The Fed’s Dilemma

Annual Outlook

With the closing of 2017, we enter the new year with specific challenges and opportunities that require pointed strategies to execute our investment objectives. While the US equity markets exhibited a hearty dose of euphoria coupled with benign volatility last year – we are anticipating an elevated level of caution and turbulence heading into 2018. That said, we are expecting the market to continue higher in the coming year driven by policy tailwinds in the near-term. Running the risk of appearing overly panglossian, our view on fiscal policy enhances our optimism for potential market returns driven by changes in the tax laws and repatriation. We believe monetary policy will continue to remain accommodative despite the recent hawkish actions by the Federal Reserve, and with the insertion of a new Fed Chairman that will most likely follow Chair Yellen’s charted course, we believe bodes well for market participants.

Market sentiment remains lofty and there continues to be a plethora of cash that remains on the sidelines. Our views towards a potential “melt-up” of the US stock market remains in place as the passage of new policy could act as an ignitor that fuels animal spirits and the desire to own equities.

We are certainly cognizant of stretched equity valuations, but as stanch practitioners of behavioral finance, we understand how phycology can at times have a greater influence on market direction than the logic of fundamental analysis, especially during the latter stages of an equity bull market.

On the economic front, the US economy seems to be on firm footing while the global economy is showing signs of increased expansion. Without the threat of a US economic recession and its influence on global economies, the likelihood of an accelerated bear market seems to be a low probability outcome.

Given the current market conditions we are expecting a pullback in the equity markets during the first half of 2018, albeit with mild consequences. Going back to 1950, the S&P 500 has experienced average annual drawdowns of approximately 8.5% from its annual opening price. If you exclude periods of outlier drawdowns such as the Kennedy Slide of 1962, the crash of 1966, the oil crisis and economic recession of 1973 and 1974, the dot.com bust of 2001 and the Great Recession of 2008 and 2009, the annual drawdowns are much more subdued at 5.3%.

Barring any major catalyst that greatly influences the US economy and corporate profits in a negative fashion, we would view a correction of 5% to 10% as a buying opportunity for those selective companies that are on our watchlist for 2018.

What is important to discern from historical market returns is that the stock markets path of least resistance is higher. From 1950 through 2017, the S&P 500 is higher 72% of the time. It’s an interesting exercise to reacquaint oneself with a historical perspective than to attempt to administer an investment thesis based on a “gut feeling” that a bear market is long overdue. While we remain observant and alert to the possibility that the next bear market could appear at any time, we are positioned under the assumption of continued asset appreciation and prepared should conditions change from our current thesis.

The Fed’s Dilemma

It’s worth mentioning the challenges of modern day monetary policy and its potential effect on the capital markets. While our investment strategy stems from a bottoms-up valuation methodology, having our finger on the pulse regarding macro issues can impact the types of sectors that we would favor considering our economic cycle.

We additionally need to plan for any outcome including an economic and market downturn using our hedging criteria and having a birds-eye view is relevant.

What we are seeing throughout the industry is a growing debate on the effectiveness of monetary policy since the Great Recession, and more specifically one of the key tools used by policy makers to determine the direction of our monetary system.

I am referring to the Phillips Curve. The Phillips Curve is an economic theory developed in 1958 by A.W. Phillips that postulated an inverse relationship between inflation and unemployment did in fact exist.

The reasoning behind the theory simply noted that economic growth will bring about increased jobs and wages potential which leads to inflation. Seems fairly straight-forward but certainly not without its flaws and modifications.

One key example comes from the late-great Milton Friedman. Milton Friedman, one of the foremost pioneers in dynamic economic thinking and a genius in his own right had asserted in 1968 that the short-run analysis coming from the Phillips Curve could be applicable to inflation analysis but that in the long-run the inflation and unemployment relationship would eventually breakdown. It didn’t take long for Dr. Friedman to be proven correct in his assessment when the 1973-75 economic recession ensued. During this period, both inflation and unemployment increased in lock step and thus stagflation was born. Stagflation punctured an enormous hole in the hull of those that adamantly adhered to the Phillips Curve theory.

Federal Reserve Chair Janet Yellen has been very consistent in her messaging that US labor conditions remain robust, even in the face of tepid if not weakening employment data.

The Fed has turned hawkish in light of these economic conclusions and have started their campaign of both raising interested rates, albeit at a slower pace than at first expected and unwinding their $4.5 trillion balance sheet.

The hawkish tone of the Fed has many on Wall Street on edge. Certainly, this economic recovery from the depths of the 2008-09 crisis has been the slowest on record post WWII, so the lackluster economic growth figures have become somewhat of a “new normal”. With that, several leading industry experts are going on record to express their reservations that the US economy is still too fragile to withstand a tightening of monetary policy. Chair Yellen takes into account a tight labor market and 4.4% unemployment rate which is considered to be “full employment”, and using the Phillips Curve, justifies monetary tightening to ward off the deteriorating effect of inflation that looms just around the corner.

