Inflation Is Like Wine

by Brad Houle, CFAExecutive Vice President

This week, a few of us at Ferguson Wellman had the opportunity to attend a lunch presentation where Dr. John Williams, president of the Federal Reserve Bank of San Francisco, was speaking.

He started his remarks with a disclaimer that everything he was about to say was his own opinion and not the opinion of the Federal Reserve. That said, one can imagine that there are detailed guidelines around what Fed Governors can say in a public setting.

“Jawboning” is an expression for the Fed communicating its intentions to the market. Dr. Williams’ comments were being reported in real time on Bloomberg as well as other financial media outlets. These days, what the Fed says it is going to do is as important or more important that what it actually does. This week, Dr. Williams conveyed the message that the Fed was going to raise rates at the next Fed meeting without actually saying so.

One of the takeaways from the presentation was the how the Fed thinks about inflation and the lag between monetary policy changes and the actual impact. Dr. Williams said this about inflation: "The inflation side of the equation is where the winds are blowing colder than I’d like.” For those of us who lived through the ’70s and ’80s, the need for higher inflation seems anathema to a healthy economy, but that’s where we are right now. He also said, “Inflation is like wine … a little bit is actually good for you.”

With respect to the lag between monetary policy changes and the impact, Dr. Williams said, "Milton Friedman famously taught us that monetary policy has long and variable lags. Research shows it takes at least a year or two for it to have its full effect."  Looking at the current inflation data in the context of this logic supports why the Fed will most likely raise interest rates even if inflation is below the 2 percent target.

There was a question from the audience regarding the notion that economic data is backward looking, yet Fed Governors are tasked with being forward looking. How would they reconcile the two? Dr. Williams shared how the Federal Reserve Governors are regionally based with volunteer boards within their districts. He said that they spend a lot of time speaking with business owners, bankers and other community leaders who live in the district. These efforts are a critical source of forward-looking information for the Fed.

Communication from the Federal Reserve increased greatly under Chairman Bernanke and has continued under the Yellen Fed. It was fascinating to glimpse a small step in the Fed's painstaking and deliberate communication with the financial markets.

With that, today’s U.S. jobs market report of 211,000 new jobs in November seems to seal the deal that interest rates are going to rise this month. The market responded favorably today with a 2 percent rally in the S&P 500 and the U.S. dollar strengthening as well. This confirms that, in addition to comments from the Fed, when economic data speaks – the markets listen.

Our Takeaways from the Week

• We anticipate an interest rate hike from the Fed in two weeks, albeit gradual
• The economy continues to grow at a steady, healthy pace

Disclosures

Good News First

by Jason Norris, CFAExecutive Vice President of Research

Good News First

The jobs market continues to chug along adding 215,000 jobs in the month of July with upward revisions to June and May of 14,000. While this is a solid pace of gains, it hasn’t been strong enough to push wages higher.

Equity markets, on the other hand, have struggled the last several sessions, despite favorable earnings reports. We have seen the major declines in profits in the energy sector; however, the rest of the economy seems to doing well. With just under 90 percent of companies in the S&P 500 reporting second quarter earnings, year-over-year profit growth could very well be negative 1 percent. While nothing to write home about, the main culprit has been the energy sector. Energy earnings are going to be down close to 60 percent year-over-year. If you back out the energy sector, earnings for the rest of the market will be up 5 percent year-over-year. Healthcare, consumer discretionary and financials have led the way higher. We recommend that investors don’t get caught up in the headline numbers, especially now that one sector is having such a major impact on the overall number.

