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Markets End Quarter on a Choppy Note  

June 30, 2017 

**An unexpected decline in U.S. orders for business equipment in May indicates cooling capital-goods investment may weigh on second-quarter economic growth, Commerce Department data showed Monday. Orders for non-military capital goods excluding aircraft fell 0.2% (the estimate was for a 0.4% gain) after a 0.2% increase in the prior month. Shipments of those goods, which are used to calculate gross domestic product, fell 0.2% after 0.1% gain the prior month. Bookings for all durable goods fell 1.1% (the estimate was for a 0.6% drop) following 0.9% decline in the previous month.   Excluding transportation equipment demand, which is volatile, orders rose 0.1% (the estimate was for a 0.4% gain). The broad slowdown in equipment orders and shipments raises the risk that business investment will provide less of a boost than anticipated to the economic rebound this quarter, leaving the heavy lifting to household spending. The outlook for capital-goods production is clouded by cooling automobile sales, while overseas markets -- though improving -- are yet to show the kind of demand acceleration that would spur exports of U.S. made goods. In addition, some companies may be waiting for clarity on more favorable tax policies from Congress before stepping up investment. 

We had a couple of Fed governors giving speeches this week with comments that were worthy of note. New York Fed President William Dudley indicated that easier financial conditions support the Fed tightening policy. A muted market response to plans to shrink Federal Reserve’s balance sheet “suggests that these communications have generally been effective in fostering an orderly adjustment in expectations about how we are likely to normalize our balance sheet,” he went on to say. “Monetary policymakers need to take the evolution of financial conditions into consideration,” Dudley said in remarks delivered Sunday at the Bank for International Settlements’ Annual General Meeting, in Basel, Switzerland and posted online Monday. “For example, when financial conditions tighten sharply, this may mean that monetary policy may need to be tightened by less or even loosened. On the other hand, when financial conditions ease, as has been the case recently, this can provide additional impetus for the decision to continue to remove monetary policy accommodation.” Additionally, Federal Reserve policy maker John Williams also spoke this week indicating he sees interest rates rising as inflation moves up. He made the case Monday for further gradual increases in interest rates, saying he expects inflation to rise to the central bank’s 2 percent target next year as unemployment edges lower. “Gradually raising interest rates to bring monetary policy back to normal helps us keep the economy growing at a rate that can be sustained for a longer time,” Williams said in remarks prepared for delivery at the University of Technology Sydney. The comments by the president of the Federal Reserve Bank of San Francisco suggest that he’s lining up with Fed Chair Janet Yellen, his predecessor at the bank, in an emerging debate on how to respond to an easing in inflation during the last few months. While some Fed officials have argued for a pause in the rate-hiking campaign to wait for clearer signs that inflation is indeed headed higher, Yellen has played down the significance of recent weak price data and suggested that the Fed remains on course for higher rates. Williams seemed to agree. “Some special transitory factors have been pulling inflation down,” he said. “But with some of these factors now waning, and with the economy doing well, I expect we’ll reach our 2 percent goal sometime next year.” 

Those special factors include a steep drop in the cost of mobile-phone services. That helped pull down the Fed’s favorite inflation gauge to 1.7 percent in April from 1.9 percent in March and 2.1 percent in February. Williams also saw a danger in the Fed allowing the unemployment rate to fall too far. “The very strong labor market actually carries with it the risk of the economy exceeding its safe speed limit and overheating, which could eventually undermine the sustainability of the expansion,” he said. At 4.3 percent in May, the U.S. jobless rate was already below what Williams thinks is its long-run sustainable rate of 4.75 percent. And he sees it dropping some more. “Given the strong job growth we’ve been seeing in the United States, I expect the unemployment rate to edge down a bit further and remain a little above 4 percent through next year,” Williams said. The Fed earlier this month raised interest rates for the second time this year. Policy makers have penciled in one more rate increase for 2017 and three more for 2018, according to projections released after their June 13-14 meeting. Williams is not a voting member of the Federal Open Market Committee this year but will vote in 2018. Williams affirmed the Fed’s intention to begin trimming its $4.5 trillion balance sheet this year, saying the central bank would start off “nice and easy.” The aim will be to gradually reduce bond holdings in a widely telegraphed and predictable fashion, he said. “I hope I’ll not be perpetuating an unfair stereotype about economists if I say that ‘boring’ is a virtue,” Williams said. “Indeed, my new mantra is, ‘Boring is the new exciting.’”  It’s nice to see a Fed governor with a sense of humor! 

