September 2017 Recap

Hurricanes Harvey, Irma, and Maria wreaked havoc within a few weeks of each other.  Houston was hit with historic rainfall from Harvey, and much of Florida was ravaged by wind damage from Irma.  But Puerto Rico suffered the most out of the Caribbean islands with Maria making landfall in September.  The U.S. territory was already struggling economically, and it was only a few months ago that Puerto Rico Electric Power Authority (PREPA) filed a form of bankruptcy.  The bankruptcy was intended to initiate the long process of restructuring $9 billion of its debt.  Puerto Rico’s poverty rate exceeds 40% of its population, and now the entire island was out of power and is in dire need of aid.  The Federal government is being called on for emergency assistance, and President Donald Trump made a trip to the island in just the last few days.

US ECONOMY

Plenty of data came in during September, and broadly the data is positive and paints a healthy picture of the U.S. consumer.  The final reading of Q2 GDP came in at 3.1%, which was above the estimates of 3.0%.  Consumer confidence and sentiment readings also came in very strong at 119.8 and 95.3 respectively.  Consumer spending is a big part of GDP growth, so these numbers are more than meaningful.  Unemployment remains low at 4.4%, and looking at data about home loan delinquency also paints a positive picture of American households.  In 2011, about 8.44% of home loans were delinquent, and today that figure stands at 4.24%.

The economic impact of the hurricanes will be critical to monitor.  Natural disasters disrupt some business activities, but they also create other types of economic activity.  Insurers will take a hit.  Oil production was disrupted in the Gulf.  Travel and leisure in Florida will surely take a sizable hit.  But there are now an estimated 1 million vehicles in the Houston area that will need to be replaced, which is a nice tailwind for the auto makers.  Home builders and contractors will be busy rebuilding, and manufacturing suppliers will have to pick up the slack too.  Manufacturing PMIs (Purchasing Managers’ Indexes) and Markit services PMIs are holding solidly in the 50s (any readings above 50 are positive), and rebuilding efforts could help keep PMIs in this range.

INTERNATIONAL

The United Nations unanimously voted for additional sanctions on North Korea, and in a major blow to the country, Chinese banks have been charged to stop dealings with North Korea.  Speaking of China, economic data looks rosy there with increases in both exports and imports.  Eurozone services and manufacturing PMIs came in solid for September.  Flash services PMI was up to 55.6 vs. 54.8 estimated, and flash manufacturing PMI came in at 58.2 vs. 57.2 estimated.  And job creation in the Eurozone was the second highest seen over the past decade.

Economic growth from the world’s larger countries is looking stronger, but there are various issues to monitor.  U.K. Prime Minister Theresa May finally proposed an amount for the U.K.’s divorce settlement with the European Union.  It was $20 billion, a much lower figure compared to early estimates of up to $100 billion.  The U.K. has to press forward to find an amicable trade relationship with the EU.  May also threatened a trade war with the U.S. after the U.S. slapped punitive tariffs on Bombardier’s British-built aircraft.  This is an example of why lawmakers argue about protectionist tax policies because while the policy may try to encourage U.S. manufacturing, it could come at the cost of losing friendly trade relationships with other countries.

STOCKS

Volatility increased in August, and there was about a week of carryover into September before the S&P 500 rediscovered the uptrend, finishing the month 2.1% higher.  International developed country stocks, as measured by the MSCI EAFE, finished up 2.5% for the month, and year-to-date results for the benchmark are just over 20%.  Emerging markets stocks are also showing impressive YTD results at 25.4%, but September was a flattish month with MSCI Emerging Markets Index losing about -0.5%.

Possibly the most interesting nuance of these asset class returns is that U.S. small company stocks, as measured by the Russell 2000, surged 9.6% from mid-August lows.  Discerning the why’s behind these moves is sometimes difficult, but investors may be optimistic that a possible tax deal will translate to better earnings for these companies.

CENTRAL BANKS

The results of the September Fed meeting were two-fold: unchanged rates and more language on the process of unwinding the Fed’s massive balance sheet.  Let’s take a moment to look at the people that make up the Fed.  At present, only 10 of the 12 seats on the Federal Open Market Committee (FOMC) are occupied, and Janet Yellen’s term as Fed Chair will be up next year.  Early in September, Fed vice chair Stanley Fischer announced his resignation for personal reasons.

