"Will the Federal Reserve continue to take a cautious approach ..."

Portfolio Update - March 2017

The New World Order – 235,000 New Jobs. From Fake to Fabulous

“We're operating in an environment where the U.S. economy is performing well, and we seem pretty balanced. So, I think people can feel good about the economic outlook.”– Fed Chair Janet Yellen

In a world seemingly turned on its head, with Congressional bloodlust and frenzy threatening radical legislative change in healthcare, taxation, infrastructure, and God knows what else as of just a short week ago, the equity markets continued their drive upwards at a robust, probably unsustainable rate, and ahead of the still-modestly positive economic fundamentals. Chilled by the recent bucket of ice water dumped on Republican healthcare ambitions, the markets have turned south for a moment, but will it sink the Trump and Republican manifesto, and with it, the economy and the markets? Not likely.

Even with the recent Trump healthcare blues, are equities still too frothy? Most likely yes, but as markets take stock of the prospects and timetable of the new President’s – and Congress’ -- aggressive agenda and 2017 version of “Voodoo Economics”, they will continue to see the positive opportunities outweighing the negative. And the Federal Reserve’s March hike in the federal funds rate, reflecting the Fed’s economic optimism, did little to dampen their enthusiasm. Unless, of course, Congress begins to wind itself into a pretzel, which it well may do, and the Trump administration as well, in which case, things may not be so bad anyway.

“Just the facts, Jack” says Fed Reserve Chair Janet Yellen. Fully aware of the crazy new world, Chair Yellen has made clear that the Fed is only interested in the economic data, and not the political and legislative noise and speculation. At the end of the day, after all the hoopla, it comes down to corporate profitability and economic growth. Will consumers spend? Will businesses produce and remain profitable? Will there be a hiccup – i.e. “correction” -- when the markets realize that much of Trump’s agenda will struggle, including healthcare, tax reform, and global trade?

Will the Federal Reserve continue to take a cautious approach and keep interest rates below historical levels to encourage sustained economic growth? While equities enjoy support, will bonds continue to be under pressure? For the near and mid-term, the answer for all most of the above questions likely is ‘yes’.

For investors, in a nutshell, bond portfolios will struggle as interest rates are likely to climb, and equities generally, supported by strong economic fundamentals stand to gain.


Jobs, Baby! 235,000: the latest, and pretty darn good jobs number released by the government – the first under the new administration -- made headlines everywhere. Despite the fact that this number of new jobs added is in line with the last year of the Obama presidency, and numbers that Trumpists everywhere have denounced as utterly fake, the new administration couldn’t help itself from taking a high degree of ownership. Ah, the spoils of victory.

While some may feel the bloom is coming off the Trump rose, clearly the post-election go-go market enthusiasm has been embraced by institutional and regular investors alike, with the S&P500 equity index up nearly 6% for the year, and over 10% since Trump’s election victory. The extent to which this upward movement is based on a belief that Trump will have a positive impact on the markets versus the markets merely being free of the general uncertainty – no, misery -- prior to the November elections can be debated. We could just as easily be looking at a massive Hillary Rally. Indeed, whether Trump is ultimately a help or a hindrance over time, no one knows, although the risks – at least those we can imagine -- are worth considering.

So the lead question, now that equity markets have repeatedly crashed through their prior historical highs is this: is this for real and can this happy dance continue? And the answer lies significantly in part to three broad issues: are the economic fundamentals sound? Are stock prices given corporate earnings and expectations reasonable? Are there significant threats afoot that could bring things crashing or sliding down slowly but torturously?

So for those who love to skip to the end, here’s a glimpse: mostly “yes” to all three.

Economic Fundamentals. Check. Let’s begin with the Federal Reserve’s green light. As Federal Reserve Chairman “Just the Facts” Yellen pointed out in her recent “people can feel good” about the economy remarks in Chicago and March press conference, sustained strong jobs numbers, a low unemployment rate of 4.7% and improving productivity and wages all point to an improving employment picture, a foundation to a positively-directed economy, despite an anemic GDP growth of only 1.9% over 2016. The 235,000 jobs added is not a one-trick pony -- the recent and healthy new jobs numbers are continuing a trend begun in 2010.

Janet Yellen repeated that the Fed’s position hasn’t changed and that the Federal Reserve continues on a course consistent with a positive outlook, regardless of any Trump or Republican proposals – what she refers to as “speculation”. Whether the Affordable Care Act of the Obama era gives way to Republican healthcare exorcism, whether regulations are stripped across the board, whether tax rates are drastically cut – the Fed is willing to ignore these efforts until they show up in the data, or if the equity markets get way out of control.

