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posted on 07 August 2017

The Side Effects From Experimental Monetary Policy

Written by

MacroTides Monthly Report 07 August 2017

How often have you had this experience? You’re watching a show on TV and a commercial comes on and you notice the smiles on the faces of everyone in the commercial. Everyone is active and moving around, often outdoors enjoying an activity whether it’s walking on a beach or playing a sport. As you watch the scenes unfold, you hear a voice that sounds like the person is smiling and having the best day of their life. Life really is good.

happy.girl


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And then the words the voice is saying begin to register.

“The side effects can include shortness of breath, liver damage, stroke, a small number of cases of paralysis have been reported, excessive gastro intestinal bleeding, blindness which sometimes is permanent, heart failure, sudden death, and the loss of taste and memory."

Bummer!

The information on the side effects of drugs is mandated by the Food and Drug Administration (FDA) which is a good thing. As noted on the FDA’s website, the Food and Drug Administration’s Strategic Action Plan for Risk Communication is an initiative to tell consumers how the agency makes decisions on the safety and effectiveness of FDA-regulated products.

This is how the agency’s Center for Drug Evaluation and Research evaluates the safety and effectiveness of drugs.

The Regulation of Drugs

How the Facts Are Collected:

  • The first step for a company seeking approval to sell a new drug is to perform laboratory and animal tests to learn how the drug works and if it will be safe enough to be tested in humans. The company submits an Investigational New Drug Application (IND) for FDA’s review prior to testing in humans.
  • The company performs a series of clinical trials in humans in three phases, which FDA monitors, to test if the drug is effective and safe.
  • Next, the company sends its data from all these tests to FDA's Center for Drug Evaluation and Research (CDER) in a New Drug Application (NDA). A team of CDER physicians, statisticians, toxicologists, pharmacologists, chemists and other scientists review the data and proposed labeling.
  • If this review establishes that a drug's benefits outweigh its known risks for its proposed use, the drug is approved for sale.
  • After the drug is on the market, the FDA monitors its performance in a number of ways. One of those ways is the through MedWatch, the agency’s safety information and adverse event reporting program, which receives reports of suspected adverse reactions (side effects of medicines) from consumers, health care practitioners and pharmaceutical companies. And the agency has access to databases that collect information on prescription drug use and health outcomes. These data help FDA staff identify and understand side effects of medicines.
  • If an unexpected drug-related health risk is detected, a Drug Safety Communication may be issued to consumers and healthcare professionals. A statement is added to the drug label about the new safety concern to ensure continued safe and effective use of the drug. Occasionally, approved drugs may be withdrawn from the market for serious safety risks if it is determined that the overall risks outweigh any benefits the drug may provide.

The impact of the Federal Reserve on the economy affects every working American directly in their daily lives and affects their future. It could be argued that the Federal Reserve has a greater impact than Congress or the president on the lives of every American since the economy touches everyone directly or indirectly. Members of the Federal Reserve Open Market Committee (FOMC) are nominated by the president and approved by Congress. Although they can only serve one term on the FOMC, that term is for 14 years, far longer than any president and most members of Congress.

Compared to any drug approved by the FDA and used by consumers, the Federal Reserve affects far more people. Despite this widespread impact, there is no formal evaluation on the potential negative side effects of monetary policy. The Federal Reserve and other central bankers have been allowed to conduct monetary policy without any supervision, even though the Fed, ECB, and BOJ have veered into experimental policies since 2008 without any prior precedent. The Chairperson of the Fed is required to appear before the Senate and House Banking, Housing, and Finance Committees twice a year. Listening to the statements and questions of the esteemed members of Congress incites a mixture of comedy, concern, and disbelief on how little these folks understand about economics and the impact of monetary policy.

The Federal Reserve’s intervention in 2008 and 2009 by cutting rates to near zero percent and the initiation of its first Quantitative Easing program were appropriate and probably prevented a complete financial crisis and possible depression. The Fed provided the drugs needed to stabilize the financial system and restart the economy’s heart beat. But when the Fed began to focus on asset prices, they started down a road that increased wealth inequality, while keeping interest rates near zero percent for seven years created a number of dislocations that were and continue to be particularly harmful for retirees and pension funds.

