February 2, 2018

Stocks closed mixed yesterday in a volatile session. The market will have a lot to digest this morning after big earnings reports last night from Apple#, Amazon, and Alphabet#, as well as earnings this morning from oil giants Exxon Mobil# and Chevron#. In addition, we will be getting a big employment report prior to the market opening. While early predictions suggest a robust gain in jobs, market watchers will be more focused on the rate of growth in wages, looking for signs of rising inflationary pressures.

Markets turned volatile this week. While a lot of reasons have been given, one common one has been rising concern about inflation and the course the Federal Reserve might take under new Chairman Jerome Powell. While Mr. Powell has indicated that he is comfortable with the course laid out by his predecessor, Janet Yellen (i.e. about three 25 basis point increases in the Federal Funds rate in 2018), that presumes the economy follows the Fed’s predicted course. Fed policy passed an inflection point over the past two years as it began to raise rates for the first time since the Great Recession, stopped its bond buying program, and subsequently allowed some maturing bonds to mature without replacing them. Thus, the process of slowly reducing the size of the balance sheet has begun. Other developed nations may begin to follow suit this year. It is widely suspected that the ECB will begin to taper or end its bond buying program by the end of 2018. Japan might wait a bit longer, but policy there is less clear.

Historically, markets have exhibited heightened uncertainty as the Federal Reserve changed policy when the Chair position changed. Despite some of the headlines in the business media pointing to heightened inflation concerns, the 10-year Treasury yield has remained in a very narrow range of 2.70-2.80% all week after rising a few ticks yesterday. Sure, a narrow trading range certainly doesn’t correlate to several 1-2% intraday moves.

I think there are other forces at work. First, investors who deferred taking profits in taxable accounts stepped back during the first three weeks of 2018 as the market went straight up. Once that phase ended, and it certainly did last week, profit taking increased. While volatility rose, markets remained relatively calm. Early morning selling never gathered much momentum and we haven’t seen cascading rushes to sell into the close that we often see in more frightened market environments. If, however, there is a sudden jump in the rate of wage increases this morning, that could all change.

Since the passage of the bill to reduce corporate taxes, the stock market has surged higher. Clearly corporations are to be the primary beneficiaries of the new law. The impact will be a big positive to earnings. Since stocks react to higher earnings, the increase in prices over the past 3 months isn’t an unexplained anomaly. The hope of President Trump and his supporters is that not only will the new law lower taxes, it will also stimulate more consumption and more investment. In one word, that would imply more growth. But as I have noted frequently, there is little data that suggests a big tax cut leads to big changes in overall economic growth. While few would dispute the idea that there will be at least some increment to growth in the short run,
there are also risks of higher deficits, higher inflation, and higher interest rates. Should the economy grow too fast, the Fed might be forced to step on the brake and slow the economy, a move that would be harmful to stocks. Clearly, today the ultimate outcome is more conjecture than fact.

But let me introduce some related facts and thoughts. First, during Janet Yellen’s four years as head of the Fed, our economy created an average net new jobs each month of about 209,000. No matter how much fiscal and monetary stimulus might be added from here, it is almost impossible to duplicate that over the next four years. An increase of 75,000 or a bit more is sufficient to keep the unemployment rate steady. Were 209,000 jobs per month to be created over the next four years, the implied unemployment rate would be close to 3%, maybe even a touch lower. Note that more baby boomers are now leaving the work force than entering. Thus, a shrinking, almost fully employed workforce would have to create a massive amount of jobs. It simply isn’t going to happen that way.

In addition, yesterday the government released fourth quarter productivity statistics. Productivity declined 0.6% in the fourth quarter and rose just 1.2% over the past year. The 1.2% increase is about average for the last five years. Over time, the tax cuts could trigger a major increase in corporate investment activity that could move the needle, but it takes time to turn the investments into productive assets. Thus, even under the best of circumstances, productivity improvements will come slowly and incrementally.

The bottom line is that we may be in for a repeat of last year. From Trump’s election in the fall of 2016 until mid-February, markets went into explosive rally mode. The stock market spiked, yields soared, and the dollar strengthened. Then reality began to creep in. Bond yields retreated after inflation was a no show. Trump had early problems getting anything passed by Congress. The dollar began to weaken. Stocks still rose, but mostly because of falling inflation expectations and the impact of the weak dollar. Earnings beat expectations by a bit, but not enough to cause the explosion in stock prices that we witnessed in 2017.

The tax cuts reignited animal spirits and we once again had a strong rally from November 2017 into January. But now that stock prices have adjusted to the impact of the tax cuts, it is time for a reality check once again. To grow 3%, much less the 4-5% the President likes to talk about, productivity has to improve. If growth on that order were to happen, it is hard to see how it might happen without inflation rising faster than expected. That would set off a more aggressive stance by the Federal Reserve and higher interest rates all along the curve. Thus, even real fast growth might be concerning. Somewhere in the middle is a fine line of just slightly faster growth that fails to ignite inflationary pressures. No wonder markets are starting to get a bit nervous.

We will see higher earnings this year and they should be good all year long. Yields are starting to elevate and that will compromise the gains that come from higher earnings. No one yet knows which force is greater, the thrust from higher earnings or the headwinds created by higher rates. I suspect that battle will take quite a few months or even longer to play out. Unless the markets form conclusions, volatility could be elevated. Today’s employment report may give a few hints as to both the direction of the economy and the path of inflation. That is why it could be so important.

Today, Christie Brinkley is 64.

James M. Meyer, CFA 610-260-2220

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# – This security is owned by the author of this report or accounts under his management at Tower Bridge Advisors.

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