Meanwhile, consumer sentiment hit a 10 year high in January, consistent with strong consumer spending levels in the last quarter of 2016. (Curiously, polls show ecstatic Republican voters more likely to participate in the spending spree, and Dem voters far less enthused.) Yes, although exporters and manufacturers continue to suffer from the high US dollar valuations, they’re hanging in. But inflation is low, only around 2%, even after consideration of significant price increases of oil and gas to more sustainable levels. And business sentiment, perhaps due, in part, to the new business optimism, justified or not, of less regulation and other “encumbrances”, has begun to turn significantly upbeat as well. Whether or not this business ebullience translates to new capital investment in equipment and labor is still to be seen.

The upshot: the economy is, and has been, quite solid.

Corporate earnings, second on the list of key positives, disrespected and decreasing for the better part of two years, are now finally stepping into the limelight as a rising star, with two of the strongest earnings quarters in two years, stepping up each quarter since their March 2016 lows, and an expectation of a continuance. Naysayers may howl that the market is way overpriced in this run-up with S&P 500’s price/equity ratio over 25 times earnings (the historical average is 17) and destined for a Humpty-Dumpty-like demise. This number is based on last year’s earnings. But to realists, who are looking forward, not backward, and see corporate earnings growth over the next year, the picture rosier by far, with S&P 500 price/equity ratio closer to 18. This is clearly not the dotcom bubble of the late ‘90s.

Still, the curmudgeons might cry foul about GDP growth, still limping along near 2%, when all – including the President -- would like to see a number twice that. But we’ve talked a lot about this over the years. Slow is GOOD! Some angst is good to prevent the markets from significant overheating. The Fed will not be inclined to move too aggressively to curb what might otherwise seem like a superheated economy, with only two more Federal Reserve federal funds rate hikes anticipated this year, and anticipation of impending government infrastructure programs will only help grease the skids. The Fed Funds rate, now around 1% is still 4% lower than just 10 years ago.

So, added to increasing corporate profits, the solid economic fundamentals and delightfully low inflation levels actually point a positive picture for equity markets, despite turtle-like GDP growth. (But keep in mind, as the chart indicates, that the expected rise in interest rates will have a deleterious effect on bonds – as interest rates rise, existing paper values on bonds will fall, as discussed later. That’s been the big issue for diversified investors the last six months.)

Smiles Around the World. And it not just here, in the politically bisected USA, where things are looking pretty good: global growth is picking up elsewhere around the world. Slowly, yes, but growing nonetheless. The rest of the world is about a year or so behind us in recovery from the Great-Recession trauma, which is creating all sorts of challenges in the bond markets, but global growth is expected to slightly exceed last year’s growth of 3.1%, with developed markets (like old Europe) at around the 2% level.

Trump Effect

So let’s get to the gorilla in the room. The world markets, just a few months back (although it feels like years) in mid to late 2016, were clearly terrified of a Trump presidency, as the correlation between market upticks each time Hillary’s poll numbers over Trump increased, and terror hit the markets with each Trump surge. Panic was more the emotional response immediately after the Trump victory, as the chart clearly shows. But then something “marvelous” happened: the apocalypse didn’t occur, war was not declared on China, stocks continued to trade, and the realization set in that Trump’s policies combined with Republicans in Congress salivating over a world set free from government regulation might not be that bad for the economy in the near future after all. Climate change be damned, we’ll party hard now.

In addition to the prospect of less regulation on extractive industries and banks adding to business’ bottom line, the anticipation of Trump’s promise of lower corporate interest rates, massive infrastructure investment and defense spending seems to be having its impacts on the markets as well. Sure, Trump is seeking to rip up the free trade agreements (and “Thou shalt not hinder Free Trade” being one of the central commandments of the Good Conservative Bible… Look it up), but like those who circled the Golden Calf while Moses was busting his hump carrying stone tablets, many Republicans are already embracing Trump’s false god of isolationism with their “if you can’t beat ‘em, join ‘em” survivalist mentality, but also knowing they can probably keep ward off some of Trumpists’ isolationistic fanaticism.

There also been a general disbelief that Trump’s expensive wall – which could powerfully antagonize two of our most important trading partners -- is not likely, at the end of the day, to run the entire circumference of the US after all. This is good because neither Mexico nor Canada have sent in their checks.

