The Schwab EXPLORE® conference is one of my favorite annual professional conferences of the year, even though it is a very small venue of about 100 – 125 of their largest clients. There are several reasons I enjoy and gain value from this annual event such as, quality one-on-one time with Schwab’s Chief Investment Strategist and longtime friend Liz Ann Sonders, and several years friend, Chief Global Investment Strategist, Jeffrey Kleintop, in addition to Schwab’s top management. The event also allows for time to share ideas with top peers in the industry, but foremost is the one-on-one time with the guest speakers.
This year we were honored to have Dr. Janet Yellen, former Chairperson of the Federal Reserve and the first woman to hold this position. In my opinion, it is one of the most complicated and impactful jobs in the world, and you might imagine she must be a strong, deliberate, aloof deep thinker. Especially considering what it takes to run a 15 to 19-person committee, (it is a 19-person committee with 4 vacancies) of extremely educated, intelligent and ‘opinionated’ people. Like herding cats, one might guess.
Quite surprisingly, the Janet Yellen I met was one of the most gracious, calm, soft, and pleasant people I have had the pleasure to meet. She wanted to know about you and what was going on with your family. She may be 5’3”, but she is 7’ tall in my eyes.
She said that while there was usually great consensus within the Fed, when asked to put forth ideas, there could be some extreme opinions. In certain situations, she viewed the committee as a group of interior decorators deciding what color to paint a room. When one or two of them might put forth kelly green or hot pink, she would try to show them the merits of off-white. She drove consensus and helped them relinquish their outlier opinions.
Dr. Yellen spoke about how well the country is doing economically. When she started in 2014, unemployment was at 6.7% and Fed Funds were 0%. Currently, we are experiencing the best labor market in 20 years, and she feels the 3.8% unemployment rate is actually ‘pretty real’ and not affected much by the Labor Participation Rate, dual jobs, retirees working, etc. The Fed has been concerned about the low rate, low inflation environment persisting for an extensive period, like in Japan, but she was not concerned. She had confidence in the stimulus being successful, hoped to stop the asset purchases (which were as high as $3.5-Trillion), and because so many things are priced off it, tried to get the 10-year treasury down from 3.4%.
Dr. Yellen felt that the market suffered an avoidable set-back due to Dr. Bernanke’s poor communication skills, which led to the Taper Tantrum and the market falling 6%. When he announced that we would be cutting back asset purchases, the market acted surprised and rates shot up because the market misinterpreted it to mean we were also going to raise short-term rates. One of Dr. Yellen’s legacies will be that she drove transparency at the fed, which her successor Dr. Powell is continuing, by having live meetings.
“We should expect “gradual” rate increases, and will err on the side of letting inflation overshoot Fed targets, which is notable.”
– Dr. Janet Yellen
At the last Federal Open Market Committee meeting, 2 of the 15 members slightly changed their view regarding rate increases. One member changed their prediction from 3 rate increases to 4 in 2018, while the other member changed from 2 to 3 rate increases in 2018. The standard among the members is 4 rate increases in 2018. In addition, they increased their growth projections slightly and inflation projection by 0.10%. There is still a possibility of a 4th rate increase this year, (we just had our 2nd increase raising Fed Funds to 1.75% – 2.00% and slightly less for excess fund deposits) and at the time of this writing, I understand Goldman Sachs has increased their view to be 4 or 5 rate increases this year.
“The committee sees additional improvements in unemployment, which could be down to 3.5% by next year, which is well below normal and would lead to a slightly more restrictive monetary policy.”
– Dr. Janet Yellen
The target Fed Funds rate is 3.4% by, or for 2020, which implies 5 or more rate increases.
Four or more rate increases in 2018 will start to become a headwind and slow things down, which is what they want if growth and inflation continue on their current trajectories.
We all agree that different countries around the world are in various stages of repair, with the U.S. leading due to the dramatic monetary actions we have taken. Dr. Yellen believes the EU will start raising rates soon, but not Japan. She is concerned that the breakdown in trust among allies could drag the market down, and most of the investment community agrees. Dr. Yellen also opines that tariffs are inflationary and result in tighter monetary policy, reduced capital spending and suspended business plans. The extent of the tariff talks is minor at this point, but could become much worse. Inflation is currently at 2.1%, and monetary policy will get more restrictive if the economy overheats. Troubling, is that when Dr. Powell was asked what the Fed will do if trade breaks down, his response was “not sure”.
What is concerning to us and Dr. Yellen is that government debt has soared over the last 10 years. And with debt service barely manageable to unmanageable at the current ultra-low rates, debt service will soar with rising rates. When asked if rising rates could be positive for the markets since it is indicative of an improving economy, Dr. Yellen said she stated that when announcing QE-3 as a positive and Dr. Powell reiterated the same on June 13th. She also stated that “we need immigration to grow”, which accounted for 0.5% of our labor growth.