Imagine those who worked hard for 40 years and were frugal enough to save $1 million for their retirement. In 2007, they would have expected to earn more than 5% on their savings, which would generate more than $4,000 a month. Combined with a modest monthly check from Social Security, they envisioned a comfortable retirement. But after the Fed cut rates to near zero percent and held rates that low for 7 years, earning just 1% on a 5-year Certificate of Deposit was a reach. Suddenly, their lifetime of saving was only providing them $10,000 a year rather than $50,000.

welsh.monthly.2017.aug.fig.01

It is important to remember that the Fed’s experimentation with negative real interest rates began in 2002 after the Fed lowered the federal funds rate to 1.25% in November 2002 and to 1.0% in June 2003. Negative interest rates occur when the inflation rate is above the level of the federal funds rate. The Fed increased the funds rate from 1.0% starting in June 2004 until it reached 5.25% in August 2005. Other than the period from November 2004 and May 2008, the federal funds rate has been below 2.0%. During the past 16 years, the funds rate has been higher than 2.0% for just 3.5 years.

The percent of those age 65 and older who are still in the work force increased from less than 3% in 2000 to 4.5% in 2011, when the first wave of Baby Boomers turned 65. Since 2011 it has soared by 30% to 6%, double what it was in 2000. Baby Boomer demographics are certainly playing a role, but the Fed’s policy of negative interest rates has been a contributing factor. Many retirees are working part-time jobs to fill the gap between what Social Security and their savings provides. Not the Golden Years many of these folks envisioned while they were working and saving for retirement.

welsh.monthly.2017.aug.fig.02

The Fed’s low interest rate policy appears to have suppressed wage growth as corporations spent trillions on stock buybacks rather than increase worker’s pay. Average Hourly Earnings for Production and non-supervisory employees has increased to 2.5%, about where it was in 2014, but just 60% of the post World War II average. Mediocre wage growth is a big reason why GDP growth has been so tepid during this recovery. The cost of living for many consumers has been climbing faster than wages, especially for health care, cell phones, cable connectivity, and rent.

welsh.monthly.2017.aug.fig.03

The Fed’s QE programs drove longer term interest rates down. While this helped housing, tighter lending standards by mortgage lenders in the wake of the financial crisis offset most of the benefit. Lower long term rates did make it feasible for corporations to borrow money to buy their stock and buy they did. Since mid 2013, companies in the S&P 500 have averaged more than $120 billion per quarter in stock buybacks. Since the market bottom in March 2009, corporations (Non-financial companies) have been the biggest buyer of stocks when compared to global investors, Households, and Institutions. The Fed wanted to boost asset values, and although the Fed never purchased stocks directly, their low interest rate and QE policies enabled corporations to act as their proxy.

welsh.monthly.2017.aug.fig.04

welsh.monthly.2017.aug.fig.05

In total, S&P 500 corporations have purchased more than $3 trillion worth of their stocks since 2009, which has significantly reduced the number of shares outstanding.

welsh.monthly.2017.aug.fig.06

With fewer shares outstanding, earnings per share have increased by 265% since 2009. This is the largest increase in earnings per share in history. Sounds pretty good and seems to justify most of the 371% increase in the S&P 500 since it bottomed at 667 in March 2009. However, revenue during the same period only rose by 32%. This underscores how much of the increase in earnings is the result of stock buybacks and shrinkage in outstanding shares, as opposed to the sale of goods and services.

welsh.monthly.2017.aug.fig.07

Financial engineering has been far more important to earnings growth than broad based economic growth thanks to the Fed’s ultra-low interest rate policy. What makes these numbers even worse is that companies have borrowed so much money to fund their stock purchases. Non-financial debt as a percent of GDP is up to the level it reached in 2007 and above where it was in 2000.

welsh.monthly.2017.aug.fig.08

Companies made the choice of buying their stock back rather than increasing wages or investment because maximizing shareholder value has been the dominant factor in boardrooms since the mid 1980’s, as I discussed in the July Macro Tides. But the Federal Reserve has facilitated the acceleration of stock buybacks since 2002 with its negative interest rate policy.