Therein lies the debate.

With employment near or at full capacity, one would entertain that inflationary pressures should start to become evident throughout the economy and yet wages and inflation figures have been stubbornly benign.

The Federal Reserve Bank of Cleveland has a convenient and simple way to track inflation expectations over time. Their inflation expectations model incorporates Treasury yields, inflation data, inflation swaps, and survey-based measures of inflation expectations to calculate the expected inflation rate (CPI) over the next one to thirty years. Their ten-year survey tracks very closely with the ten-year TIPS yield. From the inception of this data base starting in the early 1980’s, we have seen a consistent decline in inflation expectations and actual inflation has been hard to come by in recent years, despite the tight US labor market.

Chair Yellen’s explanation to this phenomenon is that the lack of inflation is transitionary and will make its appearance soon. This has been going on for years now.

So, it begs the question, is Chair Yellen conducting monetary policy with too much emphasis on an antiquated model?

Clearly the Fed has the best data available to them and it is foolish to believe that their entire basis of direction comes from a single point of reference, but it is concerning that the belief in the underlying theories sets a bias when making important decisions. Think of the late 1990’s and the dot.com boom. Warren Buffett is clearly a value based investor that looks to buy undervalued companies based on underlying fundamental beliefs. Using price-to-earnings or price-to-book ratios may not be exactly what he is using to analyze his investment options, but they do serve as a core tenet and underlying foundation for his analysis. He was hailed as being outdated and obsolete in the late 1990’s because he didn’t understand the new economy and how things were different this time. Of course, he was correct and continues to this day to impress the financial world with his insights and investing prowess.

Thus, if Chair Yellen is conducting layers and layers of research on a flimsy foundation then her directional bias will be incorrect. Could she be proven correct as was Warren Buffett coming out of the late 1990’s – absolutely. The only problem with the comparison between the two is that value investors such as Graham, Dodd and Buffett have established value based theories that have withstood the test of time. There is still much doubt on the accuracy and relevancy of the Phillips Curve.

In fact, germinating straight out of the Philadelphia Federal Reserve, Fed Director of Research Michael Dotsey co-authored a research paper indicating the relationship between unemployment and inflation isn’t a useful gauge to predict future inflation. The authors conclude, “Our results indicate that monetary policymakers should at best be very cautious in their reliance on the Phillips curve when gauging inflationary pressures”

Based on released Fed minutes, the majority of the FOMC believe in the validity of the Phillips Curve but there have been a few vocal dissenters in the ranks. Surprisingly, Kansas City Fed President Esther George spoke openly and candidly during a Bloomberg TV interview out of Jackson Hole when she said, “There may in fact be something wrong with the models, I don’t know, I think that continues to be a question that many economists are asking” This is even more profound considering she is one of the hawks in the group.

So, what is wrong with the model?

We tend to believe the answer could be partially explained by increasing consumer debt levels. Net debt – to – income levels have doubled since the Phillips curve was adopted and consumer credit is growing by almost twice as fast as income. If the consumer is running out of steam then less disposable income will be available even under full employment conditions, so inflationary pressures will be more subdued than historically believed. What’s needed in our opinion is a deleveraging of consumer credit and a firming of consumers balance sheets in order for this model to have its normalized relevancy.

In fact, when you compare the US consumer debt – to – income ratio to that of inflation, you tend to get greater predictive accuracy then when using unemployment as a means of comparison. At the very least we need to be prepared to accept that the Phillips Curve may be seen as a vertical line at the natural rate of employment with little impact on inflation.

Portfolio Impact

Our internal investment discussions at Ruterra Partners will address the possible shortcomings of misguided monetary policy and our investment thesis will include possible negative outcomes should these missteps occur. More importantly we are discussing our response to potential economic and market pitfalls so that we are prepared for any market eventuality.

One possible scenario is that Fed policy turns out to be too hawkish and inflation never shows up. We track many variables to determine economic and market strength but most notably we track the movements in the two – and – ten-year treasury yield curve and high yield credit spreads.

Indeed, the yield curve is not inverted but it has been flattening. It now sits where it was post President Trump taking office and is the flattest it’s been since the 2008 crisis. With an 80 basis-point differential at the time of this writing, it wouldn’t take much in the way of policy miscalculation to invert the yield. Bear in mind the last two times the yield curve was inverted was late 2000/early 2001 and late 2006/early 2007, just prior to two of the worst equity cycles in our generation.