In European Central Bank news, Mario Draghi called for continued euro-area stimulus this week even as the economy enters a new phase in its upturn, saying support is still needed to entrench the trend. “All the signs now point to a strengthening and broadening recovery in the euro area -- deflationary forces have been replaced by reflationary ones,” the European Central Bank president said on Tuesday in Sintra, Portugal. “However, a considerable degree of monetary accommodation is still needed for inflation dynamics to become durable and self-sustaining. So for us to be assured about the return of inflation to our objective, we need persistence in our monetary policy.” The comments at the annual ECB Forum reflect the intensifying public debate over whether the central bank should continue pumping liquidity into the financial system after more than four years of economic growth and improving resilience.  Policy makers didn’t use their latest policy meeting to discuss whether to wind down their 2.3 trillion-euro ($2.6 trillion) bond-buying program, which is scheduled to run until the end of this year, meaning investors may get relatively short notice of any change. The euro jumped as Draghi said that most factors damping inflation are temporary. The Governing Council used its June 8 meeting to say that risks to growth are now broadly balanced instead of tilted to the downside, and dropped its expectation that interest rates might be cut again. Draghi acknowledged that further changes in the policy stance are coming, but said they should be slow. “In the past, especially in times of global uncertainty, volatility in financial market prices has at times caused an unwarranted tightening of financial conditions,” he said. “So in the current context where global uncertainties remain elevated, there are strong grounds for prudence in the adjustment of monetary-policy parameters, even when accompanying the recovery. Any adjustments to our stance have to be made gradually, and only when the improving dynamics that justify them appear sufficiently secure.” The ECB president did leave room for policy steps that would signal a reduction in the pace of stimulus, without necessarily tightening financial conditions. That could encourage more hawkish members of the Governing Council to push for action. “As the economy continues to recover, a constant policy stance will become more accommodative,” Draghi said. “The central bank can accompany the recovery by adjusting the parameters of its policy instruments -- not in order to tighten the policy stance, but to keep it broadly unchanged.” We respect Mario Draghi and his position – traders seem to also have a great deal of confidence in his ability to lead the central bank. 

In other European news, euro-area economic confidence jumped to the highest level in a decade as the European Central Bank edged toward unwinding unprecedented stimulus. An index of executive and consumer sentiment rose to 111.1 in June from 109.2 in May, the European Commission in Brussels said Thursday.  The reading is the strongest since August 2007 and compares with a median estimate of 109.5 in a Bloomberg survey of economists. The report comes two days after ECB President Mario Draghi confounded investors by arguing that there’s room to adjust stimulus measures as the economy improves, even though he called for prudence and patience.  A gauge for private-sector activity signaled the euro-area economy recorded its fastest expansion in six years in the second quarter as business confidence in Germany hit a record and consumer sentiment in France surged. 