Low interest rates have also played a role in the dismal rate of productivity during the last five years, which has averaged 0.5%. Corporations didn’t invest in new equipment in part because GDP growth has been a fraction of other post World War II recoveries. The lack of business investment contributed to low growth, so low interest rates may have had the perverse effect of dampening growth, rather than spurring investment and growth as the Fed expected.

welsh.monthly.2017.aug.fig.09

Companies have leveraged their future by increasing debt to buy shares to make the next quarter’s earnings’ report meet or beat the Street’s estimates. The only silver lining is that the Debt Service cost of all the newly assumed debt is much less than it was in 2007 and 2000 because interest rates are so low. It is worth noting that the second slowest post World War II recovery occurred in the 2001-2007 expansion, which also included a stock buying binge by corporations. (Chart above of S&P 500 Dividends and Stock Buybacks)

The Fed’s policy of sustained low short term interest rates and QE programs that lowered long term rates have exacerbated the coming crisis in public pension funds. According to the American Legislative Exchange Council (ALEC), public pension funds are underfunded by a staggering $5.6 trillion. As ALEC noted in its October 2016 report,

“When state pension funds are examined through the lens of a more realistic valuation, pension funding gaps are revealed to be much larger than reported in official state financial documents. This report totals state-administered plans’ assets and liabilities and finds nationwide total unfunded liabilities to be $5.59 trillion. The nationwide funding level is a mere 35 percent, which is one percentage point lower than two years ago. Combined across all states, the price tag for unfunded pension liabilities is now $17,427 for every man, woman and child in the United States. The only way to solve this growing problem is for states to enact meaningful pension reform. While some might feel that America’s public pension crisis only threatens current workers and retirees, it is in fact a problem that affects everyone. Taxpayers are on the hook for the legal obligation to cover the promised benefits of traditional, defined-benefit pension plans. Additionally, every dollar that is spent filling the gap in public pensions is a dollar taken away from core government services. This forces legislators to make the difficult decision of leaving their citizens with fewer services or enacting economically damaging tax increases."

State and local governments continue to use unrealistic assumptions for average investment returns during the next 30 years. ALEC analyzed more than 280 state-administered pension plans, and found the simple, unweighted average discount rate was 7.37%. Compared to the Fed repressed yield on 30-year Treasury bonds of 2.85% and yield of 4.6% on 30-year investment grade corporate bonds, public pension funds are criminally negligent. The 7.37% discount rate allows politicians to mislead taxpayers about the true state of public pension funds.

More than 70 percent of the total costs of pension benefits are paid for by the plan’s investment earnings. If investment returns are less than 7.37%, state and local governments must either raise taxes or cut services so contributions to pension plans can be increased. If public pension funds earn 2.34%, the gap between contributions and liabilities amounts to $5.6 trillion. Tax increases and reductions in public services could amount to $5.6 trillion over the next 30 years, if the analysis by ALEC is accurate. What a mess!

In May 2016, the Stanford Institute for Economic Policy Research released its research on public pension funds entitled, "Pension Debt: United States Public Employee Pension Systems". Stanford’s conclusion was that states use unrealistically high rates of return to discount their pension liabilities. The Stanford study found that pension debt totals $4.8 trillion, not much different than the study by ALEC.

What makes the coming public pension crisis so alarming is that it has received so little attention even though it is so obvious. The question isn’t if there will be a crisis, only how big and the timing. Politicians bear the greatest responsibility for voting for such generous benefits for public employees and for maintaining projections of returns that are beyond unrealistic. The Federal Reserve has earned at least an honorable mention for pursuing a monetary policy that will make the pension crisis worse.

If the Federal Reserve was a pharmaceutical company, the FDA would require the FOMC to put a warning at the top of each FOMC meeting statement: Monetary policy can be harmful to the health of the economy and result in weaker GDP growth, wage growth, productivity, and an increase in income inequality, a greater concentration of wealth in the top 1%, and asset bubbles in equities and debt instruments.

The FDA has the authority to remove approved drugs from the market for serious safety risks, if it is determined that the overall risks outweigh any benefits the drug may provide. Unfortunately, the negative side effects from the Federal Reserve’s pursuit of experimental monetary policy cannot be removed from the market. But the negative effects will persist for many years to come.