We also look at credit spreads between high yield instruments and treasuries – but given the largely unorthodox monetary policy decisions post Great Recession, we believe the predictive ability of the model is somewhat diminished through the heavily manipulated treasury market stemming from years of quantitative easing and balance sheet maneuvering. To combat that specific challenge, we compare credit spreads of high yield and investment grade securities and get a similar picture to what we’re seeing with the yield curve. Spreads are widening but not quite yet in recessionary range. Rather they are indicating more of the same tepid and grinding economic growth that has characterized the Great Recessionary recovery. Again, policy mishaps can certainly nudge credit spreads to alarming levels if the FOMC isn’t especially prudent in their analysis.

Possible bad and worst-case scenarios

Under our first scenario we estimate that the Fed is too hawkish in their view and inflation doesn’t arrive. We would estimate an economic recession that could be described as mild compared to 2008 -09 with the US stock market as measured by the S&P 500, declining 10% to 15%. This correction would be a function of a loss of earnings power due to economic slowing but multiple contraction could remain limited given a benign inflationary picture.

We say this because previous research indicates a direct correlation between inflation (expectations) and market earnings multiples. Simply stated, with the lack of inflation, the market is justified trading at higher multiples. With inflation expectations in the two percent (2%) annual range, an average trailing earnings multiple of 19.6x is typical compared to a long-term overall average of 15.6x. As a frame of reference, the average trailing earnings multiple for the S&P 500 during periods of higher than normal inflation (plus 5%) is 9.8x.

Consider worst case scenario two – The Fed overshoots on the hawkish side and inflation shows up exonerating the rules set forth by the Phillips Curve. Internally, we at Ruterra Partners consider this the worst-case scenario that could prove devastating for US equities. In this scenario we lose both real earnings and earnings power which results in double-trouble. The loss of real earnings due to an economic slowdown coupled with contracting multiples due to the loss of earnings power to inflation could set us on course for another bear market (decline of 20% or greater).

Worst Case Strategy

We’ve planned and prepared for both the bad case and worse case scenarios. Should the economic growth cycle come to an end and the stock market suffer, we are prepared to incorporate our beta neutral hedging strategy in the portfolio that will minimize the negative drawdown effects of the declining market while preserving our capital. We’ll continue to build cash reserves through the collection of dividends and option premium that will be partially offset by the cost of portfolio insurance. Implied volatility will surely rise so the costs of portfolio insurance will rise. With the ability to “ride the storm” we’ll come away from the event in a much stronger position with a greater ability to find good companies that are a relative bargain.

Under this scenario, we wouldn’t anticipate many opportunities to be produced from merger arbitrage as those market conditions are not conducive for the merger and acquisition market. Most likely the appropriate position in our merger-arb portfolio will be on the sidelines until the markets stabilize.

We anticipate the greatest returns produced from our pairs trading mispricing portfolio. It has been evident that during times of extreme market turmoil, the results from this strategy have been the most fruitful. As a market neutral methodology, the model produces the greatest returns from market volatility. Thus we expect to keep our returns intact with our stated goals while we wait for better opportunities within our core portfolio.

Tax Reform

It can certainly be said that the Trump Administration is having difficulty gaining traction on the many proposals he put forth during his campaign. The complete failure of repealing and replacing the Affordable Care Act (Obamacare) was disheartening to President Trumps base. I call it a complete failure, not because I necessarily support the position, but because it wasn’t robust enough to even get it past Republicans that currently enjoy the majority in Congress.

That said, it created a sense of urgency for Republicans to prove their ability to get something done and it appears tax reform is a clearer path to bipartisan support.

The White house has released its initial proposal for tax reform and hence the infighting has begun. While the details remain quite vague, the general proposal consists of significant changes in individual and corporate taxes as well as changes to corporate foreign income. For individual taxes it collapses seven tax brackets into three or possibly four, nearly doubles standard deductions for most households and increases child credits, retains mortgage interest deductions and eliminates state and local deductions. On the corporate tax front, the proposal calls for lowering the corporate tax rate from 35% to 20% and lowers pass-through small business taxes to 25%. It also allows for immediate write-offs of business investment and preserves tax breaks for research and low-income housing.

In return, corporations will have less leeway for tax deductions across the board. It will also provide a one-time tax on stockpiled foreign profits and allows tax-free repatriation for future foreign profits.

The White House has dug its heels into a supply-side economic theory that lower corporate taxes will create jobs and enhance economic growth. This job-creating and economic growth function will more than offset the lower revenues for the Federal Government as most republicans have embraced “dynamic scoring” when calculating future deficits.

I’ll share with you a few thoughts that we have in regard to the tax plan but we’ll finish off most importantly with how this proposal could affect the capital markets and what we have planned to achieve our stated investment objectives.