The Fed hasn’t had its full complement of governors since 2013, and there has been at least one vacancy for 85% of the past decade.  President Trump is in position to nominate a new Fed Chair and other new members, but it’s unclear what monetary policy plans would change as a result. In any case, he’ll be able to tip the balance and put “his folks” in power, and uncertainty about those impending appointments may lead to market volatility next year.

COMMODITIES

According to the Department of Energy, the U.S. now imports 22% less oil than it did a decade ago, and the U.S. Gulf Coast was the source of 18% of U.S. oil production in 2016.  Petroleum exports from the U.S. have quadrupled over the last 10 years, rising from 1.3m barrels-per-day (bpd) in 2006 to 5.2m bpd in 2016.  Hurricane Harvey disrupted Gulf Coast oil operations, and OPEC members met in Vienna to discuss the continuation of production caps on cartel members.  These factors led to a recent increase in both oil and gasoline prices.

THE END OF THE PARTY (at least for the U.S.)

Markets peaked in Oct 2007, and it took about a year for the Financial Crisis to take hold.   Lehman Brothers was the biggest player to go out of business almost a year after the market peak, and more major shake-ups and consolidation in the financial sector would soon follow.  When you look at the main issues that caused the Great Recession, you can sum them all up with one word really: leverage.  Sub-prime mortgages were the result of loose lending standards on top of a hot economy with rising real estate prices.  Throw in corporate greed, and you end up with exotic derivatives and derivatives of derivatives of sub-prime mortgages, which were sold as new investments to people who didn’t really know what they were buying.  And how did we fix the problem?  With more leverage.

Federal Reserve Chair Ben Bernanke announced his plan to implement Quantitative Easing (QE) in November of 2008.  Quantitative Easing was the next form of stimulus from the Fed after the Fed Funds rate had been slashed from 5% in August of 2007, to less than 1% by October 2008. The Fed’s QE plan involved the creation of “bank reserves” which were to be used to buy bonds from U.S.  banks, mainly Treasuries and mortgage-backed securities. QE came in 3 rounds over 6 years, and the scale of the purchases was staggering: Round 1 was $1.725 trillion, Round 2 was $600 billion, and Round 3 was $1.7 trillion.

Interestingly, Bernanke penned an op-ed piece in the Wall Street Journal just 8 months after QE began entitled “The Fed’s Exit Strategy.”  Fast forward to October 2017, and we are about to see the “Exit Strategy” finally kick in. The plan is to shrink the Fed’s $4.5 trillion balance sheet initially by simply not reinvesting in new debt.  Until now, cash from a matured bond was reinvested, keeping those assets on the Fed’s balance sheet.  Now that cash will simply “roll off” the balance sheet.  It will start with $10 billion per month and eventually increase to $20 billion per month.  Ultimately, the plan is that by reducing the Fed’s role as a bond buyer, the inventory of bonds will remain higher, causing bond prices to go down, resulting in long-term interest rates going up.

According to the plan, interest rates should continue to rise in general as the global economy shows strength.  Low rates and QE provided significant stimulus to aid the recovery, but they should not be relied upon anymore. We’re not in the economic ICU anymore; we’re on the mend and in the process of recovery, and that’s great. Healthy economies translate to healthier interest rates, but that path to healthier rates can be a little rocky.  Don’t be surprised by bumps in the road, but also don’t forget that the Fed has been nothing less than extremely cautious with policy since the Great Recession.  The Fed waited 7 long years to increase interest rates by a measly 0.25%, and they don’t want to mess that up now.

The Fed may be stepping aside and leaving the bond-buying party, but its counterpart in Europe, the European Central Bank (ECB), has about run out of European bonds to buy in their own version of QE. Meanwhile, in Japan, the Bank of Japan may also look to fill in the gaps by purchasing U.S. Treasuries as their version of QE may never end.  The next phase of monetary policy is upon us, and we’ll be closely monitoring capital markets for both intended and unintended consequences.