Powering down the Fed’s bond buying engine.

We trust you’ve had a restful and enjoyable summer.

This was a difficult hurricane season for many of our fellow Americans, especially those in Puerto Rico and across the South. A number of category 4 and 5 hurricanes made landfall in the US, causing enormous damage in Puerto Rico, Houston, Florida and the Virgin Islands. Several Caribbean islands have suffered almost complete devastation. Aside from the enormous human toll exacted by the loss of lives and homes, the hurricanes have also impacted US industry. Several sectors were impacted, including tourism, oil and pharmaceuticals (Puerto Rico is home to several pharmaceutical plants). Many hourly workers missed work for days or weeks, affecting their earnings. The impact is visible in the September jobs report, which shows a loss of 33,000 jobs.

This loss breaks a consecutive streak of 83 months of employment gains, stretching back to 2010. Markets largely shrugged off the terrible jobs report due to these effects, which are believed to be temporary. We expect October’s report will be skewed in the other direction as many workers head back to work.

Taking a longer term view, it seems clear that man-made climate change leads to warmer ocean and air temperatures. These conditions produce larger, more destructive storms which arrive with greater regularity. In the West, we have seen a series of destructive forest fires this year. Climate change has also expanded the range of invasive insect species which have killed off large stands of trees in our forests. Under hot, drought conditions brought on by global warming, these dead trees become kindling for forest fires. Our changing climate will pose major issues for insurers/re-insurers and local governments, particularly in flood and drought-prone areas. Communities will have to review zoning regulations in the face of these fires and storms. The cost of adaptation and recovery will be high, and doubtless some communities will be unable to recover fully.

The Fed has signaled it will treat the September jobs report as an outlier and stick with its plan to normalize monetary policy. This is almost certain to include one more interest rate hike before year end, likely in December. The Fed has also indicated it will proceed with its plan to reduce its 4.5 Trillion dollar holdings in bonds. These were purchased between 2008 and 2014 as part of the “quantitative easing” program, in an effort to stabilize financial markets. Based on its published plans, we expect the balance sheet to shrink by 250 Billion in 2018 and up to 400 Billion in 2019 and subsequent years, depending on economic conditions. These are substantial numbers, and we expect them to maintain steady upward pressure on interest rates across the maturity curve. We expect Janet Yellen will be replaced as Fed Chair when her term ends at the end of Jan 2018. This raises critical questions about the Trump administration’s ability to nominate and confirm a candidate who is credible and seen as independent of political pressure.

Stock markets continued their upwards drift, hitting new highs this quarter. These moves were supported by steady economic numbers, including GDP and employment. Corporate earnings have also remained steady, though insurance sector earnings are expected to be down significantly in the third quarter. Gains have been led by the technology and financial services sectors, which have grown to become the largest components in the S&P500. Both sectors are cyclical, and in our view a long expansion and the increasing ubiquity of technology has driven some of these stocks to unsustainable levels.

The market seems to have largely ignored Washington, tuning out several dramatic weeks in Congress as major legislation to transform health-care, infrastructure and deregulation have stalled or collapsed. A Republican effort to pass a tax reform bill is still underway, but it looks increasingly unlikely that this effort will pass either. The tax reform package proposed has not been scored by the CBO, but most analysis indicates it will add to the deficit. The proposal includes several modifications to deductions and tax brackets. Overall, its impact would be to reduce the tax burden on the very wealthiest of Americans, and shift some of those charges on the poorest and on Americans earning less than 400k a year. The scale of the proposal, the major uncertainties involved, and the haphazard manner in which it was developed lower the chances of passage. We do not believe the tax reform proposal will be enacted in its current form. At best, we believe the administration may be able to pass a severely watered-down bill.

Looking ahead to the end of the year, we expect equities markets to largely ignore Washington DC, unless the administration managers to pass significant legislation. The prospect of interest rate hikes and the Fed’s plans to shrink its balance sheet are likely to exert downward pressure on stocks. We continue to maintain our defensive positioning, with lower than average allocations to higher-risk assets like stocks and long-term or high-yield bonds.

 

Regards,

 

Subir Grewal, CFA, CFP                           Louis Berger