Trump and the Federal Reserve

dubious strategies…

I was thinking about last year’s Federal government shutdown the other day.  There are two million+ Federal workers.  They make an average salary of just above $90,000 a year, which is 50% more than the typical worker in the US.   Add in health insurance and pension benefits and their total compensation is double the national average.

On the surface, it seems odd to me that Federal workers began to run out of money almost the minute Mr. Trump laid them all off late last year.  On second thought, though, given their apparent job security and generous benefits, there’s arguably no urgent reason for them to build up savings.  Maybe they do live at what for others might be right on the edge.

That might explain the outsized negative impact laying Federal workers off en masse had on the economy, given that they represent only about 1.3% of the workforce?  If each consumes as much as two average workers, which I think is a reasonable guess, then the layoff does the same damage as 2.5% of the total American workforce becoming unemployed.

This is bigger than you might think.  A 2.5% rise in unemployment is what happens in a garden-variety recession.  No wonder the economy appeared to fall off a cliff in January.

 

Consider, too, the effect of the Trump decision to withdraw from international associations in favor of waging country-to-country trade warfare.  The resulting flurry of highly targeted tariffs and retaliatory counter-tariffs has made the US, at least for the moment, a uniquely bad place for new capital investment.  That’s even without considering the administration’s policy of restricting domestic firms’ ability to hire highly talented foreign technicians and executives–a policy that has made Toronto the fastest-growing tech city in North America.  Again, no surprise that new domestic capital additions sparked by tax cuts have fallen far below Washington estimates.  And, of course, tariff wars have lowered demand for US goods abroad and raised prices of foreign goods here.

My point is that–apart from the ultimate merits of administration goals–they are being pursued in a strikingly shoot-yourself-in-the-foot way.

…continue

Yes, Federal workers are back on the job.  I can’t imagine that they will resume their old spending habits, though, given the new employment uncertainty they are facing.  Last week the administration discussed disrupting the supply chains of American multinationals with operations in Mexico.  Yesterday, the talk was of a possible $11 billion in new tariffs on imports from the EU …and the retaliation that would surely follow.  Even if none of this materializes, their possibility alone will increase the reluctance of companies to operate inside the US.  The negative effect of all this may be much greater than the consensus thinks.

 

now the Federal Reserve

This central bank’s official role is to set monetary policy through its control of short-term interest rates.  Its unoffical role is to be a political whipping boy.  It takes the blame for (always) unpopular rises in interest rates that are needed to keep the economy from overheating, and on track to achieve maximum sustainable long-term GDP growth.

The two instances where the Fed has succumbed to Washington arm-twisting–the late 1970s and the early 2000s–have created really disastrous outcomes, the big recessions in 1981 and 2008.

Despite this, Mr. Trump has apparently decided to offset the negative economic effects of his tax and trade policies, not by stopping doing what’s causing harm, but by forcing the Federal Reserve into an ill-advised reduction in interest rates.  His first step down this road will apparently be the nomination of two loyalists without economic credentials to fill open seats on the Fed’s board.

If the two, or similar individuals, are nominated and confirmed, the likely result will be a decline in the dollar, the start of a residential real estate bubble and a further shift of corporate expansion plans away from the US.  We may also see the beginnings of the kind of upward inflationary spiral that plagued us in the late 1970s.

 

investment implications

Replying to a comment on my MMT post, I wrote:

“Ultimately, though, the results would be a loss of confidence, both home and abroad, that lenders to the government would be paid back in full. That would show itself in some combination of currency weakness, accelerating inflation and higher interest rates. Typically, bonds and bond-like investments would fare the worst; investments in hard-currency assets or physical assets like real estate/minerals, or in companies with hard-currency revenues would fare the best. I think gold, bitcoin and other cryptocurrencies would go through the roof.”

I think the same applies to Mr. Trump gaining control over the Fed.

 

 

 

 

 

 

 

 

 

 

 

threatening Federal Reserve independence

trying to intimidate the Fed?

Just before Christmas, news reports surfaced that President Trump was discussing how to go about firing Jerome Powell, Chairman of the Federal Reserve, ten months after having him appointed to the post.  The purported reason:  Mr. Trump was blaming stock market turbulence–not on his tax bill, which failed to reform the system and increased the government deficit, nor on the negative effect of his tariffs–but on Mr. Powell’s continuing to gradually raise short-term interest rates from their financial crisis lows back toward normal.

Ironically, the S&P 500 plunged by about 10%, making what I think will be seen as an important low, as the president’s deliberations became public.

why this is scary

The highest-level economic aim of the US is maximum sustainable GDP growth, with low inflation.  In today’s world, the burden of achieving this falls almost entirely on the Fed (even I realize I write this too much, but: the rest of Washington is dysfunctional).  The unwritten agreement within government is that the Fed will do things that are economically necessary but not politically popular, accepting associated blame, and the rest of Washington will leave it alone.

