiography.

Excerpt from Ed Yardeni’s New Book

Here, in summary, are a few of the lessons I have learned over the years from doing what I do:

(1) Be an investor, not a preacher. Investing isn’t a moral pursuit. It’s not about right or wrong, good or evil. It’s about bullish or bearish. In other words, don’t let your political views bias your investment decisions. Buy low, sell high, but invest for the long run, if you are young enough.

(2) Be an empiricist, not a dogmatist. Get to know the data before you come up with your theory. This helps to avoid the curse of faith-based, rather than fact-based, analysis. Recognize that there are lots of intellectual hucksters promoting their theories without ever letting the facts get in the way. When the facts suggest a scenario that you didn’t expect, be open-minded enough to recognize its import. Don’t let cognitive bias blind you to what’s really going on. Be willing to change what you believe if the facts warrant it. Staying wedded to constructs or ideas that have outlived their usefulness is a sure way to lose money.

(3) Be a policy wonk, not a critic. Don’t second-guess policymakers and expect them to change course just because you are convinced they are on the wrong one. However, as I learned along the way, pay close attention to new legislation that changes taxes or regulations. I wish I had paid more attention to the unintended consequences of some of the major laws that deregulated the financial industry.

(4) Be a lender, not a borrower. While we all know that Polonius said, “Neither a borrower nor a lender be,” there’s no evidence that Einstein said, “Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.” But it sounds like something he might have said. You can make a bundle of dough by borrowing money and buying stocks on margin. But you can also lose lots of money that way. If day trading isn’t your day job, succeed at what you do best and let dividend-yielding companies work their magic of compounding your return.

(5) Be revolutionary, not evolutionary. I’m not advocating that you conspire to overthrow the government. However, change happens, and sometimes it happens much faster than was widely anticipated or even perceived as it was happening. The end of the Cold War and China entering the World Trade Organization were revolutionary changes with major consequences for the global economy and financial markets. While such dramatic events might be infrequent, the revolutionary impact of technological innovation on our lives seems to be moving at a faster and faster pace.

(6) Be an optimist, not a pessimist. History shows that optimistic investment strategies tend to work better over time than pessimistic ones. Doomsdays occur from time to time, but they don’t last as long as the good times. If you are going to be bearish, try to be so when everyone is too bullish. Then when everything falls apart, you can say, “I told you so.” However, don’t forget to turn optimistic once everyone else is pessimistic. Remember: don’t worry, be happy, but stay informed!

For more, please see the book’s website and Amazon page.

Global Growth Fundamentals Remain Strong

Economies around the world continue to experience synchronized growth, as they have since the second half of 2016. However, there is some chatter going around about a slowdown in the global economy. I am not seeing it in the stats I follow. Consider the following:

(1) Global trade at record levels. I don’t expect a trade war. Global trade remains at a record high. I believe that countries have become too interdependent to resort to widespread prohibitive protective barriers. The volume of world exports rose 4.5% y/y to a record high during December 2017. The sum of inflation-adjusted US imports and exports closely tracks the global measure of world exports. It was up 3.0% y/y during January, edging down from December’s recent high. The growth rates of both measures have been running around 4.0% since late 2016, a significant improvement from the near-zero growth rates during late 2015 and early 2016.

Given the importance of China in world trade, I also note that the sum of Chinese imports and exports, in nominal terms, rose 19.3% y/y to a record high of 30.0 trillion yuan during February.

(2) Global M-PMI remains high. Some of the recent concerns about global growth focused on the decline in March’s global M-PMI to 53.4 from a recent high of 54.5 at the end of last year. The weakness was led by a drop in the M-PMI for advanced economies from 56.3 during January to 54.9 in March. However, the March readings for both the global and advanced M-PMIs remain solidly above 50.0.

