Janet Yellen2

by Joseph Y. Calhoun

Well, that was ugly. The lousy employment report released this past Friday threw the markets and probably the FOMC for a loop. Stocks didn’t really do anything – yet – but other markets more than made up for that minor oversight. The dollar was down 1.5% on the week, all of that after 8:30 Friday morning. Gold was up 2.57% on the week with all of that coming, again, after the Labor Department reported the sour state of the labor market. The 10 year Treasury yield, which flirted with 1.9% early in the week finished 20 basis points lower, around 1.7%, a drop in yield of nearly 6% in one day.

And so once again, the Fed finds itself with egg on its face, hoisted by its own petard of forward guidance. As I’ve said numerous times over the last few years, forward guidance – what other kind of guidance is there by the way? – is only as good as the Fed’s forecasting ability. Which is, sad to say, not very good. Forward guidance has itself become the destabilizing force, a source of volatility rather than a dampener, creating uncertainty rather than providing the opposite. It is hard to believe markets would have had to adjust so sharply Friday if the members of the Fed had just been silent the last few weeks. There has certainly been nothing in the economic data that could have been cited to justify a rate hike. As I said a couple of weeks ago, if we had economic performance like this and interest rates were anywhere near normal, the Fed would be hinting at a rate cut, not a hike.

If the Fed is truly data dependent, willing to adjust policy only if the economic data supports the notion, then they will be hard pressed to do anything other than sip coffee and eat doughnuts at their meeting next week. It does not require much analysis to see the economy is not hitting on all cylinders and is a lot closer to recession than the Fed can admit. The employment report that moved markets so quickly is but one of many stats trending in the wrong direction. One need not take my word for that. The bond market is a better economic prognosticator than anyone at the Fed or on Wall Street or at Alhambra ever will be and it is saying pretty loudly that the economy stinks. The 10 year Treasury is not trading at 1.7% because everything is hunky dory.

The reports on the economy last week were pretty uniformly weak and less than expected. There were exceptions such as the Personal Income and Spending report but even those had problems. Spending was up but at least some of the increase was due to rising gasoline prices. Factory orders were up but outside a surge in civilian aircraft orders the rest of the report was pretty soft. There was some actual good news in the trade report for a change with both exports and imports higher. Of particular note was a rise in capital goods exports. It is just one month though and the year over year change for trade is still negative if a little less dire than the last report.

The Chicago PMI and the Dallas Fed survey followed the other regional manufacturing reports from last week in falling back to contraction. The ISM manufacturing survey was a little better than expected but at 51.3 isn’t pointing to anything other than weak growth. The same can be said about the non-manufacturing version also released last week and a lot less than expected at 52.9. Construction spending was down, consumer confidence was down and the Beige Book reported weaker growth. The one economic sector that has offered some glints of hope is real estate – despite the negative trend in construction spending. House prices are rising – up 5.4% year over year according to Case Shiller – and sales have been at least generally trending up. I can’t help but wonder how long that will last if the economy continues to weaken but for now it is a positive.

While the odds of recession have no doubt been rising, it is still not a certainty that one is in the offing soon. The Atlanta Fed’s GDPNow forecast, which has been pretty accurate the last few quarters, is still pointing to 2.5% growth in Q2, although that is down from 2.9% just recently. Surely, the Fed hopes the data improves but if it doesn’t the consequences may be significant. You can be sure that the weak data is welcome on the Donald Trump for President bandwagon that is gaining passengers by the day. If Hillary Clinton represents the conservative, stay the course choice, then a weakening economy may be the death knell for the Clinton 3.0 campaign.

If the economy worsens, one has to wonder what exactly the Fed would or could do. Changing policy in a significant way before the election is not going to be a popular choice in the Trump camp. You can bet there will be accusations of political favoritism, of Democrat Yellen trying to push the Clinton campaign across the finish line. And certainly the Fed knows that and will try to avoid it – or at least I think they will. Frankly, with QE’s impact on inequality, I can’t believe another round would be welcome to all those Bernie Sanders supporters either who are loathe to support Clinton anyway. So if QE is out, what else might the Fed do? Negative interest rates? I suppose that’s possible but so far it hasn’t accomplished much in Japan or Europe.