The price of oil won’t necessarily be helping out the energy sector in the third quarter. With WTI at $44, it is close to its March lows. We moved to an overweight in the energy sector six months ago with the belief that as prices fell, demand would increase and supply would decline. What surprised us was the supply side. While rig count has declined by 60 percent domestically, U.S. supply has been somewhat slow to respond to reduced drilling activity. Nevertheless, U.S. supply has peaked and should decline into the second half of the year. We contrast the ex-growth situation domestically with OPEC, where key producers Saudi Arabia and Iraq have combined to boost cartel volumes by 6 percent so far this year. Aside from flattened production domestically and OPEC’s production growth this year, the key to our call for higher oil prices is stronger than commonly perceived demand growth and production from non-U.S., non-OPEC regions around the world. Despite oil prices that reached $140/barrel in 2008, this key source of global supply has failed to deliver any additional production over the past eight years. Our bet is that if additional volumes weren’t forthcoming in more propitious times, this key source of approximately 54 million barrels/day of supply is likely declining at currently depressed prices. Therefore, it will increasingly help to balance the market. We still believe oil will be closer to $70 then $40 at year-end and are focusing on companies with strong balance sheets to weather this near-term storm.

Only a Matter of Time        

Recent economic data has not been conducive to a September Fed rate hike. While the unemployment rate at 5.3 percent is a positive sign, coupled with weekly jobless claims at historic lows, there is still a lot of slack in the labor market. There are currently over 5 million jobs that are available, which is an all-time high. While this data signals a tight labor market, the unemployment rate figure does not. Also, wages aren’t increasing at a rate that is a threat to inflation. Earlier this week, the Employment Cost Index showed only a 2 percent increase in labor costs, which comprised 2.1 percent in wages and 1.8 percent in benefits. Today’s jobs report confirmed this with hourly wages rising only 2.1 percent.

We believe a Fed rate hike will happen before the end of the year. Given current data trends, whether it is September or December is a toss-up. We have seen and read about indications that the Fed wants to start the process; however, we believe the data is still signaling uncertainty.

Our Takeaways for the Week

• The Fed will raise rates by the end of 2015
• Stocks continue to be weak, which could be seasonal, but we believe that fundamentals are still attractive

Disclosures

Spring is Finally Here

by Shawn Narancich, CFA Executive Vice President of Research

Spring is Finally Here  

True to our outlook for the quarter and in-line with anecdotes from the mass of companies reporting first quarter earnings, the U.S. economy appears to be gaining speed after a weather-induced slowdown earlier in the year. While investors were disappointed to learn that first quarter GDP barely budged in the U.S., their disappointment was short-lived, as the blue-chip Dow Jones Industrial Average traded to new highs this week, with the benchmark S&P 500 not far off its best-ever levels. Merger and acquisition deal flow has picked up markedly, signaling greater confidence in corporate America to deploy near-record levels of idle cash. To our surprise, benchmark 10-year Treasury bonds remain remarkably well bid, with yields that held stable after a bullish jobs report likely reflecting continued geopolitical risk in Eastern Europe.

Green Shoots

Investors were encouraged to see that the U.S. jobs market kicked into a higher gear, producing substantially better than expected growth of 288,000 net new jobs in April. Previously reported jobs numbers were revised higher and the unemployment rate fell to a 5-and-one-half-year low of 6.3 percent. Bears will argue that a drop in the labor force participation rate to 36-year lows was responsible for the falling jobless rate, as discouraged workers gave up the hunt for jobs. We would argue that an accelerating economy will produce more job opportunities for disaffected workers, pulling them off the sidelines and tempering the decrease in unemployment. Average hourly earnings remain subdued, rising at the slowest pace of the year, and likely heartening the Fed, which earlier in the week left its QE3 tapering on course for conclusion by year-end. In addition to healthier labor markets, equities are responding favorably to further strengthening of the U.S. Purchasing Managers Index, a benchmark gauge of manufacturing health; it rose for the fourth consecutive month in April and dovetails with the rising levels of manufacturing and construction employment seen in the payroll report. U.S. auto production in March rising at the fastest pace since 2007 is another data point confirming for us the renaissance in domestic manufacturing. Finally, we were encouraged to see March consumption spending increase by nearly 1 percent sequentially, indicating that shoppers are beginning to spend at healthier rates following a brutal winter.

