The Fed and the Economy – What’s Next?

Navigating the low-return environment has been one of the top concerns for fixed income investors throughout 2016. Consider the fact that 35% of the global treasury market (as of this writing) is trading at negative nominal yields, which begs the question: Why are interest rates so low?

Read below to find out why or watch our explanation on YouTube

The common assumption is that the Federal Reserve and other central banks are keeping rates low, or that the cause is the 2008 financial crisis. In our view, however, this thinking is not entirely accurate. In fact, low interest rates are not a recent phenomenon. Real 10-year yields in the U.S. have been declining since the 1980s. Nominal 10-year yields were low in the 1960s, peaked at 15% in 1981, and have been falling ever since.

plot2

With an interest rate hike at the December 13-14 FOMC meeting seen as a foregone conclusion, we have to ask: What is the upper limit of the Fed’s potential to raise rates, given the long-term trend? How effective is Fed policy likely to be in the future? These are important questions because low long-term rates could very well mean that equities and other “risky” assets will remain overvalued, while fixed income investors struggle to meet target returns.

To address our Fed questions, we start with the understanding that the Fed cannot create growth; it can only affect money supply and nominal rates. The Fed is unable to solve economic changes or even influence real rates. Therefore, tracking the state of the economy is what ultimately determines long-term real returns. At Astor, we track economic trends using our proprietary Astor Economic Index®, and incorporate economic data into our portfolio allocation decisions.

Second, the long-term trend in real rates has rendered Fed policy tools such as the “Taylor Rule” ineffective. (Named for Stanford University economist John Taylor, the Taylor Rule was used previously to predict interest rates based on inflation, GDP, or other economic factors.) The Taylor Rule assumes a constant neutral or equilibrium Fed Funds rate, whereas both the FOMC and the markets agree that the neutral rate is much lower. In March 2015, Fed Chair Janet Yellen admitted to a non-constant neutral rate policy, and others including Fed Vice Chairman Stanley Fischer and former Fed Chair Ben Bernanke also have spoken at length about it.

Third, we also have seen FOMC participants consistently shift down their long-term economic projections. The reasons for these diminished views are the same reasons why interest rates are low; hence these are the variables that we at Astor are watching closely:

Productivity – Growth in productivity has been disappointing, averaging only 0.5% in the last seven years, compared to economists’ forecasts of more than 2%.

dee-2

Payrolls and Growth — Even though payrolls have showed a lot of improvement—this has not translated into faster economic growth, which, in our view, can only mean that the U.S. growth potential has been lowered as well.

Inflation — Wages have remained stagnant, and inflation hasn’t gone up, despite the growth in payrolls. The only likely explanation, as we see it, is that the relationship between wage and payroll growth has changed because inflation expectations are much lower.

dee-3

Structural factors – Factors such as a high savings rates, shifting demographics, and low capital spending and investment also have lowered the real interest rate.

dee4

Taking all these factors into consideration, our conclusion is that, without improvement, it’s questionable how effective Fed policy can be in the future—and possibly during the next recession, whenever that occurs—because the Fed cannot change the real economy. In addition, after its quantitative easing (QE), the Fed holds more than $4.2 trillion in assets, mainly Treasury bonds and mortgage securities. This raises another question—will the Fed become an active seller moving forward, and how will that further impact fixed income securities?

As we consider what the Fed will do moving forward, these questions will remain on our radar.

All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information.

 

The Astor Economic Index® is a proprietary index created by Astor Investment Management LLC. It represents an aggregation of various economic data points: including output and employment indicators. The Astor Economic Index® is designed to track the varying levels of growth within the U.S. economy by analyzing current trends against historical data. The Astor Economic Index® is not an investable product. When investing, there are multiple factors to consider. The Astor Economic Index® should not be used as the sole determining factor for your investment decisions. The Index is based on retroactive data points and may be subject to hindsight bias. There is no guarantee the Index will produce the same results in the future. The Astor Economic Index® is a tool created and used by Astor. All conclusions are those of Astor and are subject to change.

312161-566

What Investors Got Wrong in 2016

As we look back on 2016, a notable theme is just how wrong the markets were when it came to predicting events and risk drivers.