Mr. Trump seems, despite his Wharton diploma, not to have gotten the memo.  This despite the likelihood that his strange mix of crony-oriented tax cuts and trade protection has made so few negative ripples in financial markets because participants believe the Fed will act as an economic stabilizer.

What happens, though, if the Fed is politicized in the way Mr. Trump appears to want?

The straightforward US example is the 1970s, when the Fed succumbed to Nixonian pressure for a too-easy monetary policy.  That resulted in runaway inflation and a plunging currency.  By 1978, foreigners were requiring that Treasury bonds be denominated in German marks or Swiss francs rather than dollars before they would purchase.   The Fed Funds rate rose 20% in 1981 as the monetary authority struggled to get inflation under control.

The point is the negative effects are very bad and happen surprisingly quickly.  This is more problematic for the US than for, say, Japan because about half the Treasuries in public hands are owned by foreigners, for who currency effects are immediately apparent.

 

 

 

 

 

 

technical analysis–November 20th

During the course of trading on Tuesday of last week, the NASDAQ 100 touched the closing (though not the intraday) lows of February, before rebounding sharply.  Simultaneously, the S&P 500 did a similar thing, only its stopping point was the higher lows of April.

 

It looks increasingly likely to me that this action is going to serve as the marker for a selling climax–the point where short-term speculators feel all hope of a rebound is lost and dump out their holdings in a final surge of selling with little regard for price–for the market downturn that began in October.

This positive sign for the market has been reinforced by the statements of influential Fed members that short-term interest rates are presently just below neutral, meaning that that body sees little need to continue to push them upward.

Barring any further damage to the economy from Mr. Trump’s bizarre tariff policies, it looks like we’ll enjoy enough market stability for us to return to the business of picking stocks.

thinking about Walmart (WMT)

On August 16th, WMT reported very strong 2Q18 earnings (Chrome keeps warning me the Walmart investor web pages aren’t safe to access, so I’m not adding details).  Wall Street seems to have taken this result as evidence that the company makeover to become a more effective competitor to Amazon is bearing enough fruit that we should be thinking of a “new,” secular growth WMT.

Maybe that’s right.  But I think there’s a simpler, and likely more correct, interpretation.

WMT’s original aim was to provide affordable one-stop shopping to communities with a population of fewer than 250,000.  It has since expanded into supermarkets, warehouse stores and, most recently, online sales. Its store footprint is very faint in the affluent Northeast and in southern California, however.  And its core audience is not wealthy, standing somewhere below Target and above the dollar stores in terms of customer income.

This demographic has been hurt the worst by the one-two punch of recession and rapid technological change since 2000.   My read of the stellar WMT figures is that they show less WMT’s change in structure than that the company’s customers are just now–nine years after the worst of the financial collapse–feeling secure enough to begin spending less cautiously.

 

This interpretation has three consequences:  although Walmart is an extraordinary company, WMT may not be the growth vehicle that 2Q18 might suggest.  Other formats, like the dollar stores or even TGT, that cater to a similar demographic may be more interesting.  Finally, the idea that recovery is just now reaching the common man both justifies the Fed’s decade-long loose money policy–and suggests that at this point there’s little reason for it not to continue to raise short-term interest rates.

the administration, the economy and the stock market

I’m taking off my hat as an American and putting on my hat as an investor for this post.

That is, I’m putting aside questions like whether the Trump agenda forms a coherent whole, whether Mr. Trump understands much/any of what he’s doing, whether Trump is implementing policies whispered in his ear by backers in the shadows–and why congressmen of both parties have been little more than rubber stamps for his proposals.

My main concern is the effect of his economic policies on stocks.

the tax cut

The top corporate tax rate was reduced from 35% to 21% late last year.  In addition, the wealthiest individuals received tax breaks, a continuation of the “trickle down” economics that has been the mainstay of Washington tax policy since the 1980s.

The new 21% rate is about average for the rest of the world.  This suggests that US corporations will no longer see much advantage in reincorporating abroad in low-tax jurisdictions.  The evidence so far is that they are also dismantling the elaborate tax avoidance schemes they have created by holding their intellectual property, and recognizing most of their profits, in foreign low-tax jurisdictions.  (An aside:  this should have a positive effect on the trade deficit since we are now recognizing the value of American IP as part of the cost of goods made by American companies overseas (think: smartphones.)

My view is that this development was fully discounted in share prices last year.

The original idea was that tax reform would also encompass tax simplification–the elimination of at least part of the rats nest of special interest tax breaks that plagues the federal tax code.  It’s conceivable that Mr. Trump could have used his enormous power over the majority Republican Party to achieve this laudable goal.  But he seems to have made no effort to do so.

Two important consequences of this last:

–the tax cut is a beg reduction in government income, meaning that it is a strong stimulus to economic activity.  That would have been extremely useful, say, nine years ago, but at full employment and above-trend growth, it puts the US at risk of overheating.