Liz Ann Sonders, Chief Investment Strategist
Liz Ann Sonders sees liquidity shrinking and believes it’s time to start considering risk management. While both the markets and U.S. economy continue looking positive, she sees the runway looking shorter, like LaGuardia, versus Denver (our meeting was in Vail). Leading Economic Indicators (LEI) are showing no real stress, (typically 13 months prior to a downturn), and indicate forward growing GDP, but not necessarily for the S&P. LEI’s are good predictors of GDP, but not necessarily the stock market (we tell our clients ad nauseum that the market and the economy are two different things and often do not move together). She is also concerned about the skills gap, because the top issue for corporations is finding qualified labor to fill job openings.
She finds some value in monitoring the Underlying Inflation Gauge (“UIG” is a measure of inflation that was just introduced in September 2017 so it is not widely followed), which is a complementary inflation measure to CPI, and is useful, as it helps to detect turning points in inflation trends. However, according to several articles, it is more useful in detecting inflation trend changes, where in the past practitioners generally just used “core” CPI or PCE.
We have shifted from a market driven by monetary policy (low rates), to one now driven by fiscal policy, (tax rates and tariffs, etc.), which clearly affects the markets and leads to rotations. Like Dr. Yellen and ourselves, our uncontrollable debt, which is the fastest rising debt in the world, is Liz Ann’s biggest concern, since it lowers productivity and growth and causes inflation. She is also slightly concerned that we may have exaggerated the earnings growth from the tax reform and she also pointed out that the average market drop in mid-term election years is 17%, but typically springs back.
Jeffrey Kleintop, Chief Global Investment Strategist
Jeff shared that 185 of the 189 foreign economies are improving and he believes we recently experienced a correction, not the beginning of a Bear market. He sees the risk of recession as “low” because the gap between inflation and unemployment is only about 1.4% and the gap is positive for most countries, and many are getting close to overheating.
Jeff looks at the relationship of the 3-month Treasury and the 10-year Treasury, (in terms of when the yield curve inverts), as a recession indicator, whereas, it is more common to look at the 2-year and 10-year Treasuries. His research suggests that most often, recessions occur 6 to 14 months after the yield curve inverts, (when the 3-month rate gets higher than the 10-year rate), which is abnormal, and typically about 3 months before the stock markets fall.
He feels that we have market risk in the intermediate term, with Protectionism/Tariffs having the potential for problems, but mostly ‘noise’ in the short-term. He is bullish on Emerging Markets and as banks eventually adopt a more restrictive monetary policy, he prefers large foreign companies over small. You will find that we agree with most of these positions as they are conveyed in our monthly newsletter.
Ian Bremmer: Political Scientist & Author
Ian Bremmer is a specialist in U.S. foreign policy, states in transition, global political risk, meets regularly with foreign heads of state, and has a world of insight into China and European leaders.
He pointed out that most of us thought China would have to reform politically to gain more global acceptance as it begins to open its stock market, which only accounts for 2% of world stocks, and tries to integrate with global banking, etc. Yet they just named their president “president for life”! However, Ian thinks it is a good thing, because he felt they were on a path to fail.
China is currently building ports and major rail lines, which benefits the entire world. Within 10 years China will surpass the United States as the world’s largest economy, but there are several things that could go wrong. As they try to move to a middle-income country, there is potential for large corporate debt, environmental and cyber security problems, to name a few. In China, the government is responsible for monitoring & maintaining all data. Through another source, I know that they are implanting chips in certain factory workers to monitor fatigue, performance and other data.
The Chinese are very strategic and will be targeting tariffs on ‘Red States ‘to affect our politics. Bremmer believes that 30 days after the Chinese impose retaliatory tariffs, we will impose restrictions on Chinese ownership of companies in certain U.S. industries. But, there will be restraint, because China was the primary reason there was progress with N. Korea. Bremmer said that President Trump’s 3-hour meeting with Xi Jinping of China, convinced him to shut down business deals and significantly limit energy, aid and support. He said the Head of the Foreign Relations Committee changed his view from a 50% chance of military action, to 0%. Real estate is currently booming in S. Korea, a true win for the markets.
Conversely, Bremmer felt the G-7 meeting was the worst since the first meeting in 1975, with alliances fading, almost all world leaders unhappy and opposed to the U.S. leaving the Trans Pacific Partnership, the Paris Climate Accord, the Iran deal, UNESCO, and possibly not extending China’s deal with ZTE. Bremmer said that President Trump did not want to go to the G-7 meeting, arrived late, departed early for his historic meeting with North Korean leader Kim Jung-un in Singapore and canceled a meeting with President Macron. In addition, President Trump is unhappy that you do not see Cadillacs in Europe and that we pay most of NATO costs.
Bremmer’s concern is that we have lost the ability to drive cooperation with allies and that could affect the markets. He sees U.S.-E.U. tariffs coming and problems with both Mexico and Canada, and thinks shorting the Peso is a good idea. He is very optimistic about India, whose ‘corruption level’ (my term), has significantly decreased, as they are building roads, have implemented a “services tax” and have a good leader.
It is certainly going to be an interesting 2nd half of 2018.
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