The Urge to Merge

All of a sudden, deal-making abounds: the planned combination of orthopedic device makers Zimmer and Biomet, Comcast’s proposed acquisition of Time Warner Cable, GE’s bid for Europe’s Alstom, Exelon’s planned acquisition of fellow utility Pepco Holdings, and Pfizer’s $106 billion bid for British drug maker AstraZeneca. This sample of proposed combinations highlights companies attempting to grow their bottom lines through sales and cost synergies at a point later in the economic cycle, when organic growth is harder to come by.

Only time will tell whether these deals actually get consummated as antitrust issues and nationalistic sentiment could foil at least a couple of them. For investors, the bidding activity shines a positive light on the economy and corporate valuations that we believe will continue to expand.

Late Innings of Earnings Season

Nearly 75 percent of the S&P 500 Index has now reported first quarter earnings. With forecasts that initially called for a decline in earnings now morphing into the reality of low single-digit growth, we observe that corporate America is once again proving its ability to under-promise and over-deliver.

Our Takeaways from the Week

•  Evidence of an accelerating economy continues to mount as weather-induced weakness fades
•  Heightened deal activity and better-than-expected corporate earnings leave stocks well bid, trading at near-record highs

Disclosures

"Putin" Russia Behind Us

by Shawn Narancich, CFA Executive Vice President of Research

Good Friday, Great Week

Shaking off another bout of Russian adventurism in the former Soviet Union, stocks moved further into record territory this week on the heels of a better than expected jobs report domestically and encouraging manufacturing reports both here and abroad. Investors have witnessed a slow but steady reversal of the early 2014 risk-off trade, with benchmark U.S. Treasuries retracing approximately half of their earlier year gains and the S&P 500 now up 7 percent from its early February lows. Despite cold and snowy weather that has put a damper on retail sales this winter, we continue to foresee a stronger U.S. economy this year, supported by a rejuvenated energy sector that is in turn producing a renaissance in U.S. manufacturing.

Decoupling

A monthly jobs report signaling net non-farm payroll gains of 175,000 is not ordinarily a reason to celebrate, but viewed against the cold and snowy weather of one of the nation’s worst ever winters, the fact that February employment gains approached the average levels achieved last year is notable. We are encouraged to observe that local and state employment, after being such a material drag for so long, posted gains during the month, but even more important is the continued employment gains reported in construction and manufacturing. Dovetailing with the detail of today’s jobs number was the purchasing managers report for February out earlier this week, which showed manufacturing expanding at a faster pace domestically. Given the encouraging economic data, we foresee the Federal Reserve continuing to pare its purchase of Treasuries and mortgage backed securities, as likely to be detailed at its next FOMC meeting March 19^th.

This week, investors witnessed Russia’s ruble tumble in response to the country’s Crimea incursion, forcing the central bank to boost short-term interest rates in support of the currency, but also adding to the risk that Russia falls into recession.  With emerging market currencies under pressure and in turn creating inflationary problems beyond US and European shores, we see developed economies that have increasingly decoupled from their emerging market counterparts. Supporting our outlook for the world’s developed economies to outperform in 2014, Europe reported its best retail sales numbers in thirteen years and coupled that with surprisingly strong manufacturing growth.

Tales of the Cash Register

Over the past couple weeks, U.S. retailers book-ended a fourth quarter earnings season that once again produced a clear plurality of better than expected results. For the retailers, hits and misses were as numerous as in any quarter we can recall. On the plus side of the ledger, investors were pleasantly surprised by strong sales at department store operator Macy’s and by the home improvement retailers Lowe’s and Home Depot, which both reported strong finishes to fiscal years advantaged by the rebound in housing. Meanwhile, investors in Radio Shack and Staples were left to lick their wounds, as both these companies continue to suffer from sales lost to the digital economy in general and Amazon.com in particular. Both undershot investor expectations and are in the process of closing hundreds of stores to right-size their disadvantaged business models.

Our Takeaways from the Week

• Stocks forged new highs despite geopolitical tensions in Eastern Europe

• Despite bad weather, the U.S. economy continues to make encouraging progress

Disclosures