The job market continues to boost U.S. consumer confidence as expectations rise. An unexpected rebound in U.S. consumer confidence reflects a buoyant labor market and improved business conditions, though Americans are slightly less optimistic about where things will be in six months, data from the New York-based Conference Board showed Tuesday. The Confidence index rose to 118.9 (the estimate was for 116) from 117.6 in May. The present conditions measure increased to 146.3, highest since July 2001, from 140.6 the prior month. The gauge of consumer expectations for the next six months fell to 100.6, the lowest level since January, from 102.3 the previous month. Americans are drawing encouragement from an economy that continues to provide jobs, rising stock and home prices and steady pay gains, as the share of respondents expecting higher incomes was the second-highest since 2002. At the same time, the easing of the overall expectations index adds to other sentiment figures that suggest mounting skepticism about the ability of Washington lawmakers to enact economic policies that will drive growth. “Expectations for the short-term have eased somewhat, but are still upbeat,” Lynn Franco, director of economic indicators at the Conference Board, said in a statement. “Overall, consumers anticipate the economy will continue expanding in the months ahead, but they do not foresee the pace of growth accelerating.” 

Sustained increases for home prices in 20 U.S. cities in April indicate the housing industry is juggling stable demand with a shortage of inventory, figures from S&P CoreLogic Case-Shiller showed Tuesday. The 20-city property values index rose 5.7% year-over-year (the estimate was for a 5.9% gain). The national price gauge increased 5.5% year-over-year. The seasonally adjusted 20-city index climbed 0.3% month-over-month (the estimate was for a 0.5% increase). Stubbornly low inventory in housing, particularly for more affordable properties, has helped drive steady home-price gains. While rising property values are helping cushion homeowners’ balance sheets, they also are inhibiting lower-end buyers, especially first-timers, from getting a piece of the action, as wage gains haven’t kept pace. At the same time, industry demand remains healthy, with solid job gains and low mortgage rates supporting purchases. “Since demand is exceeding supply and financing is available, there is nothing right now to keep prices from going up,” David Blitzer, chairman of the S&P index committee, said in a statement. “The supply of homes for sale has barely kept pace with demand and the inventory of new or existing homes for sale shrunk down to only a four-month supply. All 20 cities in the index showed year-over-year gains, led by a 12.9 percent advance in Seattle and a 9.3 percent rise in Portland, Oregon.  

The U.S. economy’s first-quarter growth was less tepid than previously reported, as consumer spending and trade added more to expansion, Commerce Department data showed Thursday. Gross domestic product rose at a 1.4% annualized rate (the forecast and previous estimate were for 1.2%). Consumer spending, the biggest part of the economy, rose 1.1% (the forecast and previous estimate were for 0.6%). Exports grew at a 7% rate, which was revised up from the prior estimate of 5.8% growth. While the revision was more positive than most analysts anticipated, the report still underlines a relatively weak start to the year, with consumer spending growing at the slowest pace since 2013.  Weather and other temporary factors in the period, along with rising wages and salaries, support the idea of a consumer-led rebound in the second quarter.  Federal Reserve policy makers raised interest rates earlier this month, seeing the first-quarter slowdown as transitory as the labor market improves further. The Commerce Department attributed the latest upward revision to spending data for financial services, insurance and health care.  Exports of industrial supplies and materials were higher than previously reported, boosting trade’s contribution to expansion in the period. Analysts estimate the U.S. economy will grow at a 3 percent rate in the April-to-June period, though the slowdown in equipment orders and shipments reported earlier this week raises the risk that business investment will provide less of a boost than anticipated.  Cooling automobile sales and a housing sector limited by a scarcity of affordable homes also remain headwinds for the economy this year. 

As always, stay tuned!

Earnings Season in Full Swing as Dow Hits 20000

The market headline this week was the Dow Jones Industrial Average closing above 20000 for the first time on Wednesday.  The S&P 500 and Nasdaq Composite also reached new all-time highs this week.  We will discuss this milestone in the performance section below, but our attention turns to a more ominous headline.  A potential meeting next week between President Trump and Mexican leader Pena Nieto was cancelled due to rising conflict over various issues.  Border disputes are rarely pretty but for the most part they involve discussions that take place behind closed doors with underlings mostly doing the heavy lifting in terms of debating.  However, this time is different.  President Trump has used the social media Twitter platform to espouse his thoughts on a variety of issues taking this spat into the public eye and onto the front page of newspapers and home pages of websites.  We remain apolitical in terms of who is ultimately right or wrong in terms of such matters.  Our focus remains on how this affects the financial markets because we serve as fiduciaries for our clients and act in their best interests.  That said, our take on the matter is this debate, should it continue on its current vitriolic trajectory, will ultimately be negative for markets.  Here are our reasons.

