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Strategy Monthly
A Return to Normalcy
March 20, 2017 In the presidential election campaign of , Republican candidate Warren G. Harding offered voters a platform dedi‐
cated to recovery from World War I and a “return to normalcy.” Although ridiculed for inventing a new word when an old one would do just fine, Harding carried the day and was elected with Electoral College votes and % of the popular vote. Last week, for just the third time in a decade, the Federal Reserve took another step toward “normalcy” by raising its target for the overnight funds rate to a new range of . % to . %. The move was so well telegraphed and anticipated that prior to the decision, the futures market had placed a % probability on the Fed acting, a degree of certainty rare‐
ly seen in financial markets. Reaction was therefore subdued, with stocks, bonds and currencies responding modestly. Because markets are always focused on the next thing, attention immediately turned to when the Fed would move again. A combination of Fed comments and the internal Fed survey on the likely path of monetary policy (the so‐called “dot plots”) indicate two more rate hikes this year, most likely in June and then again in the fall. This would bring the fed funds target range to between . % and . % by the end of , levels not seen since rates plummeted below that level during the financial crisis. Conventional wisdom holds that higher interest rates are bad for stock prices (and vice versa), but reality is more nu‐
anced than this binary distinction. What matters for stocks is not that the Fed is raising interest rates, but why. If rates are moving higher on fears of growing inflationary pressure, that tends to be bad for both stocks and bonds. If, on the other hand, rates are rising on growing confidence in the health of economic activity, that tends to be good for stocks. We believe that the Fed’s action last week was based on heightened confidence in the ongoing recovery of the labor market. The opening paragraph of the Fed’s statement following the decision noted that “the labor market has continued to strengthen” and that the economy in general has “continued to expand at a moderate pace.” The statement acknowl‐
edged the central role that personal consumption plays in the economy and observed that “household spending has con‐
tinued to rise moderately.” Inflation, on the other hand, has yet to rise to the level of concern, with the Fed stating, “in‐
flation was little changed and continued to run somewhat below percent.” That’s four uses of the word “continued” in the first paragraph of the Fed’s statement, implying that, whereas the slow unfolding of this economic expansion is a process, so, too, should be the Fed’s response to it. Hence the gradual increase in interest rates, to match the gradual ex‐
pansion of economic activity. Chairman Janet Yellen addressed a press conference following the announcement and dealt with questions on such technical matters as balance sheet normalization, reserve requirements and the Glass‐Steagall Act. Her favorite question BBH STRATEGY MONTHLY / Private Wealth Management 1 A Return to Normalcy March 20, 2017 of the conference, however, was a straightforward and brief question posed by Jo Ling Kent of NBC News, who asked “what message are you trying to send consumers with this particular rate hike?” “I think that’s a great question,” Yellen responded. “I appreciate your asking it. And the simple message is the economy’s doing well. We have confidence in the economy and its resilience to shocks.” The statement and press conference offered something for everyone. Hawks will take comfort in Yellen’s caution – re‐
peated from the January meeting – that “waiting too long to scale back some of the accommodation could require us to raise rates rapidly at some point down the road.” Indeed, inflation was the most common word in the statement follow‐
ing the meeting, as illustrated by the nearby word cloud (where the most commonly used words in the statement appear in larger type). The Fed is clearly eager to demonstrate that it is not underestimating the risks posed by inflation. Source: www.wordclouds.com and BBH Analysis. Doves, on the other hand, welcomed the observation that the “fed funds rate does not have to rise by all that much to get to a neutral policy stance.” Indeed, the Fed’s own survey of the future path and pace of monetary policy confirms this statement. The median path for the fed funds rate calls for it to rise to . % by the end of , . % by the end of and to a more normal level of . % only by the end of . To put that into context, the fed funds rate in summer , just before the onset of the financial crisis, stood as high as . %. Rates are moving higher, but no one is talking about high rates. Equity prices made a new record on the first trading day in March and have moved sideways since then. The rally from last year’s low point, just prior to the election, now stands at % on a total return basis. Politics notwithstanding, there is no question that the election has something to do with this rally. We believe that the renewed strength in equities re‐
flects secular improvement in corporate earnings, as well as the hope that fiscal policy will provide further cyclical sup‐
port to economic activity and therefore earnings. Investors are looking for some combination of tax reform, deregulation and infrastructure spending to fuel the next leg in the bull market. As interest rates move higher, we move ever closer to the point at which traditional bonds will play a more important role in our clients’ portfolios. Our basic view of the asset class is straightforward: at the very least, we want bonds to provide a positive return after taxes, inflation and fees. After all, it’s not what you earn, but what you keep, that counts. BBH STRATEGY MONTHLY / Private Wealth Management 2 A Return to Normalcy March 20, 2017 For the better part of the past decade, traditional fixed income has not met this litmus test, but the environment is changing. Generic AAA Municipal Yield Curves On Dates of Fed Rate Hikes 3.5%