The March levels for the US (59.3), Eurozone (56.6), the UK (55.1), and Japan (53.1) all were down from recent cyclical highs but solid nonetheless. The March M-PMIs for the major emerging economies were more muted for Russia (50.6), India (51.0), China (51.5), and Brazil (53.4). But again, they all exceeded 50.0. Keep in mind that PMIs are diffusion indexes. That means that if the current month was just as good as the previous month, the diffusion index will be around 50.0.

By the way, I've found that the sum of the US M-PMI sub-indexes for new export orders and imports is highly correlated with the growth rate of the volume of world exports on a y/y basis. The former rose to a record high of 123.3 during February and edged down to 118.4 in March. The US is experiencing a trade boom, with both real merchandise exports and imports in record-high territory. The problem is that the latter exceeds the former by $837 billion (saar).

(3) MSCI forward revenues moving higher. I’ve also found that we can track the global economy on a weekly basis using analysts’ consensus expectations for revenues over the next 52 weeks for the major MSCI stock price indexes. To derive these “forward revenues” series, I use a time-weighted average of analysts’ consensus expectations for the current year and the coming year. The current year has more weight than the coming year at the present time. By the middle of the year, they will be equally weighted. By year-end, forward revenues will be the same as the consensus expectations for 2019.

The broadest measure of forward revenues per share is the one for the All Country World MSCI (in local currencies). It dropped sharply from its record high during the summer of 2014 and bottomed in early 2016. That drop reflected the depressing impact of the plunge in oil prices on the world energy industry. Since then, oil prices have recovered but remain well below the levels of early 2014. The revenues measure also has recovered and has been rising in record-high territory this year. Industry analysts have been raising their global revenues estimates for both 2018 and 2019.

(4) NRRIs are in positive territory. I also track Net Revenues Revisions Indexes (NRRIs) for the major MSCI stock price indexes. Keep in mind that analysts have a tendency to be too optimistic, so it isn’t unusual to see NRRIs in negative territory even as the global economy is growing and stock prices are moving higher. The NRRI for the All Country World MSCI has been positive since February 2017, and increasingly so since late 2017. This measure of net revenues revisions was in negative territory every single month from July 2012 through January 2017!

Bullish Earnings Ahead

Spring started on March 20. Spring is Goldilocks’ favorite season because it is neither too cold nor too hot. Chauncey Gardiner, antihero of Jerzy Kosinski’s satirical novel Being There, also likes spring because that’s when his flowers and plants start to blossom and grow. In the movie version (“Being There,” 1979), Chauncey, played by Peter Sellers, is mistaken for an insightful economist with a penchant for gardening metaphors instead of the literally speaking gardener that he is. When asked by the President of the United States whether the government can stimulate economic growth with temporary incentives, Chauncey replies: “As long as the roots are not severed, all is well. And all will be well in the garden.” He explains that “growth has its seasons.” And “Yes, there will be growth in the spring!”

The President responds: “Hm. Well, Mr. Gardiner, I must admit that is one of the most refreshing and optimistic statements I’ve heard in a very, very long time. I admire your good, solid sense. That’s precisely what we lack on Capitol Hill.”

I presume that President Donald Trump is getting more informed economic advice than provided by Chauncey. He should be doing so now that my friend Larry Kudlow is in charge of the National Economic Council. Larry interviewed me about my book on Saturday, March 18:

“Welcome back folks, I’m Larry Kudlow, pleasure to be back with you. Old friend of mine, one of Wall Street’s absolute top number-one economic and investment strategy forecasters—he’s got a new book out—I’m talking about Dr. Ed Yardeni, president now of Yardeni Research (that’s yardeni.com), previously economist with Federal Reserve Bank of NY and the US Treasury. I want to say that Ed Yardeni and I were—I don’t know what we were—friendly rivals, but mostly friends. Down through the years—the 1980s, 1990s—there were three names at the top of the list of Institutional Investor’s All Star Team, going back. One was Ed Hyman, the other was Ed Yardeni, and the other one was a wacko named “Larry Kudlow,” so you are going to get some great stuff here. Ed has a new book, called “Predicting the Markets: A Professional Autobiography.”