Taken at face value, it is estimated that this initial plan will cut approximately $5.8 trillion in tax revenues over the next decade according to the nonpartisan Committee for a Responsible Federal Budget. This cut in revenues will be partially offset by $3.6 trillion in revenue-raising provisions leaving a net deficit of $2.2 trillion. The Urban Institute’s Tax Policy Center forecasts the plan will increase the federal deficit by $2.4 trillion in the next ten years. The Trump Administration claims these figures are static figures that do not take into account the added economic benefits and growth the economy will sustain because of these tax cuts.

Does dynamic scoring work in real life?

As we delve into our research we need to remember that the United States does indeed have the highest statutory corporate tax rates in the world at 39.1% according to the Congressional Budget Office. That said, using deductions and general tax loopholes the rate that corporations pay is quite less. The CBO estimates the effective corporate tax rate to be 18.6% for the US, still one of the highest in the world but behind Argentina, Japan and the United Kingdom.

Assuming a tax plan that cuts the statutory corporate tax rate to 20% without the deductions and loopholes from 39.1% sounds dramatic, it is less impactful when considered against the effective tax rate. Thus, it is our opinion that the “shock and awe” from this tax change may result in a near-term sugar high for the economy and the stock market but over the long term I find it difficult to believe this would lead to the 4% economic growth that some in the current administration have been touting.

Unfortunately, the dismal realities don’t end there. When comparing corporate tax rates to economic growth, the jury is still out if there is even a connection between the two. The Economic Policy Institute compared economic growth to changes in both the statutory and effective corporate tax rates from 1954 through 2006.

What they found was a very slight positive correlation between economic growth the statutory corporate tax rate. This certainly flies in the face of those that claim higher tax rates stymie US economic growth, but for the record the results appear random to me without any statistical significance between the two metrics.

To be fair they also analyzed economic growth against the effective corporate tax rate. The relationship here did have a slight inverse relationship as would be expected by supply-side economists but once again the relationship looks completely random. These figures really cast a large shadow of doubt over the assumptions presented from the White House.

The researchers go on to conclude, “In 2012, corporate profits (before- and after-tax) as a share of national income were at a postwar high. Corporate profits were relatively high throughout the late 1940s and 1950s, and fell throughout the 1960s and 1970s to reach a low in 1982. Since then, corporate profits reversed course and have generally been rising to their current postwar high.

The top statutory corporate tax rate has been falling since the early 1950s. The top corporate tax rate was 52 percent throughout the Eisenhower administration—17 percentage points higher than the current top rate of 35 percent. U.S. GDP grew by almost 4 percent annually in the 1950s compared with a 1.8 percent growth rate in the 2000s. On the surface, it would appear that more robust economic growth is associated with higher corporate tax rates. Further analysis, however, finds no evidence that either the statutory top corporate tax rate or the effective marginal tax rate on capital income is correlated with real GDP growth.”

We would venture to argue that over the longer term, the tax cuts would force the hand of the Fed to start quickening the pace of monetary tightening to off-set the near-term boost to the economy.

With unemployment at 4.4% we conclude that the Fed considers us near-full employment. They also project that inflation will show up at some point. The Fed is not veering from their course of raising interest rates and shrinking their balance sheet. So having fiscal policy with their foot on the gas, and monetary policy with their foot on the brake – it isn’t obvious to me that tax reform will likely be the panacea that brings about economic euphoria.

Politics Turned Upside Down

It would appear that President Trump has put Washington on a topsy-turvy trajectory. It wasn’t that long ago that Democrats and Republicans threatened to shut the government down and drive off the “fiscal cliff” all for the sake of keeping our national debt within certain boundaries.

Republicans didn’t want the debt ceiling raised without deficit reducing measures. Donald Trump on the campaign trail chastised President Obama as fiscally inept as our national debt increased dramatically on his watch. Fast-forward to 2017 and now it’s the Republicans proposing a tax plan that will have negative implications for our county’s debt level while the Democrats have become the fiscally responsible ones. It’s very funny how politics work.

Publicly held federal debt sits at 77% of our nations GDP and is expected to rise to 91% over the next decade. With the introduction of tax reform, we’re surely on pace to achieve 100% in the next ten years, which we consider a net negative for the US economy and our country as a whole.

Our 2018 Strategy

We expect continued economic prosperity and the stock market to continue with its upward trajectory. We believe fiscal policy measures will bolster market sentiment but pressure the Fed to maintain its hawkish posture. We will capitalize on any pullback that the market offers to build positions in select equities that have passed our stringent GARP criteria and prepare ourselves for a possible worst-case scenario with appropriate hedging strategies.

Joseph S. Kalinowski, CFA