U.S. Economy

Annual wage growth in the ten prior recoveries since World War II averaged 3.3%. Although wage growth has ticked up to 2.5% in the last two years, the average for the recovery since June 2009 is 2.2%. This means that wage growth in the other post World War II recoveries was 50% faster than in the current recovery, which is a significant difference.

The Fed’s favored measure of inflation is the Personal Consumption Expenditures (PCE) price index. (Chart Doug Short, Advisor Perspective, chart below) One of the goals of the Fed’s experimental monetary policy has been to get the PCE inflation rate up to 2.0%. As I discussed in the July commentary, the value of this goal is questionable since prices would more than quadruple during the average person’s lifespan of 80 years. Only a central banker would consider this a success and an example of ‘stable’ prices.

welsh.monthly.2017.aug.fig.10

Despite the Fed’s Herculean efforts, the Core PCE has not been above 2.0% since 2008, and has drifted lower in recent months. Most consumers have no idea what the PCE is, but they do know that the cost of living seems to be going up faster than their wages.

A quick review of various costs illustrates why so many working Americans feel like they are falling behind. Renters represent 37% of total households. Over the last decade rent as a percent of wages and salaries has doubled and consumes almost 9% of income.

welsh.monthly.2017.aug.fig.11

welsh.monthly.2017.aug.fig.12

More people have been force to remain renters since the cost of a home has been rising much faster than income. Even though mortgage rates remain low, housing affordability has suffered and is at the lowest level since 2010. This is why Existing Home sales have stagnated over the last year. The low level of inventory of homes for sale has also suppressed sales.

welsh.monthly.2017.aug.fig.13

welsh.monthly.2017.aug.fig.14

Many college graduates have had to postpone when they can afford to buy a home due to student loans.

welsh.monthly.2017.aug.fig.15

It would be hard to find many consumers who don’t have a cell phone or cable TV or both. Since 1995 the cost of cable TV has increased twice as fast as overall inflation. Since 2011 the cost curve has turned higher and has increased by more than 20%. The cost of cellular phone services are up more than 60% since 2007, but inflation as measured by the PCE is up less than 20% during this period.

welsh.monthly.2017.aug.fig.16

Medical costs continue to increase faster than wages and are likely to take another leap upward in coming months as premiums are jacked up. The rising cost of these ‘staples’ has outstripped overall inflation by a wide margin. Given all these drains on disposable income, it is difficult to identify what could spur an economic acceleration in coming months, unless Trump stops Tweeting and the Republicans stop tripping over their own feet.

Last November I discussed the outlook for auto sales and concluded they would weaken in coming months as banks tightened lending standards on sub-prime auto loans and a rising tide of cars coming off lease lowered used car prices and then new car sales. The timing of that analysis proved prescient as new car sales peaked at 18.0 million units in December. They have now fallen for 7 consecutive months and were down to 16.69 million units in July.

welsh.monthly.2017.aug.fig.17

The flood of cars coming off lease will continue to swell and put downward pressure on used car prices into 2019. As consumers choose to buy the more affordable used cars, sales of new cars will decline and the car makers will need to cut production to reduce bloated inventories of unsold cars. The July ISM fell 3.5 points and is an indication that the slowdown in autos is spreading.

According to the Bureau of Economic Analysis (BEA) its first estimate of second quarter GDP was 2.6%, which is up from Q1 GDP of 1.2%. The 2.6% is down from initial consensus forecasts for growth of 3.5% in Q2, and a few estimates north of 4.0%. My guess was that GDP would grow about 2.5% since I didn’t see any organic reasons for a pick up other than a potential change in inventory liquidation that would lift GDP from 1.4% in Q1 by about 1.0%.

As I noted in the June commentary,

“Second quarter GDP is likely to get a boost from less inventory liquidation, which shaved -1.07% from Q1 GDP. If inventories remain unchanged, GDP in the second quarter would increase by 1.07%. Statistically, GDP would benefit but little organic growth would be added."

Inventories were virtually unchanged and added almost 1.0% to the Q2 estimate.