The year began on a pessimistic note. By the February 11 low, the S&P 500 had lost more than 10%, and high-yield bonds were down more than 5%. A major culprit was sharply declining oil prices; WTI crude was down nearly 30%, which drove down commodities as a whole.

Market jitters were also caused by expectations that China’s growth rate was going to fall short, which further compounded concerns about global growth in general.

investor-pessimism

Now, at year end, the picture looks much different. Global growth in 2016 couldn’t have been better. In the U.S., a third quarter GDP reading of 3.2% exceeded expectations.

Meanwhile, China grew steadily in 2016 at a rate of about 6.7%. As a result, over the first 10 months of 2016, investors have poured more than $50 billion into emerging market stock and bond funds.

As for market performance, year-end is nearly a mirror opposite of what occurred at the start of the year. From January through end-November, the S&P 500 is up about 10%. High-yield bonds are up more than 15% year-to-date, and oil has gained almost 25%.

end-of-year-markets

The second major thing that the markets got wrong was the expectation for rate hikes by the Federal Reserve. When 2016 began, the expectation was that four rate hikes were likely. In January, Fed Vice Chairman Stanley Fischer said that four rate hikes for the year were “in the ballpark,” although China’s slower economy and other uncertainties made it impossible to predict what would happen to interest rates.

The concern in early 2016 was that if the Fed pursued the expected course, the U.S. would go in one direction with interest rates, while the rest of the world was headed lower; in some countries more negative rates were possible.

As we now know, the Fed took a more guarded stance in 2016, following its December 2015 move, which was the first rate hike in almost a decade. This change in expectations affected currencies most of all. The U.S. dollar was expected to rally, but fell 6% in the first half of the year. In contrast, the Japanese yen appreciated through August due to safe haven trades.

dollar-index

Now that we are at the end of the year, we can see how the markets did adjust to changing realities. In fact, both the Fed and the market appear to be aligned. The widespread expectation, already priced into the market, is that the Fed will raise rates at its mid-December FOMC meeting.

The year, though, is not over yet. No matter how clear things may appear, we still think predicting policy events, central bank actions, and the market’s reactions will always be a challenge.

Please watch the video on What Investors Got Wrong in 2016

All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information.

 

312161-556

Q3 GDP Beats Estimates

Q3 GDP Beats Estimates

Real GDP for Q3 2016 came in at a better-than-expected rate of 2.9%. This “advance estimate,” released by the Bureau of Economic Analysis, was above consensus/economists’ estimates of around 2.5-2.6%. In Q2, real GDP increased by an annualized rate of 1.4%.

As Astor previously observed, a Q3 GDP report that at least met expectations, along with follow-through in the ISM Manufacturing and Non-Manufacturing gauges, could be a good springboard for continued growth in Q4. This outlook also adds to the widely-held expectation, as previously noted, that the Federal Reserve will raise interest rates by the end of the year.

gdp-q3

Highlights from the report include:

  • Personal consumption expenditures rose 2.1% in Q3 vs 4.3% in Q2
  • Exports rose 10% in Q3 vs 1.8% in Q2
  • Other positive contributions were from private inventory investment, federal government spending, and nonresidential fixed investment. These increases were partly offset by negative contributions from residential fixed investment and state and local government spending. Imports, which are a subtraction in the calculation of GDP, increased.

This advance estimate for Q3 GDP is subject to two more revisions. In Astor’s view, these revisions make the backward-looking GDP “headline” number less useful for making investment decisions than economic analysis using output indicators for the current quarter, as well as near-term trends in the economy.

The Q3 second estimate report is scheduled to be released on Nov. 29.

 

All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information.

309161-524

 

 

A Mixed Picture – Economic Snapshots

The U.S. economic picture is mixed, with some signs of slowing, along with areas of strength. Let’s take a look at the current snapshots to gain a more comprehensive view.

