U.S. Equities: The Tone Is Changing

Since late last year, the U.S. stock market has started to favor defensively orientated sectors.

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Defensive sectors have troughed at extremely attractive relative valuation levels, based on our models. Conversely, cyclical sectors have rolled over, meeting resistance at very demanding valuation levels of more than two standard deviations above normal.

These nascent trend changes have developed even though the economic data have generally surprised on the upside. This may be an indication that a more forceful response will occur once the string of upside surprises loses momentum. For instance, the global PMI has been very strong, but any hint of a reversal would provide a catalyst for a full-fledged recovery in defensive versus cyclical stocks. Keep in mind that the market is priced for a non-inflationary growth nirvana and even modest economic disappointments could short circuit the buying binge.

Moreover, the 2/10-year Treasury yield curve has stopped steepening and financial conditions are no longer easing. This provides additional confirmation that the defensive versus cyclical equity sector trough is more likely a budding trend change than a pause in a downtrend.

Bottom Line: Evidence of a sub-surface trend change continues to materialize, even in the face of upward momentum in the broad market. Our U.S. equity strategists expect a mostly defensive portfolio structure, along with select interest rate-sensitive exposure, to outperform in the next 3-6 months.

The Fed Has An Itchy Trigger Finger

Despite somewhat mixed economic data, Fed officials are clearly prepping investors for a rate hike on March 15.

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Fed Governor Lael Brainard is the latest official to signal that a rate hike in mid-March has a high probability. What makes Brainard’s hawkish comments particularly noteworthy is that she is well known to have very dovish leanings. She joins Fed Presidents Dudley and Williams, who also raised the prospect of raising rates this month earlier in the week.

The sudden hawkish shift to the Fed’s rhetoric is somewhat at odds with the recent data, which do not call for any increased urgency to raise interest rates. Although the core PCE deflator rose 0.3% m/m in January, our diffusion index fell below zero. This means that the price gains were narrow and it would not be a surprise to see softer price increases in the next few months. Moreover, the annual core PCE inflation rate remained steady at 1.7%, still below the Fed’s 2% target. Meanwhile, a divergence between the “hard” activity data and the “soft” survey data persists. Reflecting the former, real consumer spending contracted in January. Consequently, the Atlanta Fed’s GDPNow model slashed its Q1 growth forecast to just 1.8%. However, the ISM manufacturing survey rose to a boom-like 57.7 in February.

Nevertheless, in light of the recent Fed commentaries, our U.S. bond strategists now believe that a rate hike in March has a high likelihood. It will take a very dovish speech by Fed Chair Janet Yellen tomorrow or a very weak nonfarm payrolls report next Friday to stay the Fed’s hand on March 15.

The U.S. equity market has shrugged off the Fed’s hawkishness. It seems that investors see accelerated rate hikes as a confirmation that the economy is strong. Whether this interpretation is correct or not, investors should keep a close eye on the yield curve. A renewed flattening trend will warn that growth expectations are being marked down, which will make lofty equity valuations more difficult to sustain.

U.S. Growth Is Heating Up

U.S. residential and non-residential investment will rebound from the depressed levels seen last year.

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Residential investment was a drag on GDP growth for two quarters in 2016, which is unlikely to persist in 2017. The progress made on foreclosures since the financial crisis has driven housing inventory to its lowest level since the mid-1990s, meaning that housing supply no longer poses a headwind to construction. Further, demographics should also help boost the housing market during the next few years. According to the Joint Center for Housing Studies of Harvard University, over the next ten years, the aging of the millennial generation will boost the population in their 30s. The growth in this age cohort implies an increase of 2 million new households each year on average.

While rising mortgage rates will be a drag on housing at the margin, they will not pose a significant headwind to residential investment in 2017. At least so far, mortgage purchase applications have been resilient in the face of rising rates.

Non-residential investment was a small drag on growth in 2016, but this was largely related to depressed investment in the energy sector. Now that oil prices have recovered, non-residential investment should return to being a small positive contributor to growth. Our composite indicator of new orders also suggests that non-residential investment will trend higher this year.

The Odds Of March

Investors should fade the recent increase in expectations of a March rate hike by the Fed.

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In the current cycle, the Fed has not lifted rates without having first guided market expectations in the months leading up to the hike. As can be seen in the above chart, rate hike probabilities implied by fed funds futures were already well above 50% one month prior to each of the last two rate hikes. If there was a strong desire to lift rates in March, Yellen would have likely sent a more powerfully hawkish signal in her testimony last week. Instead, Yellen chose not to mention the March meeting specifically and said only that the Fed would continue to evaluate the case for further rate hikes at its upcoming “meetings”.

Besides the lack of a clear signal from Yellen, still-low inflation and elevated policy uncertainty will keep the Fed on hold until June.

Trump And The Fed

President Trump could appoint up to six members to the Fed’s Board of Governors, which will affect the direction of U.S. monetary policy for several years.

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The Fed’s Board of Governors consists of seven members appointed for a fourteen year term. This includes a Chair and a Vice Chair, who serve separate four year terms in this capacity. The seven individuals on the Board of Governors, along with the president of the New York Fed, are permanent voting members of the FOMC. The remaining four votes are rotated annually among the other Fed districts. The key point is that with seven out of twelve votes, the Board of Governors has a disproportionate weight in setting U.S. monetary policy.

With Governor Tarullo announcing his resignation on Friday, there are now three vacancies on the Board of Governors. Janet Yellen’s term as Fed Chair expires in February 2018 and Stanley Fischer’s term as the Vice Chair will expire in June 2018. It is very likely that they will not be reappointed. In addition, it is quite possible that Governor Brainard, a Democrat and Clinton supporter, will also step down sometime in the next few years. All this means that President Trump may end up appointing five or six Fed governors.

It is certainly easy to envision Trump stacking the Board of Governors with doves. An accommodative Fed would help his agenda on two fronts. First, he is a self-proclaimed “king of debt” and his fiscal policies would blow out the deficit. The budgetary shortfalls could be financed at lower than otherwise interest rates. Second, a dovish Fed would push the dollar lower, providing support to manufacturing and exports.

The problem with this theory is that Trump’s public pronouncements on monetary policy have generally been on the hawkish side. He criticized Janet Yellen on the campaign trail, accusing her of trying to goose the economy in order to help the Democrats at the polls. Granted, Trump’s views on the hard money/easy money debate may have changed now that he is president and poised to benefit politically from a more stimulative monetary policy. Nevertheless, it could still be difficult for him to make a complete U-turn on the subject, especially since Senate Republicans are likely to resist efforts to pack the Fed with doves.