I mentioned that I remain bullish on the stock market because the outlook is bullish for earnings. Previously, in the 3/14 Morning Briefing, I wrote:

“The Q4-2017 earnings season is over. Industry analysts received quite a bit of guidance on the positive impact of the corporate tax rate cut at the end of last year on earnings this year. There will be more to come during the Q1-2018 earnings season in April, which will provide more specific numbers showing how much the Tax Cut and Jobs Act (TCJA) boosted earnings during that quarter, and is likely to boost earnings over the rest of the year.

“In other words, I suspect that neither the analysts nor investors have fully discounted the big windfall the TCJA will provide to corporate bottom lines. That’s because corporate managements probably weren’t sure themselves about the full impact of the TCJA during their conference calls in January, which obviously focused on last year’s final results. So while many of them were giddy about the coming earnings boost in their calls with analysts and investors, they might actually have toned down their giddiness!” Let’s review the latest relevant data:

(1) Revenues for S&P 500/400/600. Industry analysts are expecting S&P 500 revenues to grow 6.8% this year and 4.6% next year. They are expecting S&P 400 revenues to grow 6.1% this year and 4.1% next year. For the S&P 600, they are predicting 6.5% in 2018 and 4.5% in 2019.

Forward revenues, the time-weighted average of consensus estimates for this year and next year, continue to move up in record-high territory for the S&P 500/400/600. On a y/y basis, forward revenues for the S&P 500/400/600 are up 8.0%, 11.9%, and 14.5% through the week of March 15.

(2) Revenues for S&P 500 sectors. Since the start of the data in 2006, forward revenues are at record highs for the following S&P 500 sectors: Consumer Discretionary (up 7.0% y/y), Consumer Staples (9.9%), Financials (8.8%), Health Care (7.4%), Industrials (8.5%), Information Technology (15.5%), Materials (11.3%), and Real Estate (2.7%).

(3) Net Revenues Revisions Indexes. March data are now available for our Net Revenues Revisions Indexes (NRRIs) for the S&P 500 and its 11 sectors over the past three months. NRRIs are positive for all sectors with the exception of Real Estate and Utilities. Here is the performance derby for the NRRIs: Industrials (22.5%), Materials (20.5), Financials (16.4), Health Care (16.2), Information Technology (16.1), Energy (16.1), S&P 500 (14.7), Consumer Discretionary (14.1), Consumer Staples (12.9), Telecommunication Services (3.6), Real Estate (-2.7), and Utilities (-13.1). At 14.4 during March, the S&P 500’s NRRI is at a record high, slightly exceeding the previous record high during May 2004.

(4) S&P 500 earnings. We will soon find out whether Q1-2018 earnings turned out to be even better than industry analysts expected after receiving guidance last quarterly earnings season on the positive impact of the TCJA on earnings this year. They certainly raised their 2018 earnings-per-share estimates sharply during the 14 weeks after the TCJA was enacted on December 22 through the week of March 22 for the S&P 500/400/600 by $11.58 (7.9%), $7.41 (7.2%), and $5.43 (11.6%). They now expect 2018 earnings for these three composites to grow 19.6%, 19.6%, and 23.6%.

(5) S&P 500 buybacks. S&P 500 buybacks data are now available through Q4-2017. I like to combine buybacks with dividends paid by the S&P 500 as a measure of corporate cash flow that is getting ploughed back into the stock market. I realize that not all dividends are reinvested in the stock market, but lots are reinvested, particularly by institutional investors.

The sum of buybacks and dividends last year was $938 billion. The four-quarter moving sum of this series has been hovering around $900 billion since 2014. Buybacks totaled $548 billion last year, continuing to hover around $500 billion since 2014. Dividends rose to another record high of $436 billion.

I expect that buybacks and dividends will continue to be bullish for the stock market. Both could get a lift from significant repatriated earnings from abroad resulting from the TCJA.