3/15/2017
12/14/2016
12/16/2015
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29
Years to Maturity
Source: Bloomberg and BBH Analysis. As the nearby graph illustrates, the yield curve for high‐
quality municipal bonds has moved up with each Fed rate hike, with most of the increases happening in the interme‐
diate part of the curve. With CPI inflation running at . % (as of February), there still isn’t much real return on offer. Nevertheless, if the Fed carries through with two more rate hikes this year, we may get the chance to increase the expo‐
sure to municipal securities in our clients’ portfolios. One note of caution: this graph displays market averages, and as our fixed income colleagues remind us, credit analysis is critically important in the municipal world. Individual issues are already offering limited opportunities to investors, and we are working to take advantage of those opportunities when they arise. What are the risks to this broad scenario? It is certainly possible that the Fed’s optimism is overstated, and Chairman Yellen reiterated that it will continue to analyze and respond to data as it comes out. The Fed is not wed to a particular path of interest rates. In particular, we would watch the labor market closely. Diminished confidence in the health of the job market would prompt the Fed to revise its opinion of economic activity. It is also possible that the expected cyclical benefit of fiscal policy fails to materialize. Hope for tax reform, deregulation and infrastructure has been seemingly supplanted, at least for now, by a focus on immigration reform and renovation of the Affordable Care Act. Leaving aside the obvious political difficulty of legislative progress on either of these fronts, nei‐
ther is economically stimulative. If the fiscal initiatives of the Trump administration get bogged down, hope for a cyclical boost to the economy and corporate earnings may fade. A final risk is longer term. Over the past decade, many economists have become boys (and girls) who cried wolf on the subject of inflation. Fears that a rapid ex‐
pansion in the Fed’s balance sheet would fuel consum‐
er inflation never came to pass, as the extra money created (at least electronically) never flooded the economy. In “economese,” the velocity of money con‐
tinued to decline in spite of a fivefold increase in the size of bank reserves. The Velocity of Money M / Nominal GDP 2.2
2.0
1.8
1.6
1.4
2000
2002
2004
2006
Source: Bloomberg and BBH Analysis. 2008
2010
2012
2014
2016
Data updated through Q .
BBH STRATEGY MONTHLY / Private Wealth Management 3 A Return to Normalcy March 20, 2017 Average Hourly Earnings Year‐over‐Year Growth 4.5%
4.0%
3.5%
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Source: Bureau of Labor Statistics and BBH Analysis. Data updated through February .
The extra supply or availability of money therefore did not spark inflation. But remember what happened at the end of the story about the boy who cried wolf. The wolf showed up. Rising wages might boost the demand for goods (as distinct from the supply of money) and therefore exert more inflationary pressure. Paychecks have been moribund for quite a few years, so much so that boosting wages is an explicit objective of the Trump administration’s policies. Success on this front might lead to more inflation‐
ary pressure, and, indeed, wages have already begun to accelerate. Nothing in this chart of average hourly earnings is inflationary yet, but warrants continued attention, as in‐
flation poses the most serious threat to the long‐term preservation and growth of capital. Analysts and economists have spilled barrels of ink over how different this cycle has been. The real difference is one of timing: the path of economic and market development is consistent with previous cycles, although the pace leaves something to be desired. Economic growth and market activity have allowed the Fed to work toward more normal mon‐
etary policy, although we shouldn’t allow that growing confidence to obscure the risks that still face investors. To para‐
phrase our founding fathers, eternal vigilance is the price of financial liberty. G. Scott Clemons, CFA Chief Investment Strategist This publication is provided by Brown Brothers Harriman & Co. and its subsidiaries (“BBH”) to recipients, who are classified as Professional Clients or Eligible Counterparties if in the European Economic Area (“EEA”), solely for informational purposes. This does not constitute legal, tax or investment advice and is not intended as an offer to sell or a solicitation to buy securities or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code or for promotion, marketing or recommendation to third parties. This information has been obtained from sources believed to be reliable that are available upon request. This material does not comprise an offer of services. Any opinions expressed are subject to change without notice. Unauthorized use or distribution without the prior written permission of BBH is prohibited. This publication is approved for distribution in member states of the EEA by Brown Brothers Harriman Investor Services Limited, authorized and regulated by the Financial Conduct Authority (FCA). BBH is a service mark of Brown Brothers Harriman & Co., registered in the United States and other countries. © Brown Brothers Harriman & Co. 2017. All rights reserved. 2017. PB‐2017‐03‐20‐1278 BBH STRATEGY MONTHLY / Private Wealth Management 4