Federal Government Tax Receipts provide a more unambiguous picture of the economy’s health than GDP, which contains a fair amount of noise from changes in inventories, trade, and seasonal adjustments. Through June 30, the twelve month growth rate of Federal Government Receipts was just 1.1%. This figure reinforces my sense that the economy has experienced very little acceleration in growth since June 2016.

welsh.monthly.2017.aug.fig.18

The Federal budget year begins on October 1 and runs through September 30. The figures in the graphic above reflect tax estimates by the Congressional Budget Office made in January for Total Receipts, Individual, Corporate, and Payroll Taxes. Through June 30, each category is well below the CBO’s estimate, especially corporate taxes. This raises an intriguing question about the quality of corporate profits.

The BEA does use a different measure for calculating corporate profits that goes back to 1929 called "Profits from Current Production". This calculation measures income earned by corporations from current production, before tax liability, excludes financing flows and capital gains and losses, values inventory withdrawals at current cost, and estimates economic depreciation at current cost.

There are several benefits of using Profits from Current Production. They are unaffected by tax-law and reporting-rule changes, are inclusive of income that escapes tax authorities, are exclusive of dividends, capital gains and losses, and other flows arising from means of financing production and exclusive of financial adjustments reported for other purposes, such as deductions for “bad debt". Got all that?

Using these parameters the BEA has been able to measure Profits from Current Production consistently since 1929. Both public and privately-held corporations file tax returns, which the BEA uses to calculate Profits from Current Production. This means the BEA is using a profit measure than encompasses the whole economy, rather than just public company earnings reports that have been massaged by smart accountants.

Based on the BEA’s profit measure, profits peaked in the fourth quarter of 2014 at $1,741.4 trillion, 5.66% higher than $1,642.7 trillion as of March 31, 2017. Year over year, profits were up 3.66% from March 2016. This suggests that profits and the overall economy are not as wonderful as the new all-time highs in the major averages would imply, or worthy of the effusive comments about how great profits are by Wall Street strategists.

welsh.monthly.2017.aug.fig.19

Federal Reserve

Prior to the Fed’s meeting in June and in the post FOMC meeting press conference, the Fed and Janet Yellen painted a picture of a Fed determined to normalize monetary policy. The Fed even outlined how it plans to shrink its balance sheet which was unexpected. When Chair Yellen appeared before Congress on July 12, she performed a 180 degree pirouette and was far more dovish, and financial markets responded. Since July 11, and as of August 3, the Dollar is down -2.95%, the S&P is up 1.95%, the Emerging Market ETF (EEM) is up 4.51%, the European ETF (EFA) is up 3.45%, and the Asia ex Japan ETF (EPP) is up 4.35%.

The Fed’s fixation on getting inflation up to its misguided target 2.0% will not be reached in coming months and could provide the Fed a policy reason not to increase rates. With economic growth failing to pick up in recent months, and the path to fiscal stimulus becoming cloudy, the odds of the Fed increasing the federal funds at its September meeting have dropped to 0% and less than 40% for a December hike.

The Dollar has declined 9.6% since January and the Trade Weighted Dollar Index (TWI) has fallen -7.5%, since it has a smaller weighting to the Euro. The decline in the Dollar indexes will lift import prices and exports in coming quarters. The Broad Dollar TWI chart inverts the percentage change in the TWI and adjusts it three months into the future. A decline in the TWI is reflected by the rising blue line, so the correlation with changes in inflation are easier to see.

welsh.monthly.2017.aug.fig.20

Imported deflation bottomed near -4.0% in early 2016 and is now a positive 1.2%. It will continue to rise in coming months, as the decline since July 11 of -2.95% in the Dollar Index is reflected in higher import prices.

In a global economy, the changing value of a country’s currency has an impact on the competitiveness of companies as they sell their products internationally. Companies in the S&P 500 derive 43% of their revenue from overseas. Between May 2014 and March 2015, the Dollar Index increased by 25% which represented a headwind for multi-national companies in 2015 and 2016. The Dollar’s decline since January is large enough to be a tailwind and help U.S. companies better compete. There is a lag between changes in a currency and its economic impact of about 6 to 9 months, so the Dollar’s weakness this year will progressively boost exports, especially in the first of half of 2018.

In lieu of increasing rates at the September meeting, the Fed will probably begin tapering its $4.5 trillion balance sheet before the end of 2018. That way they look like they are making progress toward normalization while they wait to see if a fiscal stimulus program emerges from Congress, and if the debt ceiling proves to be a problem or just another opportunity for political grandstanding. If the Fed follows the plan they laid out after the June meeting, it will shrink its balance sheet by $180 billion in the first 12 months or by a whopping 4%. One small step toward normalization, one giant leap for a central banker!