An additional Trump effect, such as his proposed $1 trillion infrastructure investment, could be a huge positive as well – were it real. Clearly the need for major infrastructure is increasingly urgent, and despite Obama’s best efforts at a major infrastructure overhaul to not only deal with a crumbling infrastructure as well as spur economic growth, the Republican’s opposition limited the opportunities then. But, oh have times changed. Indeed, both Trump and Hillary ran on major infrastructure investment platforms, but only Trump planned on not having the government – or you and I -- pay for it. (If you believe that, there’s a rusty bridge to sell you.) Start thinking of the national debt as a really big number, because all the private investment setting up tolls on roads and bicycle paths named for major food chains, won’t raise a penny for crumbling pipes and other infrastructure which cannot charge user fees. This is a long conversation for another day, but when folks start reading the fine print on this, disappointment will prevail.

Tax Reform and the Rest. Trump, the Congressional Republicans and Democrats have all been yearning for a massive reduction and greater fairness in corporate tax rates for years, albeit for different reasons. Particularly now that healthcare has run into a wall, Trump and the Republicans will turn to tax reform to take down taxes across the board. The Dems will be looking for greater fairness and seeking to eliminate the huge perks and tax breaks major corporations receive at the expense of the American taxpayer.

But any efforts at tax reform are likely, at best, to have a neutral effect on tax revenues, as corporations are likely to retain some of their perks. While the statutory corporate tax rate is fairly high at nearly 35%, it’s misleading, despite the Republicans’ charge. The real effective tax rate that corporations pay in the US is closer to 25%, which is slightly lower than the rates of most of the rest of the developed world. And the reality is that many major corporations, i.e. GE, have managed to skirt taxes altogether. All that said, both sides are interested in making the tax structure more consistent with our trading partners.

Moreover, as a few have recently found out, this stuff is really “complicated”. Reducing corporate taxes will need to be balanced by income elsewhere. And that’s where the legions of lobbyists, state governors and other will take sides. Don’t be surprised if any significant tax reform takes us deep into 2018.

Trump Threats – at least the ones we know

With the two basic legs of economic success – sound economic fundamentals and corporate profits – are solid and well-glued, it’s the third leg that’s the problem. So despite Trump and Congressional Republican policies that are likely to be stimulative to corporate profits and increasing stock values, some very real threats are afloat – aside from a potential climate catastrophe and the disruptions it creates. The tearing up of free-trade agreements with Mexico, China, Canada and other nations, if not done with extreme care could be very problematic. Mexico, is after all, our second largest trading partner, and they’re still pretty miffed at our taking Texas and California.

And that isolationism, closely tied to Trump’s “America First” populism is spreading like a bad virus throughout Europe, and Trump’s victory only giving courage and inspiration to those with wicked inclinations. Challenging, “populist” (for lack of a less complementary description) elections are threatening to turn things on their heads in at least 3 elections. Recently defeated Islamaphobe Gertt Wilders, the “Trump of the Netherlands” remains anxious to confiscate Korans, close mosques, among other generous activites, and following remains significant. Marine Le Pen, running now leader of the National Front in France, can’t wait to tear apart the Eurozone, deny Islamic immigrants access to public schools, and worse. At least Germany’s Angela Merkel is expected to be reelected as Chancellor, but her ruling coalition government is likely to lose many seats to the Anti-Muslim “Alternative for Germany” Party.

And let us not forget Britain’s Prime Minister Angela May and her single-minded focus on forcing the exit of the former Empire out of the Eurozone, with the Article 50 “Brexit” process moving forward over the next week or so.

We see this rise of populism and isolationism here and abroad as substantial mid- and long-term threats to global growth -- a problem to both US exporters, who will find fewer markets for their goods and services -- and consumers who will see higher prices for imported goods.

Anti-immigration policies threaten economic growth. With Trump’s efforts at restrictive immigration policies here and abroad (creating barriers to entry and escalation of deportments), the damage is two-fold: limiting lower-cost labor which is the underpinning of farming, tourism, entertainment, construction and so many other essential industries and services; and shutting out – or kicking out – the best of the best: those extremely skilled and educated DREAMers from other countries coming here and to other developed countries to start new businesses, create breakthrough products and stoke the economic engine of progress.