–who pays for this?  The bill’s proponents claim that the tax cut will pay for itself through higher growth.  The more likely outcome as things stand now, I think, is that Millennials will inherit a country with a least a trillion dollars more in sovereign debt than would otherwise be the case.

One positive consequence of the untimely fiscal stimulus is that it makes room for the Fed to remove its monetary stimulus (it now has rates at least 100 basis points lower than they should be) faster, and with greater confidence that will do no harm.

Two complications:  Mr. Trump has begun to jawbone the Fed not to do this, apparently thinking a supercharged, unstable economy will be to his advantage.  Also, higher rates raise the cost of borrowing to fund a higher government budget deficit + burgeoning government debt.

 

Tomorrow: the messy trade arena

corporate taxes, consumer spending and the stock market

It looks as if the top Federal corporate tax rate will be declining from the current world-high 35% to a more median-ish 20% or so.  The consensus guess, which I think is as good as any, is that this change will mean about a 15% one-time increase in profits reported by S&P 500 stocks next year.

However, Wall Street has held the strong belief for a long time that this would happen in a Trump administration.  Arguably (and this is my opinion, too), one big reason for the strength in US publicly traded stocks this year has been that the benefits of corporate tax reform are being steadily, and increasingly, factored into stock quotes.  The action of computers reading news reports about passage is likely, I think, to be the last gasp of tax news bolstering stocks.  And even that bump is likely to be relatively mild.

In fact, one effect of the increased economic stimulus that may come from lower domestic corporate taxes is that the Federal Reserve will feel freer to lean against this strength by moving interest rates up from the current emergency-room lows more quickly than the consensus expects.  Although weening the economy from the addiction to very low-cost borrowing is an unambiguous long-term positive, the increasing attractiveness of fixed income will serve as a brake on nearer-term enthusiasm for stocks.

 

What I do find very bullish for stocks, though, is the surprising strength of consumer spending, both online and in physical stores, this holiday season.  We are now nine years past the worst of the recession, which saw deeply frightening and scarring events–bank failures, massive layoffs, the collapse of world trade.  It seems to me that the consumer spending we are now seeing in the US means that, after almost a decade, people are seeing recession in the rear view mirror for the first time.  I think this has very positive implications for the Consumer discretionary sector–and retail in particular–in 2018.

the Fed’s next move

The highest economic policy objective of the US is achieving maximum sustainable growth in the economy consistent with annual inflation around 2%.

If growth deviates from this desired path, either through overheating or recession, the government has two tools it can use to nudge the economy back toward trend:

monetary policy, controlled by the Federal Reserve, which can relatively quickly alter the rate of growth of the money supply and thereby either energize or cool down activity

fiscal policy–government taxing and spending–controlled by the administration and Congress, and which may be thought of as more strategic than tactical, since there are typically long lags between need and any legislative action.

As a matter of fact, the Fed has been calling for fiscal stimulus from Congress and the administration for several years–worrying that continuing monetary stimulus is increasingly less effective and even potentially harmful to the economy.  Its pleas have fallen on deaf ears.

The Fed has been using two methods to keep rates low:

–it has kept the Federal Funds rate, the interest rate it sets for overnight bank deposits, at/near zero, and

–it has taken the unconventional step of putting downward pressure on rates of long-maturity instruments by buying a total of $4 trillion+ of government securities in the open market.  This is called quantitative easing.

Donald Trump was the only candidate to address the problem of fiscal policy inaction, by promising giant fiscal stimulus through lower corporate tax rates plus a massive spending program to repair/improve infrastructure.

After Mr. Trump’s surprise win last November, the Fed seems to have breathed a sigh of relief and aanounced a series of interest rate hikes that would begin to return monetary policy closer to a normal amount of stimulus–based on the idea that Washington would also provide serious fiscal policy stimlus in 2017.

We’re now in month nine since the election, without the slightest sign of any action on the fiscal front, despite the fact that the Republicans hold the Oval Office and both houses of Congress.  Senator Pat Toomey (R-Pa) remarked last week that this is because no one expected Mr. Trump to win, so Congress made no plans to implement his platform.   It hasn’t helped that, despite his campaign rhetoric, Mr. Trump has shown little grasp of, or interest in, the issue.

This leaves the Fed in an awkward position.

I think its solution will be to shift from raising the Fed funds rate to slowing down or stopping its purchases of securities farther along the yield curve.  Although in a sense the Fed is already no longer buying new government bonds, it is taking the money it receives in interest payments and principal return from its current holdings and reinvesting that in new securities.

Its first step will be to reduce or eliminate such reinvestment–which will presumably nudge longer-term interest rates upward.  Since the process is being so well advertised in advance by the Fed, it’s likely that most of the upward movement in rates will have occurred before the Fed begins to act.  The most likely date for the Fed to more is in September.