It’s Not Just the Fed’s Balance Sheet That’s Changing
Thursday, September 21, 2017

Two special notes before I start this week’s commentary. First, L'Shanah Tovah to those of you celebrating Rosh Hashanah.
 
Second, though our Investor Conference is getting close to selling out, there is still time to register. You will want to hurry because late fee pricing will go into effect on Monday, September 25. The event is being held in Orlando, where both our conference facilities and hotels incurred no discernable damage from Hurricane Irma. (Our hearts and prayers go out to everyone who has been affected by this summer’s storms.) The conference is a great opportunity to learn and meet fellow AAII members. Click here to learn more and to register.

Yesterday, the Federal Open Market Committee (FOMC) announced its plan to unwind its balance sheet. Starting next month, the Federal Reserve will stop reinvesting $6 billion of proceeds from maturing Treasury securities and $4 billion proceeds from maturing agency debt and agency mortgage-backed securities. The dollar amounts will be gradually rising each month, subject to adjustments as warranted. The FOMC also updated its forecasts for economic growth, keeping the annual long-term projection for GDP expansion at 1.8%. Interest rates were left unchanged and expectations for how rates will be raised next year trended downward.

All of this is occurring as Fed Chair Janet Yellen’s term will expire in February. It’s not clear who will actually hold the seat when the next term starts. In addition, President Trump will have four Federal Reserve Board vacancies to fill once vice chair Stanley Fischer steps down in October. Former senior Treasury official Randal Quarles’ nomination for the board is currently pending before the Senate.

The sheer number of personnel changes could alter future monetary policy from what it would have been. Yellen’s approach has been dovish. The FOMC under her tenure has been very cautious about raising rates and pulling back monetary stimulus even with a tightening cycle now occurring. A big reason has been lower-than-expected inflation. The chart at the right is an update to one I published a year ago. As you can clearly see, long-term growth expectations—though unchanged from 12 months ago—remain below levels projected in 2012 and 2013.

Whether the president’s appointees to the Federal Reserve will be comparatively more hawkish or dovish remains to be seen. Throughout his real estate career, Trump has relied heavily on borrowing. This would suggest a preference to keeping interest rates low. As long as inflation remains at tame levels, the economic data would make it hard to justify a shift to a significantly more hawkish monetary stance.

This is not to say that there won’t be more interest rate hikes before the current tightening cycle ends. There have been precedents for Federal Reserve chairs to butt heads with the presidents they’ve served under. If a future Fed chair believes there is evidence for an acceleration in the rate of inflation, we could see a more frequent approach to raising rates than we have seen since the first post-financial crisis interest rate hike was announced in December 2015. (There have only be two additional hikes since then.) Whether such a shift would actually occur is highly uncertain.

The other wildcard is the Federal Reserve’s balance sheet. By not reinvesting the proceeds of maturing bonds, the central bank is effectively reducing demand for those bonds. The effect of this on the credit market will be the subject of economic studies and textbooks for decades to come. Fed officials are going to have to be sensitive to any ripples in the credit markets and adjust accordingly. To predict how things will turn out is to make a big guess. It’s an uncertainty, but it’s a well-telegraphed uncertainty and so far the bond markets have not shown signs of fear about it.

More on AAII.com

Highlights from this month's AAII Journal

  • Take RMDs Early or Late in the Year? – There are pros and cons to taking required minimum distributions at year-end, at the beginning of the year or at regular intervals throughout the year.
  • The Factors Driving Dividend Policy – An analysis of global dividend policies attributed the rationale for companies to pay and raise their dividends to many factors.

AAII Model Portfolio Update
Ultra Clean Holdings (UCTT) was sold from the Model Shadow Stock Portfolio because its price-to-book ratio exceeded the valuation limit of 3.0. The proceeds from the sale of the stock—which had tripled in value—were used to add Amira Nature Foods Ltd. (ANFI), Delta Apparel Inc. (DLA) and Strattec Security Corp. (STRT).
 
The AAII Model Shadow Stock Portfolio, which is a real-money portfolio of micro-cap value stocks, fell 2.1% in August. The Vanguard Small Cap Index fund (NAESX) lost 0.9% for the month, and the DFA U.S. Micro Cap fund (DFSCX) shed 2.2% in August. Since its inception in 1993, the portfolio has realized an annualized return of 15.8% versus the Vanguard 500 Index fund’s (VFINX) gain of 9.3%. The DFA U.S. Micro Cap fund (DFSCX) has an annualized return of 11.4% over the same period.
 
No changes were made to the Model Fund Portfolio. The portfolio declined by 0.9% in August, versus a 0.3% increase in the SPDR S&P 500 ETF (SPY). Since its inception in July 2003, the Model Fund Portfolio has an annualized return of 8.8%, while the SPDR S&P 500 ETF has an annualized return of 8.9%.
The Week Ahead
We’ll see more companies announcing results during what is the run-up to the third-quarter earnings season. Included in the group are S&P members Carnival Corp. (CCL) and Red Hat Inc. (RHT) on Monday; Darden Restaurants Inc. (DRI), IHS Markit Ltd. (INFO), Micron Technology Inc. (MU), Cintas Corp. (CTAS) and Dow Jones industrial average component Nike Inc. (NKE) on Tuesday; and Accenture PLC (ACN), ConAgra Brands Inc. (CAG) and McCormick & Company Inc. (MKC) on Thursday.

