CWS Market Review – September 22, 2017

“The expectation of an event creates a much deeper impression on the exchange than the event itself.” – Jose de la Vega, 1688

First, the good news. The stock market continues its winning ways. The Dow just set nine straight daily records, and the S&P 500 is over 2,500. Not only that, but it’s been one of the calmest markets in history. Ryan Detrick notes that the Dow rose by less than 0.3% for seven straight sessions. That’s only the second time that’s happened in the Dow’s 121-year history. Volatility is low, and markets are happy.

Now the bad news. The Federal Reserve made it clear this week that they intend to keep on raising interest rates. Not just once more in December, but a few more times after that in 2018 and 2019. In my opinion, this is a big mistake.

The evidence (to me) is clear that the need for higher rates has faded. After all, inflation has cooled off. We’ve just gone through two big hurricanes. Plus, there’s been some weak economic news lately. I’m not alone in this opinion. Not too long ago, the futures market started to believe that we might not get a rate hike for the next year. But the Fed wants higher rates, and in these matters, they always get their way.

Unfortunately, as investors, we don’t get to choose the environment. We have to deal with reality as it is. In this week’s CWS Market Review, I’ll explain what the Fed said this week and what it means for us. We also got two dividend hikes from our Buy List stocks. Microsoft hiked its payout by 7.6%, and Ingredion boosted its payout by 20%. I love seeing nice dividend increases from our stocks. I’ll have more to say on these in a bit, but first, let’s look why the Fed is on the wrong course.

The Federal Reserve Holds Firm

Lately, I had been telling you that the Federal Reserve won’t be raising interest rates any time soon. Silly me. I was assuming the Fed was going off the evidence. Big mistake.

We had five very soft inflation reports in a row. Only the last one was anything close to the Fed’s target of 2%. Let’s look at some the recent data. Last Friday, the Fed said that industrial production fell by 0.9% last month, and Hurricane Harvey was responsible for 0.75% of that. We also learned that retail sales fell 0.4% in August. Take out gasoline, and retail sales still fell 0.2%. That’s not good.

The Atlanta Fed’s GDP model now sees Q3 coming in at 2.2%. The New York Fed’s model is down to 1.3%. Sure, Harvey bears some of the blame, but not all. The economy is growing, but at a tepid pace.

But the Fed is having none of this. On Wednesday, the central bank released its policy statement, along with its revised economic forecasts. I should warn you that the Fed’s track record isn’t merely bad—it’s bad for economists.

Let’s dig into the policy statement. Not surprisingly, the Fed decided against raising interest rates at this meeting. That means the target for Fed funds remains between 1% and 1.25%. In the statement, they acknowledged the damaged caused by the hurricanes, but added that “the storms are unlikely to materially alter the course of the national economy over the medium term.” This is probably true. Plus, a lot or rebuilding news to be done. Note that Continental Building Products (CBPX) had another big gap up this week while shares of Danaher (DHR) touched a new high.

The Fed also said the economy is growing moderately and the jobs market continues to get better. They also said that core inflation is low, and will probably remain so. I agree.

Now let’s turn to the Fed’s economic projections. This is often referred to as the “blue dots,” due to the dot plot in the report. The Fed now sees core inflation rising to 1.9% next year, and 2% in 2019. Mind you, the Fed has consistently overestimated future inflation. Not only that, but if anything, core inflation was been trending downward. It’ll probably something like 1.5% this year. Don’t get me wrong: I’m all for the Fed battling inflation. But I’m not wild about fighting inflation that doesn’t appear to exist.

Of the 16 members on the FOMC (not all of whom vote at policy meetings), 12 see another rate increase in December. Prior to the meeting, the futures market thought there was a 37% chance of a December hike. Now that’s up to 78%.

For 2018, the median forecast calls for three more rate hikes. That would bring the Fed funds target range to 2% to 2.25%. On a side note, if the Fed’s inflation forecast is correct, that would mean the real (or inflation-adjusted) range would finally be positive. It’s been negative for nearly a decade. In other words, you could borrow money from the Fed for free, after adjusting for inflation.