Trump tweeted that “The U.S. has a 60 billion dollar trade deficit with Mexico. It has been a one-sided deal from the beginning of NAFTA with massive numbers of jobs and companies lost.”  According to Bloomberg, the deficit is actually closer to $89 billion in 2015 (using import only data from both countries rather than net export figures), up from a surplus of $1.7 billion in 1993, the year before NAFTA took effect, and up 73% since 2008.  Though that seems large, it is peanuts compared to the $337 billion deficit with China.  Our deficit with Germany is $75 billion, $63 billion with Japan and $50 billion with our Canadian neighbors to the north.  These numbers are debatable, too, because of cross-border flows within a company’s supply chain.  The main point is that the U.S. is a debtor nation which is not in question.  We agree with Mexican Finance Minister Jose Antonio Meade when he said, “The fact you have a deficit or a surplus doesn’t mean in itself that trade is bad.”  U.S. exports rose from $41.6 billion in 1993 to over $240 billion in 2014.  Why? Because Mexico had more money to buy our goods.  A world of greater trade ultimately ends up benefiting you.  Moreover, Mexico and Canada make up just 10% of the 2015 trade deficit (The U.S. and Canada have a bilateral deal that predates NAFTA which is why that country has not been the focus of Trump’s ire as much as Mexico).  That means 90% comes from elsewhere.  The unspoken benefit of having stable geographical neighbors is priceless.  Just take a look at the problems Europe is having because so many of the EU’s constituents do not have stable neighbors on an economic and political basis.  Poor governments have porous borders, and we do not want to have other country’s problems become our own.

In terms of job lost, the data is even more skewed.  Economists estimate somewhere between 100,000 and 700,000 jobs have been lost…cumulatively over 24 years.  That is a small amount compared to the 159 million in the U.S. workforce as of December 2016 according to the Bureau of Labor Statistics.  More importantly, for the jobs that migrated south of the border…do we want those back?  Really?  Low wages, minimal benefits and a higher susceptibility to technological advancements all mark these jobs in the textile and auto industries which have had the most losses related to the NAFTA deal.  Will bringing those back save Detroit or revitalize central North Carolina?  According to an interview in The Wall Street Journal, a Mexican working in the state of Veracruz now earns $1,860 per month as a supervisor in a factory making frames for Chrysler trucks.  That’s $22,320 per year.  The 2016 Federal poverty guidelines for a 4-person household is $24,300.  Do we want to import jobs that leave a family below the poverty guideline??  This does not make sense.

If we assume that NAFTA is the source of U.S. woes and it is repealed, what happens next?  Those jobs are not coming back precisely because nobody wants to work for that much in the U.S. with that job title.  U.S. manufacturing employment was severely hit in 2001 because China became a member of the World Trade Organization.  Lower cost Chinese workers plus an under-valued yuan was the formula which led to a dramatic decline in that workforce.  The same thing will happen now.  The peso, which has been on a slide ever since the election, will be the great equalizer and business which is lost to the U.S will just go overseas because Mexican goods will be cheaper to buyers in Europe and Asia compared to now, higher priced U.S. goods.  Ultimately, that means job losses.  The U.S. can always use its cash to support the peso in currency markets, but then where would the money come from to build that wall? 