Despite the expansion in the Fed’s balance sheet from $900 billion in 2007 to $4.5 trillion in January 2015, the velocity of money continues to plunge. Velocity is calculated by dividing GDP by M2 money supply, so velocity is basically a multiplier. The decline in velocity indicates that money supply is growing faster than GDP, but each new dollar of money supply is generating less economic growth.

welsh.monthly.2017.aug.fig.21

Between the second quarter of 2006 and the second quarter of 2009, velocity dropped from 2.035 to 1.711 or 0.324. The economy bottomed in the second quarter of 2009, which is why the recession officially ended in June 2009, according to the National Bureau of Economic Research (NBER). After a brief rebound to 1.746 by the second quarter of 2010, velocity has fallen to 1.425 as of June 30, 2017. What’s striking is that the decline since 2010 is 0.321 which almost identical to the decline experienced during the financial crisis, but it occurred during a period of economic growth!

Although there have been other periods when velocity fell while GDP expanded, the magnitude of the current plunge is alarming. It indicates that the efficacy of monetary policy in generating economic growth has been diminishing since 2006 and suggests monetary policy may be impotent when the economy experiences the next recession.

The Fed and other central banks can be expected to launch new rounds of QE when the next recession becomes problematic. Equity markets will rally big time since investors have been conditioned to buy in response to QE programs. However, unless the velocity of money rises, the economic response will be weaker than it was during the 2001-2007 recovery and the current recovery, which has been the weakest since World War II.

I’m not sticking my neck out with this forecast. Just look at the chart earlier above showing the Annualized GDP growth during economic expansions since 1949. The trend toward weaker annualized growth has been in place for more than 35 years. When global investors realize central bankers are shooting blanks, how do you think equity markets will handle it?

Mario and the ECB

The headline proclaims ‘Eurozone Growth Is the Best Since 2011’, which sounds impressive. A review of GDP growth since 2007 removes some of the sizzle from the headline since GDP growth has advanced less than 0.3% since early 2015. One of the reasons why GDP growth has essentially been treading water since early 2015 is that M3 Money Supply growth has flat lined since early 2015. The lack of money supply growth is remarkable since it has occurred as the ECB pursued a robust QE program and lowered its policy rate to minus -0.40%. The ECB’s balance sheet has ballooned from $2.0 trillion to $4.2 trillion since early 2015.

welsh.monthly.2017.aug.fig.22

The lack of M3 money supply growth indicates that despite the increase in the ECB’s balance sheet, money is not working its way into the Eurozone economy. In other words, the transmission between the growth in the ECB’s balance sheet and demand in the real economy is virtually nonexistent. This reality won’t dissuade the ECB from continuing its QE program, but the ECB will likely decide to trim its monthly purchases from $60 billion to $50 or $40 billion, when it meets on September 7. The ECB will likely maintain its policy rate at a minus -0.40%, which exemplifies experimental monetary policy.

The combined effect of central bank monetary experimentation has depressed volatility to artificially low levels in global equity, bond, and emerging markets, especially in 2017. The longer volatility remains low investors will naturally assume more risk, since they expect low volatility to continue. One example of this behavior can be seen in the willingness of investors to loan money to corporations with fewer and fewer protections. Loans that have fewer protections are referred to as covenant-lite loans and are typically backed by less collateral and more liberal payment terms which favor the borrower. If the company borrowing the money runs into difficulty, the lender will be exposed to more losses.

welsh.monthly.2017.aug.fig.23

In 2017, covenant-lite loans in the U.S. and Eurozone have comprised more than 70% of the total loans issued. In the run-up to the financial crisis, covenant-lite loans were only 30% of total loan volume in the U.S. and less than 10% in Europe. The issuance of covenant-lite loans in Europe has surpassed the U.S. compliments of the ECB’s corporate bond purchases. The damage from the surge in covenant-lite loans won’t be known until the next recession. But the willingness of investors to lend so freely is another example of the negative side effects of central bank monetary experimentation.