The median Fed forecast calls for one more hike in 2019, plus another one in 2020. The Fed also projects inflation and interest rates for the “long run.” (“But this long run is a misleading guide to current affairs. In the long run we are all dead.” – JM Keynes.)

Here’s an interesting nugget. The Fed members see long-run interest rates at 2.75%. Combined with the long-run inflation forecast of 2%, this implies the Fed believes the “equilibrium rate” is 0.75%. That’s the interest rate at which (theoretically) everything should come into balance (again, theoretically). I’d guess that if you polled economists on the equilibrium rate prior to the financial crisis, they probably would have pegged it around 2%. So as long as the Fed is below 0.75% in real terms, they view themselves as pumping up the economy.

Remember that for much of 2017, long-term interest rates have been falling. Lots of other people were betting that the Fed would take a breather. But in the last two weeks, a lot has changed. The yield on the 10-year bounced from 1.88% on September 7, to 2.11% on Thursday.

That’s not all. The yield on the two-year Treasury is now up to 1.45%. That’s the highest in nearly nine years. The two-year is a good maturity to watch, because it’s usually very sensitive to interest-rate expectations. For some context, six years ago, the two-year was yielding as low as 0.16%.

What does all this mean? A December rate hike from the Fed won’t be a disaster. The problem is that it gives the Fed less room to operate if and when things get bad. There’s also no reason to worry about the stock market. The market can rally along with higher rates. That’s what happened from 2004 to 2006.

In last week’s issue, I talked about the impact of the weak dollar on the stock market. If the dollar gains strength, this means that the nature of what’s rallying could change. For example, bank stocks tend to perform when short-term rates rise. That’s how they make their money. On our Buy List, I still like Signature Bank (SBNY), especially below $125.

This is a boring market, and boring markets are usually good markets.
Investors should continue to focus on high-quality names. In addition to Signature, two other Buy List stocks I particularly like are Ross Stores (ROST) and Intercontinental Exchange (ICE). As always, please watch my Buy Below prices. There’s no need to chase after good stocks.

Dividend Hikes from Microsoft and Ingredion

We recently got two dividend increases for our Buy List stocks. Last Friday, Ingredion (INGR) announced a 20% dividend increase. INGR’s payout will rise from 50 to 60 cents per share. Business has been good. Last month, Ingredion reported earnings above expectations.

“We are proud of our record of delivering consistent shareholder value. From dividends and share repurchases to capital investments and acquisitions, we are committed to a balanced deployment of cash consistent with our strategic blueprint,” said Ilene Gordon, chairman, president and CEO.

The new dividend is payable on October 25 to stockholders of record at the close of business on October 2. Based on Thursday’s close, INGR yields 2%.

Then on Tuesday, Microsoft (MSFT) announced a 7.6% increase to its dividend. The quarterly payout will rise from 39 to 42 cents per share. In last week’s CWS Market Review, I said, “I’m expecting 42 cents, maybe 43 cents per share.” Close enough.

The dividend is payable December 14 to shareholders of record on November 16. The ex-dividend date will be November 15. By the way, too many investors ignore the importance of dividends. Remember that those dividend increases can add up. Microsoft is now yielding 11.3% based on its 2009 low. Even in today’s terms, MSFT yields 2.26%. That’s only two basis points below a 10-year Treasury. I like Microsoft a lot.

That’s all for now. We’re going to get some key economic reports next week. On Tuesday, we’ll get reports on consumer confidence and new-home sales. Then on Wednesday, the durable-goods report comes out. On Thursday, the government will have its second revision of Q2 GDP growth. Last month, the estimate for Q2 growth was revised to 3.0% from the initial estimate of 2.8%. Friday will be the last trading day of the third quarter. We’re also get the income and spending reports for August. Be sure to keep checking the blog for daily updates. I’ll have more market analysis for you in the next issue of CWS Market Review!

– Eddy

Posted by on September 22nd, 2017 at 7:08 am

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.