September 22, 2017

Stocks slipped yesterday as the Dow broke a 9-session winning streak. Some simply attributed the decline to profit taking. Others linked it to Wednesday’s well advertised decision to begin to reduce the size of its balance sheet.

The Fed isn’t about to sell any securities. Simply allowing maturing debt issues to roll off without replacing them will accomplish the task. Initially, for three months, the Fed will allow $10 billion per month to roll off. That is a pace that will hardly be noticeable within a market measured in the trillions of dollars. The pace will pick up to $20 billion per month in the first quarter of 2018 and ultimately reach a $50 billion monthly rate next October. At least that is the plan du jour subject to change. At that rate, $300 billion will roll off in the first year and $600 billion in subsequent years. Therefore, it will take more than 2 years to reduce the balance sheet to $3 trillion and roughly 3 years to get down to $2.5 trillion, a target size most feel is a reasonable long-term level. Simply said, this is going to be a long process. Furthermore, to think the game plan isn’t going to change at some point over the next three years is probably a stretch of one’s imagination.

But it is clear, whatever pace you think is right, the Fed has begun to tighten. Just to look back, between rate cuts and balance sheet increases, the Fed was in an expansion mode into the fall of 2015 when it stopped deliberately expanding its balance sheet. It executed one short-term rate increase of 25 basis points in December 2015, but essentially stayed put until late 2016 when it initiated a second increase. We have seen two more this year and the odds are about 50:50 that a third is coming in December. Now the Fed is on a course to begin normalizing the size of its balance sheet. Any time a central bank raises rates and/or reduces the size of its balance sheet, observers correctly label the process as tightening. But there is a difference between slowing down by stepping on the brake and slowing by applying less pressure to the accelerator. The key question isn’t whether the Fed is tightening or not; the key is whether Fed policy is incentivizing borrowing or not. With inflation around 2%, less if you ignore gasoline price hikes and more if you include them, a Fed Funds rate of about 1% clearly is still well below where interest rates would logically be without central bank intervention. In English, that means the Fed still is stimulating more borrowing. If rates were pressed to much higher levels, the increased costs to borrow would cause a reduction in investment. The Fed chooses that route when it views an overheated economy. We are nowhere near there at the moment. Thus, the Fed still has its foot on the gas but not with the same pressure as a year ago. At least until the Fed Funds rate matches or exceeds the core rate of inflation, that will remain the case.

In the past, many have suggested that rising stock prices, as well as rising asset prices for other financial assets, can be directly linked to expansionary Fed policy. But, as I noted above, over the past year plus the Fed has slowly raised rates and kept the size of its balance sheet constant. Yet, as it exited quantitative easing, the process of an aggressive monetary policy, gains in asset prices accelerated.

There are two explanations for this. First, while the Fed stopped expansion, other central banks not only continued but accelerated their programs. Thus, on a worldwide basis, easy money continued and it is likely to continue on a combined basis for at least another year even as the Fed starts the process of balance sheet reduction and keeps raising rates at a measured pace. Second, growth around the world has accelerated. That has helped corporate earnings, the key driver of stock prices, to increase well above expectations.

The Fed program announced on Wednesday won’t change that overnight. But clearly when the world’s largest central bank starts to move forward at a more measured pace, one needs to take notice. In time, higher interest rates here should support a stronger dollar. The dollar isn’t going to turn around overnight, but I suspect most of its weakness is now history. For a while in 2017, growth both in Europe and in emerging markets was greater than in the U.S. But currency fluctuations balance growth. Countries with weak currencies experience a rise in exports while countries with strong currencies see exports contract. The process doesn’t happen overnight, but it is inevitable. When German car companies start to see exports falter you can count on a lot of talk bemoaning an overvalued euro. It’s as certain as night and day.

The bottom line is that over the next few years, the tailwind of central bank easing will gradually diminish. That doesn’t mean asset prices have to fall but it does mean the pace of gain, at best, is likely to be slower.

Let me end today with a few quick thoughts.

North Korea – The name calling gets louder and scarier but we don’t seem to be in a different place today than a few weeks ago. North Korea sees its ability to be a nuclear power as a deterrent to direct U.S. aggression. Economic sanctions will clearly cause pain and North Korea is clearly a thorn in the side of China. But China doesn’t want a destabilized North Korea nor does it want a unified Korea on its border politically aligned with the West. Therefore, its ability or willingness to support us is limited. This is a problem that isn’t going away but, short of all- out war, it isn’t one with major investment implications.

The iPhone8 comes out today – Reviews have been tepid in part because the iPhone8 is simply an evolutionary upgrade of the 7. The phones over the last several years all have the same look and feel. Essentially, the only differences are modestly better processors each year and modestly better cameras. The reason to replace a phone has more to do now, and from now on, with how well one’s old phone is working than on the features of the new phone. But the iPhoneX, coming in November, is evolutionary. In the Apple world, new evolutionary products normally have their warts in first editions. We won’t know what those warts are for a while. But Apple will fix them and, ultimately, the X will be the vision of the phone of tomorrow. Buttons and keyboards will become less important. Voice, video and biometrics will become more important. New technology may look easy but it isn’t. The new watch has some issues and, undoubtedly, so will the new phone. Price isn’t one of the problems. If the phone lives up to its promise, Apple lovers will pay up. Count on it. We are in the period of uncertainty for the moment where demand for the old-style phone logically is a bit tepid and the new phone is still several weeks away. Rush to judgment will probably yield the wrong answers. Stay tuned. This is still an unfinished saga.

Today, Scott Baio is 57. Andrea Bocelli is 59. Debby Boone (remember her?) turns 61.

James M. Meyer, CFA 610-260-2220

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