One of the reasons why the ECB may only lower their monthly bond purchases to $50 billion, rather than $40 billion, is the strength in the Euro, which is up more than 12% since January and more than 5% since June. The stronger Euro will put additional downward pressure on inflation which is comfortably below the ECB’s target of 2.0% and trending lower. Export growth will slow in 2018 as European products cost more due to the rise in the Euro, which will be a headwind for growth throughout the Eurozone. Although the less productive countries in southern Europe will be affected more, Germany won’t be immune to the tougher trading environment. As far as central bankers go Mario has been a true believer in monetary experimentation, and a fan of the notion that more is more. The irony of his faith in monetary experimentation is that as time goes by more evidence emerges that the economic results may not equal the unintended negative side effects.

Emerging Markets

Emerging market equities and bonds have performed well in 2017, which I thought was possible if the Dollar corrected as I expected. As noted in the January 9, 2017 issue of Marco Tides,

“If the Dollar weakens as I expect, the Emerging Market ETF (EEM) could rally to $42.00 - $44.00 during 2017 in a wave C rally."

After Janet Yellen adopted a more dovish stance in her Congressional testimony on July 12, the Emerging Market ETF (EEM) jumped and traded up to $44.16 on July 27.

The range of $42.00 - $44.00 has been an area of stiff resistance on five separate occasions since 2012. The emerging market sector is overbought and there are several reasons why this resistance is likely to hold for awhile.

welsh.monthly.2017.aug.fig.25

Emerging market equities and bonds have attracted a torrent of inflows in 2017 based on valuation comparisons with U.S. equities and much higher bond yields than can be garnered in advanced economy debt markets. With the run up in prices, the valuation argument is not as compelling as it was coming into 2017.

welsh.monthly.2017.aug.fig.26

welsh.monthly.2017.aug.fig.27

The economic outlook is starting to soften based on the EM Economic Surprise Index, and debt levels in EM ex China relative to GDP have increased. This has led the ratings agencies - S&P, Fitch, and Moody’s - to increase the number of their downgrades.

welsh.monthly.2017.aug.fig.28

Finally, the Dollar’s decline was supportive of the rallies in EM equities and debt, but that may reverse soon since the Dollar Index is approaching major support near 92.00 and 119.00 on the Trade Weighted Dollar Index. If a Dollar rally emerges in the next few months as I think likely, it will provide a good excuse for profit taking.

U.S Stocks

Since not much has changed since the July Marco Tides was published on July 9, I will repeat my assessment from last month:

“My proprietary Major Trend Indicator (MTI) is still supportive of an ongoing bull market since it is comfortably above the green horizontal line. Notice how it fell below the green line prior to the declines in the summer of 2015 and early 2016. The S&P 500 is making higher highs and higher lows and is above the black trend line connecting the Brexit low in June 2016 and the early November low. The overall message from the charts and technical indicators is that after a correction, the S&P 500 is likely to at least test its prior high of 2453 and probably make a new high above 2500 before year end."

Click for large image.

welsh.monthly.2017.aug.fig.29

The correction I thought likely before the rally above 2453 and to 2500 did not occur primarily because Janet Yellen provided a much more dovish message to Congress on July 12 than I expected. The S&P has traded up to 2483 and may approach 2500 soon.

As I discussed in the July 31 Macro Tides Weekly Technical Review,

“The market is entering a window of time that has coincided with tops in years ending in 7 and during the last 20 years. The Decennial pattern suggests that a top in the S&P is likely within the next few weeks, if the pattern in years ending in 7 holds true. The trading pattern in the last 20 years also supports the potential of a top in the S&P soon. Both patterns suggest a decline is coming that could last until late October or early November."

A further confirmation of a potential correction comes from the allocation to cash by individual investors tracked by the American Association of Individual Investors (AAII). This is a contrary indicator so a high allocation to cash has usually occurred near a market bottom, while a low level of cash suggests that individual investors are overly bullish and a sign that the market is near a top.

welsh.monthly.2017.aug.fig.30

Recently the allocation to cash was the lowest since June 2000 and lower than in mid 2015 just prior to a corrective period that ended in February 2016 after the S&P had declined by 15.1%. As you can see, the allocation to cash was very high as the market bottomed in March 2003 and March 2009. My guess is that any correction is unlikely to exceed 7% during this window of vulnerability.

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