To put it bluntly, the entire “build the wall” business is just plain dumb.  The U.S. border needs tighter security more for anti-terrorism reasons than undocumented aliens looking for a job.  If money is going to be raised, to use it on a concrete structure is a misallocation of resources.  The Mexican government is not going to pay for it nor is the U.S. government.  Consumers are going to foot the bill in terms of higher prices.  The Trump administration is relying heavily on bilateral deals rather than multinational accords like the Trans-Pacific Partnership which the U.S. withdrew from this week.  The U.S. is the world’s biggest consumer economy.  We are going to get deals, but the question is will we get enough of them to offset talk of 20% tariffs on goods from countries where there is no deal?  If the U.S. agrees to a bilateral deal with Japan to protect the car and auto parts markets, then the price of a Lexus, Acura, Honda and Toyota will not spike higher, but how does that help Ford and GM, whose cars remain highly unpopular with the Japanese consumer?  And if binding rules on currency are not incorporated into these agreements, they are basically worthless.  Japan can always sign on the dotted line, then let their currency depreciate thereby avoiding the tariff and still boosting exports.  A lose-lose for the U.S.A.

This week’s GDP numbers highlight the bind the new administration finds itself in, made only harder by difficult pronouncements.  The economy decelerated in the final three months of 2016 but it would be a mistake to view the report as disappointing.  GDP expanded at an inflation and seasonally adjusted annual rate of 1.9%, down from the third quarter’s 3.5% growth which had been the strongest reading in two years.  Economists had expected a 2.2% rate.  Since the recession ended in 2009, the average growth rate has been 2.1%.  So what we have seen is one of the longest expansions in the modern era but also one of the weakest since at least 1949.  Consumer spending, rose at a 2.5% annual rate in the fourth quarter, less than the 3.0% growth in the third period.  Yet business investment picked up in late 2016 with fixed nonresidential investment higher at a 2.4% pace.  Net exports were a drag on growth, subtracting 1.7 percentage points.  That can be blamed partly on a stronger dollar during the period which made exports more expensive to foreign buyers and overseas goods cheaper to Americans.  With unemployment under 5% and wages beginning to bubble higher, there cannot be a lot of complaints in the data.  Moving a $17 trillion battleship forward at a faster pace is hard.

For President Trump to set a goal of 4% annual GDP growth is puzzling to say the least.  Overhauling the tax code and rolling back federal regulations will provide a boost.  But, 4% GDP growth, not for one quarter but on a sustainable basis is going to usher in an era of higher interest rates.  The Fed will hike at a faster pace than expected, but they are not totally to blame as the bond market is sure to beat them to the punch and push yields on securities due to mature in 10-years or longer much higher to account for more intense inflation. That will make servicing the U.S. debt load much harder.  According to nonpartisan Congressional Budget Office projections, which include modestly higher yields, “the government’s interest payments on that debt rise sharply over the next 10 years—nearly tripling in nominal terms and almost doubling relative to GDP.”  The math is beyond simple—you cannot have 4% GDP growth AND low inflation AND a weaker dollar (Trump said to The Wall Street Journal on January 17, “Our companies can’t compete with them (China) now because our currency is too strong.”)  The best environment for stocks is what we have now—low inflation with little fear of deflation and moderate interest rates which are rising in a slow, predictable pattern.

The best thing for the markets is a stronger America based upon a rising standard of living within secure borders.  If that $10 billion cost of “the wall” was spent on education, what type of return would the country get from that?  If that $10 billion was spent on more and better training of first responders and police forces, would that not benefit each and every county within our borders?  Federal Reserve Chairwoman Janet Yellen put it in different terms saying that our GDP growth “has been restrained in recent years by a variety of forces depressing both supply and demand, including slow labor force and productivity growth…I anticipate that they will continue to restrain overall growth over the medium term.”  Higher productivity is a much more important goal than a trade deficit, plain and simple.  Investors and markets are going to have to learn how to navigate President Trump’s unique style of communicating, but the system is built so not even the president can steer the ship himself.  But he can provide direction and sending the wrong note could be hazardous to the market’s health.

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