Bluster & Geopolitical Risk. Unlike the “No Drama Obama” presidency, the aggressive style of this new president seems antithetical to his prior commitment to keep us out of unnecessary wars. It’s not just his bluster: all in the first 60 days, already the risky and failed special operations mission in Yemen, the ramping up of missile test in North Korea and now the shipping of anti-missile defenses to South Korea suggest there is way more ahead. It is generally agreed that the geo-political threats via heightened geopolitical tension, military action, or a trade war (with China, for example), have risen, perhaps exponentially. The impacts would certainly roil the markets “bigly”, and could actually cause an economic slowdown.

Reality Blues. More, still, is what could be a developing uncertainty not only about the Trump administration’s ability to actually get things done given significant infighting within the administration, the Republican party’s own bifurcation, the Democrat’s increasing backbone, and the massive public outpouring of resistance at town halls and demonstrations across the nation. The incredible shrinking healthcare repeal could be just the beginning of a process that turns the Trump party atmosphere to something far more funereal. The dysfunction that Trump ran against, driven largely by a the hardliner fringe in the Republican party which has brought government to its knees repeatedly since 2009, and now augmented by his administration’s own assemblage of the wild and weird, could have a chilling effect on the current exuberance of businesses and consumers alike. Add to that the drip-drip of what would be seen as unsettling news coming out of the Congressional investigations of Trump and/or his officials’ possible ties and collusion with Russia.

Trump Aside…As we’ve been harping on repeatedly, the economic fundamentals are good and sound, and chances are that short of a major negative geopolitical event, over the near term the positive economics might not be undermined by Trump and Republican failures to pass heathcare and tax legislation or other major elements of the President’s agenda. Perhaps even a stalemate on much anticipated and hoped-for major infrastructure investment, or the passage of something far smaller in scope than posed might have limited negative impact over the next year on the economy. The fundamentals should win out.

Non-Trump Threats. The non-Trump, economic, threats really haven’t changed significantly over the last year, and one potential downer is the rising strength of the US dollar versus other currencies. This is good news on some level for those who travel abroad and get to enjoy Italy at something that may finally no longer require a second mortgage, and for consumers who are able to purchase imported goods at Macy’s at lower prices. But the downside shouldn’t be underestimated: it’s having a chilling effect on tourism (just ask Tiffany’s), and makes our goods considerably more expensive to others, which has been a major obstacle to manufacturers who rely significantly on exports. With the US ahead of the pack in terms of where we are in the recovery, and more likely to see higher interest rates with a strengthening economy and with it, inevitably, a stronger dollar, the situation could get worse, not better. That could put a further drag on the economy.

Rising oil prices, currently in a range between $40-$50 per barrel for some months now, could present inflation pressure should prices rise abruptly. A glitch in jobs hires, a weakening of growth in Europe should the central bank move too quickly on their own interest rate increases, or an overly hawkish Federal Reserve are possible challenges as well. And a deep major market correction – talking “crash” here – could have a negative impact on wealth, optimism and spending. That might be a possibility should enough behavioral depression among investors start to set in if government re-experiences some of the same massive dysfunction endured back in 2011, or if markets rocket upwards far beyond appropriate pricing.

Upshot For Investors. Driven by sound economic fundamentals and corporate profits, we see prospects of equity markets continuing to move upwards as strong. While the amount will depend on levels of consumer and economic optimism and general economic data, and short term pullbacks are likely whipsaw markets to and fro with the political winds, the economics should win out.

Bonds, however, are very much at risk. Yes, they will do well during market pull backs, and long term interest rate increases will be somewhat constrained by the very low interest rate offered by competing European bonds, we feel that keeping durations very short and finding alternatives to intermediate and longer-term US government bonds makes sense for many investors. This presents a conundrum, however, as one of the key diversification tools are government bonds, which provide ballast to portfolios when equities sink. The risks, however, we feel outweigh the potential rewards for longer term bonds, and we have been trimming bond positions accordingly.

We’re continuing to monitor these moving parts, and should we see major problems deeper in the economy, or some other foreseeable trauma likely to have deep long term implications, we’ll try to adjust accordingly. How much further up the equity markets are likely to go this year is clearly unknowable, but they remain the asset class of choice. 2018, however, is a different story, and way too early to call.

So Spring is here – finally. Let’s enjoy the spring flowers, melting snow, and the birdsong, and tune out some of the wolves in Washington.

Ron Stein, CFP

Good Harvest Financial Group


Disclaimer: each investor has different needs. The information herein should not be used to direct investment decisions without assistance. No guarantees can be made or implied in the above information.