Saturday, July 08, 2017

Guest Post: Financial Markets and Economic Update by Dorothy Jaworski

Here we are in July already!  The markets continue to roll and bond markets continue to trade in a 25 basis point range, hitting the higher end when they think the economy is strong (why else would the Fed raise rates?) and hitting the lower end when the weak economic data smacks them in the face.  I usually write with a cautious tone.  Many of my economic views contain the word “weak.”  I do not take this lightly.  I believe that we are in this era of weak growth, now eight years old, for the long haul unless changes are made to regulation and we stop adding debt at break-neck speed.  In this environment, it has been an achievement for our economy to grow at 2%. 

OMG- The Phillips Curve!
Janet Yellen, like Ben Bernanke before her, is using the Phillips curve to shape policy.  Remember that the Phillips curve is based on a set of formulas where unemployment and inflation have an inverse relationship.  With unemployment going down, inflation must go up, right?  Well, it did for a while, and now it is heading down, too.  The Fed must think it will rise again and they are raising rates in anticipation.  They must not see falling oil prices, weak GDP growth, falling gold prices, a narrowing Treasury-TIPS spread, rising debt levels, lower consumer spending, a low labor force participation rate, low productivity, and consumer prices so weak that major retail companies are closing stores at a record pace.  Someday, we will all simply shop online at Amazon and Walmart.  We will not even have to drive anywhere, since everything will be delivered to our front door.

The Fed has raised rates by 25 basis points twice so far in 2017 and has promised one more increase.  They believe that inflation is coming and that is fine.  They believe that they should raise rates because they were too low and that is fine, too.  If the Fed was motivated by the data, or their moves “data dependent” as they always claimed, they would not have raised interest rates.  Weak readings on employment, housing data, and retail sales won’t stop them.  Rising debt levels will not stop them.  Household debt in 1Q17 totaled $12.73 trillion, crossing the previous high mark of $12.68 trillion in 2008.  They are moving ever closer to a flat yield curve and slowing down 2% growth.  For what reason?  Well, maybe the Phillips curve…

The Fed also announced at their June meeting that they would be “normalizing” their balance sheet “soon,” which means reducing it by letting bonds mature and not replacing maturities or cash flows.  Remember all of the quantitative easing, or “QE,” purchase programs?  All of those bonds are on the Fed’s balance sheet to the tune of $2.5 trillion in Treasuries and $1.8 trillion in Agency mortgage backed securities.  Their “normal” balance sheet size would be under $1 trillion.  It is expected that $50 billion will not be reinvested monthly.  They also stated that they will do this “normalization” provided that “the economy evolves broadly.”  Who has any idea what that means?  It is my belief that they will proceed with this “normalization” no matter what, regardless of the cost.  Longer interest rates will tend to rise after losing a buyer for longer term MBS and mortgage rates will rise as a result.  With housing weak, our economy will be weak, and no one should be surprised.  Incidentally, Chair Janet Yellen’s term at the Fed expires in February, 2018.  There is already speculation that she will not be re-nominated.  That may be just in time for the easing to begin.

Presidential Agenda
I am very surprised that the markets are not having fits over the lack of progress on the presidential agenda.  The promises included tax cuts to 15% (although a much less dramatic decrease is expected), repeal and replacement of ObamaCare (stalled in the Senate), regulatory reform (some energy rules relaxed, but not much else), infrastructure spending to repair and replace our crumbling structures, roads, airports, electrical grids, etc.  Patience, they say!!  I believe that the stock markets believe that eventually the agenda will be accomplished.  And some good ideas have been presented, including job training and increased education for those whose skills may not match available job openings.

The Pool of Available Workers
When Alan Greenspan was Fed Chairman, he always looked at “augmented” unemployment numbers which were calculated using the pool of available workers (sum of the unemployed plus persons who want a job but are not counted in the labor force).  The augmented rate for May, 2017 was 7.5%, compared to the headline rate of 4.3%.  The pool stands at 12.4 million persons, including unemployed of 6.9 million, at the end of May, 2017.  This level compares to 12.3 million at the end of December, 2007, before the crisis hit in 2008.  The level reached 16.7 million in December, 2008 and the peak occurred in October, 2009 at 21.4 million.  It took nine years to return to pre-crisis levels.  It seems we have achieved the recovery of employment.  But why does it not seem so?  Maybe it does not feel right because wages have not kept pace, meaning inflation remains low.  We shall see.

Company Expenses Seen Rising
Corporate expenses are on the rise.  For years, regulatory and compliance costs have been growing dramatically.  Physical security costs ramped up over the past 15 years; just ask the airlines and Homeland Security.  Now an even greater threat promises to raise costs even more- the threat of cyber attacks.  Recently, we have seen ransomware virtually cripple company’s networks and Internet access, as criminals exploit vulnerabilities in Microsoft’s Windows operating system.  Some of the ransomware even has names:  WannaCry and Petya Clone.  Thieves lock up computers by encrypting files and access and demand ransoms, usually small amounts such as $300 in bitcoin.  This is becoming an increasingly frightening scenario.  In the age of
“The Internet of Things,” where every appliance and device under the sun is connected to the Internet, someone should be losing sleep.

An Even Larger Hadron Collider

Where else can you get updates on our favorite machine?  There is some excitement about the plans to build a new Hadron Collider that will be bigger and better than the machine today.  The new one, called the Future Circular Collider, will be three times as long and ten times as powerful.  It is in the planning stages and will be ready by 2035.  Considering that the current Collider took 30 years to build, that’s not a long time to wait.  Expect digging to occur under the mountains of Europe in a few years.  Let’s just hope that they put covers on this one so that birds cannot drop baguettes inside!   

Thanks for reading!  DJ 07/04/17

Dorothy Jaworski has worked at large and small banks for over 30 years; much of that time has been spent in investment portfolio management, risk management, and financial analysis. Dorothy has been with Penn Community Bank and its predecessor since November, 2004. She is the author of Just Another Good Soldier, and Honoring Stephen Jaworski, which details the 11th Infantry Regiment's WWII crossing of the Moselle River where her uncle, Pfc. Stephen W. Jaworski, gave his last full measure of devotion.

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