The week’s first economic reports will be July S&P Case-Shiller home price index, August new home sales and the Conference Board’s September consumer confidence survey. All three will be released on Tuesday. Wednesday will feature August durable goods orders and August pending home sales. The final revision to second-quarter GDP and August international trade will be released on Thursday. Ending the week, August personal income and spending, the September Chicago purchasing managers’ index and the University of Michigan’s final September consumer sentiment survey will be released on Friday.

Ten Federal Reserve officials will make public appearances. New York president William Dudley, Chicago president Charles Evans and Minneapolis president Neel Kashkari will speak on Monday. Cleveland president Loretta Mester, Atlanta president Raphael Bostic and Fed Chair Janet Yellen will speak on Tuesday. Minneapolis president Neel Kashkari, St. Louis president James Bullard and Boston president Eric Rosengren will speak on Wednesday. Kansas City president Esther George will speak on Thursday. Philadelphia president Patrick Harker will speak on Friday.

The Treasury Department will auction $26 billion of two-year notes on Tuesday, $13 billion of two-year floating rate notes (FRN) and $34 billion of five-year notes on Wednesday and $28 billion of seven-year notes on Thursday.
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AAII Sentiment Survey

Optimism declined slightly, while pessimism bounced back from a 17-month low last week.

Bullish sentiment, expectations that stock prices will rise over the next six months, fell 1.2 percentage points to 40.1%. Optimism was higher last week (41.3%). Despite the slight decline, this is the now the second week in a row, but only the third time in the past 31 weeks, that optimism has been above its historical average of 38.5%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, declined 4.1 percentage points to 32.7%. Neutral sentiment was last lower on August 2, 2017 (31.8%). This is the 21st consecutive week that neutral sentiment has been above its historical average of 31.0%.

Bearish sentiment, expectations that stock prices will fall over the next six months, gained 5.2 percentage points compared to last week’s reading, reaching 27.2%. Despite the increase, pessimism was much higher two weeks ago (35.7% on September 6, 2017) and remains below its long-term historical average of 30.5%.

At current levels, bullish sentiment remains close to its historical levels. Pessimism, though low, is also within its typical range.

While pessimism rose this week, it may have been a simple mean reversion; last week pessimism declined to its lowest level since April 6, 2016. The reading marked the largest one-week drop since July 2010. From the beginning of 2009 up to this week, there have only been 26 declines in bearish sentiment of 10 percentage points or more.

As stated last week, although the August pullback has been reversed, concerns about a larger pullback still exist among some investors, and monetary policy may play a big role in future expectations. The Federal Reserve concluded its two-day meeting on Wednesday, and (as expected) announced no change in the policy interest rate. While the bank did mention that one more rate hike by year end is likely, officials projected one fewer rate hike than initially forecast by 2019. The Federal Reserve also announced its intention to begin unwinding its $4.5 trillion balance sheet in October, and it trimmed its inflation outlook for this year from 1.7% to 1.5%, and for 2018 from 2.0% to 1.9%. The lack of inflation may have been why the Federal Reserve lowered its long-run target for the fed funds rate from 3.0% to 2.8%.

Prior to the Federal Reserve meeting, the probability of one or more additional rate increases before year-end was roughly 50-50, according to fed funds futures data tracked by CME Group. This probability jumped to nearly 70% following release of the Fed meeting minutes, while Treasury yields climbed and the U.S. dollar strengthened against peer currencies.

Now that the Federal Reserve meeting has passed, investors will likely shift their focus back to Washington. Additionally, a new earnings season is right around the corner.

This week’s special question asked AAII members how the new record highs set by the major large-cap indexes are influencing their outlook for the stock market. Nearly half of all respondents (47%) say the record highs are having a negative influence. Valuations are a key reason why. Some of these respondents say they are either purposely raising cash or postponing buying new stocks until the market pulls back. Conversely, 28% of respondents say the new highs are a reason to be optimistic, particularly because of the positive momentum stocks are exhibiting. Slightly more than 19% say their outlook hasn’t changed. Many of these respondents described themselves as taking a long-term view of the market.

Here is a sampling of the responses:

  • “Stocks are getting very expensive based on relative measures and suggest a cautious approach until a cleansing correction occurs.”
  • “Although earnings have improved, they have not kept up with the expansion of the market’s multiples.”
  • “The market is in an uptrend and making new highs, which makes me bullish.”
  • “I’m not buying, just stashing cash in the best money market funds I can find.”
  • “I stay fully invested at all times, so I’m a happy camper.”


This week’s Sentiment Survey results:

Bullish: 40.1%, down 1.2 points
Neutral: 32.7%, down 4.1 points
Bearish: 27.2%, up 5.2 points

Historical averages:

Bullish: 38.5%
Neutral: 31.0%
Bearish: 30.5%
Take the Sentiment Survey.

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