The point is that if the economy requires stimulus you probably shouldn’t be counting on the Fed to provide it. I suppose there may be some helicopter options that could be effective – effective in this case being very loosely defined – but that would require Congressional action, the odds of which in an election year are exactly zero. If the economy continues to weaken, don’t count on any policy action to forestall it – if such a policy even exists.

And yes, I suspect we will continue slouching towards recession even if we don’t arrive before election day, so you might want to start thinking about the consequences of having to call Mr. Trump by his new title – President. You need to start thinking about that now because the market anticipates, pricing in some probability of a President Trump even now. If those odds rise, the market is going to change in some way to reflect the greater likelihood of a Trump White House.

Forget for a minute that Donald Trump is the Republican nominee. Think about the policies he is likely to propose as President and how they might affect the markets. Forget the campaign rhetoric for a minute, the things he’s proposed that can’t get done because the US President isn’t a dictator and can’t just do anything he wants. Divorce the message from the messenger. His basic economic platform, stripped of the campaign trail hyperbole, is:

  1. Cut personal taxes
  2. Reform the corporate tax code and lower the rate
  3. Spend $1 trillion on infrastructure
  4. Simplify regulatory structure, stop crony capitalism
  5. Renegotiate trade treaties to favor the US

And every indication is that he would pay for this agenda with more debt. He’ll pay lip service to the deficit and debt but as he’s said, he’s “comfortable” with debt financing; it’s generally his creditors who aren’t comfortable.

The irony here is that Trump’s economic platform is essentially the compromise everyone claims to want. There was never going to be a deal that allowed Republicans to cut taxes without allowing Democrats to spend more nor vice versa. A compromise isn’t a compromise unless both sides get at least some of what they want. So the only compromise with any chance of success is one that addresses both party’s preferences, i.e. cuts taxes and raises spending. Both parties already agree on the need for corporate tax reform. In addition, most of the trade treaties of the last several decades have been passed without the support of a majority of the Democratic party. But now, the free trade orthodoxy is under siege, the losers more prominent and sympathetic than the winners. So, again, some degree of agreement on trade between the parties is starting to develop.

All else equal, if that agenda had a high likelihood of being enacted, I think the markets would react positively, pricing in higher future growth. Stocks higher, bonds lower, dollar higher. But of course, things are rarely equal and certainly not in this case. Remember this thought experiment started with an assumption – that a weaker economy is positive for Trump. The potential positive of a change in policy in the future may not outweigh a lousy economy today. A weak economy might pull bond yields lower even if the prospect of President Trump tries to push them higher. And if rates do rise, with stocks already highly valued, would a higher discount rate just offset any potential better growth? How would the dollar react to the prospect of opening new trade negotiations? How do you factor in Trump’s lack of foreign policy experience? What about his habit of insulting large swaths of the planet’s population? What discount rate do we put on boorishness?

I stress here that I’m not endorsing the Donald or predicting that he will win. But I think investors need to consider the possibilities, the probabilities and adjust if need be. I generally don’t spend much time thinking about politics. My view is that the influence of the political class on the economy is probably overstated. Presidents can’t do big things to (for?) the economy without Congressional approval. What has me thinking more about politics lately is that the agenda Trump has put forward, is one that could pass. Not that I wouldn’t like lower taxes or a more coherent, competitive corporate tax code. But that $1 trillion worth of “infrastructure” worries me; I get worried anytime bi-partisanship breaks out. One should be wary of anything that both political parties agree on especially when it has 12 zeros on the price tag.

Right now, I think the consensus is still that Hillary Clinton will be the next President; the market hasn’t priced in much in the way of a Trump victory. But if that starts to change so will the market. The policies he’s proposing are ones that Wall Street is probably going to like when they think about it. Whether that is enough to push stocks higher from here will likely depend on the state of the current economy. Keep an eye on those economic trends – and the polls. It’s going to be a long hot summer.