Weekly Economic Update 03-17-2017

3 Hikes and You’re Out!
As the stock market celebrates its second longest run in history the Fed decided to raise rates for the third time this cycle. History tells us that when the Fed raises rates for the third time towards the end of a business cycle, the outlook for stock prices is bad. The Fed has been responsible for starting the past 10 recessions by hiking rates late cycle which is bearish for an overvalued stock market. This time the market celebrated the rate hike by moving higher that day.

I am not sure why the market is celebrating higher interest rates, but that morning the Atlanta Fed released their updated GDPNow projections for the first quarter that estimates GDP growth to be a mere 0.9%. That puts us on track for another year of sub-2% growth which is hardly bullish for equities. That would also mark one of the lowest growth rates for any quarter where the Fed has raised interest rates. A reporter asked Janet Yellen why the Fed raised rates when the economy has continued to weaken since December. She replied by saying that the economic outlook has improved that that these recent declines are transitory. According to my notes, GDP growth has been contracting since the third quarter of 2014 which is hardly transitory. Maybe I’m missing something?

Inflation is Rising
The Fed raised rates because the Consumer Price Index (CPI) moved up to 2.7%, even though the core Personal Consumption Expenditures (core PCE), the Fed’s gauge for inflation, remains under their 2% target at 1.7%. The Producer Price Index (PPI) was up too, which measures the average change in selling price received by domestic producers, but 70% of that gain was attributed to higher energy costs. It should be noted that there was no mention of significant wage growth in those reports.

If the CPI continues to rise, we should expect the Fed to continue raising rates. The Fed has a dual mandate: to bring the economy to full employment and to manage inflation. They feel the economy is near full employment and now they want to make sure inflation is contained.

It is a recurring theme that inflation is draining the wall of the average American. Inflation is showing up in energy, rents and medical costs. This recent hike will only make things worse. Credit card interest rates will head up, and as you may recall, credit card balances are near the same level they were prior to the last recession. Home equity lines of credit (HELOC’s) taken out ten years ago are set to change from interest only payments to fully amortized payments over the next five years. It just doesn’t paint a pretty picture for the already cash strapped American consumer.

The Fed is playing a dangerous game by raising rates, but they don’t have many options. Get it right and the party continues. Get it wrong, which they have a perfect track record of, and the US economy is headed for an ugly recession.

Sub 2% Growth is Here to Stay
I’ve mentioned that debt is the enemy of growth, but I haven’t had the opportunity to explain why. The world is more indebted that ever before and the solution has been to take on even more debt. Meaning governments are borrowing more money to finance growth, hoping that that their economies will grow enough to pay down the debt. It hasn’t worked and has left the world with a big problem. Let’s focus on the US economy from here forward.

The US government has been borrowing money to finance GDP growth for decades. From 1952-1999 it took $1.70 of debt to generate $1 of GDP growth. From 2000-2015 that amount increased to $3.30 for every $1 of GDP growth. Last year it took a staggering $5 of new debt to generate $1 of GDP growth. You can see the trend here.

The US government must borrow an exponentially higher amount of money in the future to support the economy or risk a deep recession.

Wall Street has lead the average investor to believe there is a huge amount of pent up demand in the consumer sector which will continue to drive corporate profits, and stock prices, up. That just isn’t the case. One way to see demand is to look at the personal savings rate.

Historically the personal savings rate averages around 8.5% Today is it about 5.4%, which is the same savings rate just before the Great Depression, the recession of the 1980’s, the 2000 recession and the 2007-2008 recession.

Debt restricts growth and one way to see that is in the nominal GDP, which is the GDP before its adjusted for inflation. It shows the real growth of our economy. Last year nominal GDP grew by 530 billion. Over the next two years, due to higher interest rates, it is believed there will be a 200 billion increase in interest expenses. Those higher interest expenses get deducted off the nominal GDP amount.

Assuming all things being the same over the next two years – growth, inflation, but adding on 200 billion of interest expenses, our expected GDP growth rate is: 1.2%. And that’s assuming we don’t take on any new debt. With inflation rising, that will put an even bigger drag on GDP growth, as evident by the Atlanta Fed’s first quarter estimate of 0.9%.
With growth expectations this low, and stocks valued at all-time highs, it’s easy to see why the downside risks to our economy is much greater than any upside surprises. Now you know why debt is the enemy and why more debt will just act as an anchor to our economy growth.

Client Update:
I have started dollar cost average our move into gold and silver mining ETFs. As I have previously mentioned, based my research and that of others, there is compelling data that shows that the long-term trends are increasingly bullish for both metals and miners; a trend I’d like to ride the wave on.

Last Thursday there was a low volume day. Low volume can be a strong indicator of a trend change. Since it doesn’t always indicate a reversal of the current trend, the wise move is to wait a few days and see how the market moves before buying. This is especially true when there is a major announcement, such as a Fed rate hike, in the coming week.

This Wednesday, within the minute following the Fed rate hike announcement, physical metals, miners and Treasuries surged upwards. This had to do largely with the fact that nominal yields are negative and are going to be that way for a while – I’ll explain that in a future update. Volume was very strong that day and when there is strong volume along with a big price move, it indicates the big money is buying.

And they did. As it turns out there were a large amount of call options purchase by the big money, which are contracts to buy at a future date. Obviously, they are expecting to exercise those contracts at a higher price. This means those buyers have an invested interest in keeping and if necessary, pushing prices higher. This is a good signal!

Keep in mind there is no strategy that can eliminate downside risk when investing. By watching the volume and the trend, it is possible to reduce the downside risk when making a move back in. That has been my objective. Seek out an asset class that has favorable long-term momentum, look for a bottom and wait for the big money to buy before entering. The goal here is to ride the wave, not attempt to create the wave.

The reason for dollar cost averaging in is to leave cash to buy the dips. Again, there is no sure-fire way to know if prices are going to move up the next day. Sometimes the best move is to buy a little at a time. I this case I outlined a plan to invest 25% of the cash in each portfolio model over the following four days, with the option to suspend the plan if necessary.

I expect prices to hang around the bullish trend line for a few days before there is another move up. It’s possible there may be another move down, but if there is, I don’t expect it to last long. This is based on past price movements that look similar to this move.