There’s a 50/50 chance that Democrats and…
Will Republicans and Democrats agree on a budget, and avoid a
government shutdown after midnight Friday?
I’d say the odds are 50/50. Actually, I put the odds of a
shutdown at about 55%. There’s certainly enough substance here to
be wary.
The government could shut down because of disagreements over
defense spending, funding for Trump’s wall with Mexico,
deportation of illegal immigrants brought to the U. S. as children
(the “Dreamer Act” also referred to as “DACA”), funding for
Planned Parenthood, funding for Obamacare (called “SCHIP”),
disaster relief and more.
There’s not much middle ground between Democrats and Republicans
on many of these hot button issues.
How would a shutdown affect the Fed’s plans to raise rates on the
13th?
If an agreement can’t be reached and the government does shut
down, it’s very difficult to imagine that the Fed would go
forward with its planned interest rate hike on Dec 13.
Meanwhile, markets are almost certain the Fed will raise rates.
It’s already “baked into the cake.”
The euro, yen, gold and Treasury notes are all fully priced for
rate hike. If it happens, those instruments won’t change much
because the event is priced.
But we could see a violent market reaction if Janet Yellen stays
put and doesn’t raise rates.
If the Fed doesn’t raise rates, gold could soar as the Fed passes
on its best chance to raise rates and markets perceive that easy
money is here to stay. Euros, yen and Treasury notes will also
soar.
Of course, saying the
government could shut
down is different than saying the
government will shut
down. Again, I give it about a 55% chance at this point.
And there are lots of ways for things to go wrong.
Late last week the Commerce Department released the October PCE
core inflation data. This is important because that’s the number
the Fed watches. There are plenty of other inflation readings out
there (CPI, PPI, core, non-core, trimmed mean, etc), but PCE Core
year-over-year is the one the Fed uses to benchmark their
performance in terms of their inflation goal.
The Fed’s target for PCE Core is 2%. The October reading was
1.4%. For weeks I’d been saying that a 1.3% reading would put the
rate hike on hold, and a 1.6% reading would make the rate hike a
done deal. So, the actual reading of 1.4% was in the mushy middle
of that easy-to-forecast range.
What’s interesting is that the prior month was also 1.4%, so the
new number is unchanged from September. That’s not what the Fed
wants to see. They want to see progress toward their 2% goal.
On the other hand, the 1.4% from September was a revised number.
It was earlier reported at 1.3% (the same number as August).
You can read this two ways. If you see the August 1.3% as a low,
then you can say the 1.4% readings for September and October were
progress toward the Fed’s 2% target. It’s a thin reed, but Yellen
could use this to justify her view that the year-long weakness in
PCE Core is “transitory.”
On the other hand, these 0.1% moves month-to-month are really
statistical noise and may even be due to rounding. The bigger
picture is that PCE Core is weak and nowhere near the Fed’s
target. Another rate hike in December could be a huge blunder if
it slows the economy further and leads to more weakness in PCE
Core.
On balance, the PCE Core number is probably just enough (barely)
to justify a rate hike. I’ve raised my probability of a December
rate hike from 30% to just over 50% — 55%. That’s what analysts
are supposed to do; they update forecasts continually based on
new data. You can’t be stubborn about your analysis.
I’m not trying to be “in consensus” or “out-of-consensus.” I just
want to get it right, and that means sometimes I’ll be in
consensus. Other times, I won’t be.
But you should forget how the market is pricing the outcome. The
Fed funds futures market has been off by orders of magnitude
before. In mid-February 2017, the futures markets gave the odds
of a rate hike in March at 30%.
I was giving 80% odds.
Within three trading days at the end of February, the market odds
shifted from 30% to 80% before converging at 100% by the March
meeting.
That does not mean I’ve got it right this time. But it does
illustrate that the futures market does not always get this right
— not even close.
And markets are being set up for a fall.
Bull markets in stocks seem unstoppable right up until the moment
they stop. Then comes a rapid crash-and-burn phase.
Is there ever any warning that a collapse is about to happen?
Of course there is. Analysts warn about it all the time and
provide mountains of data and historical evidence to back up
their analysis. The problem is that everyone ignores them.
You can talk about the dangers represented by CAPE ratios, margin
levels, computerized trading, persistent low volatility and
complacency all you want, but nothing seems to slow down this
bull market.
Yet there is one thing that can stop a bull market in its tracks,
and that’s corporate earnings.
The simplest form of stock market valuation is to project
earnings, apply a multiple and, voilà,
you have a valuation. Multiples are already near record highs, so
there’s not much room for expansion there.
The only variable left is projected earnings and that’s where
Wall Street analysts are having a field day ramping up stock
prices. Earnings did grow significantly in 2017 on a
year-over-year basis, but that’s mainly because earnings were
weak in 2016, so the year-over-year growth was relatively easy.
Now comes the hard part.
How do you expand earnings again in 2018 when 2017 was such a
strong year? Wall Street just uses a simple extrapolation and
says next year will be like this year, only better! But there is
every reason to doubt that extrapolation.
Earnings are likely to fall short of expectations, which can lead
to a correction. Once that happens, multiples can shrink as well.
Soon you’re in a full-scale bear market with stock prices down
20% or more.