To learn more about The Economic Picture, watch this video

ISM Manufacturing

In our opinion, the most worrying data have been ISM Manufacturing Index readings. ISM Manufacturing declined to 49.4 in August from 52.6 in July, which points to continued weakness in a sector that has been a major drag on economic growth. However, the manufacturing survey has shown improvement since February 2016. Therefore, we’ll need to see more than one month’s reading in order to detect a change in trend.

us-chart1Consumer Spending

A more positive story is consumer spending, which remains robust and is the strongest contributor to GDP. Much of the rise in the preliminary Q2 2016 GDP came from 4.2% growth in consumption.

us-chart2Wage Growth and the Employment Picture

Sustaining that strength in consumer spending depends largely on wage growth, which remains sluggish. However, the Atlanta Fed’s Wage Growth survey shows the pace of wage growth is close to 3.6% year-on-year and accelerating rapidly, which is not far from the previous cyclical peak of 4%.

us-chart3

 

Another slowing, but still robust indicator has been Non-Farm Payrolls, as labor market data show continued strength. Jobless claims remain relatively low and have been consistent with a still-strong trend in employment growth. Payrolls for August were below consensus, but our indicators, we believe, still point to strengths.

The unemployment rate has been holding at 4.9%, and the U-6 underemployment rate remained at 9.7%.  Within August’s private payrolls, manufacturing, construction and mining lagged whereas retail and financials showed the most growth.

Productivity

Weak productivity growth, at near 0, remains the factor that is holding down GDP growth, despite labor market strength. With disappointing productivity growth for several years, we believe a rise in investment as a share of GDP would be necessary in order to see any future productivity gains.

us-chart7

 

Fed Q3 “Now-Casts”

As the third quarter comes to a close, it’s important to note that the “now-casts” produced by the Federal Reserve Banks of Atlanta and New York continue to show stronger growth for Q3 than the first half of the year. The Atlanta Fed is current forecasting a 3.7% seasonally adjusted annual rate of return (SAAR) for the third quarter. The New York Fed forecast for Q3 is 2.6%. These forecasts are significantly higher than their own respective final estimates for Q2, and also higher than the Bureau of Economic Analysis’ preliminary estimate for Q2 of 1.2%. (The third estimate for Q2 GDP will be released on Thursday).

Overall, the consensus of economists’ estimates for U.S. economic growth looks stable, but have decreased to 1.54% for 2016 and 2.25% for 2017.

 

The Astor Economic Index

Meanwhile, the Astor Economic Index® (AEI), the cornerstone of our fundamentally-driven, macroeconomic-based approach to asset allocation, shows the economy is growing—but at a comparatively slow pace. As always, we continue to keep our finger on the pulse of the economy to determine the current trend as we invest accordingly.

 

 

 

All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information.

 

 The Astor Economic Index® is a proprietary index created by Astor Investment Management LLC. It represents an aggregation of various economic data points: including output and employment indicators. The Astor Economic Index® is designed to track the varying levels of growth within the U.S. economy by analyzing current trends against historical data. The Astor Economic Index® is not an investable product. When investing, there are multiple factors to consider. The Astor Economic Index® should not be used as the sole determining factor for your investment decisions. The Index is based on retroactive data points and may be subject to hindsight bias. There is no guarantee the Index will produce the same results in the future. The Astor Economic Index® is a tool created and used by Astor. All conclusions are those of Astor and are subject to change.

309161-492

 

 

Breaking up is not that hard to do: Real Estate (RE) classification

Effective September 1, 2016, the Global Industry Classification Standard (GICS®) will undergo its first major change since its inception in 1999.

As a result of the evolving investment landscape, not to mention the global economy, real estate will be carved out of the financial sector. The new 11th sector will primarily contain equity REITs.

All Dow Jones and Russell indices will be unaffected by the change.

MSCI will make the change on Aug 31, but S&P 500 will change on Sept. 16, which is when most sector funds will rebalance.

The Break Up

The financial sector will be split into financials ex-real estate and real estate. After the change, we estimate that the S&P 500 will have a 14% weight in the “new” financials and 3.2% in real estate.

REITS and Real Estate Management & Development, which are currently sub-sectors under financials, will be renamed to form the new sector of “Equity REITS” composed of 28 companies in the S&P 500.

Mortgage REITs will remain within the financial sector given their greater similarity to traditional financial companies; however, they are a negligible percentage of the index.

From our calculations, specialized REITs (35%), retail REITs (22%), residential REITs (13%), and health care REITs (12%) will be the major components of the new real estate sector.

In making this change, we believe that both MSCI and S&P 500 recognize the increasing role of real estate in global equity markets and considerable growth in assets since 2009. In addition, the increasing specialization of real estate firms has made real estate the least correlated sub-group within financials.

Astor’s View

Volatility:  We expect that financials’ volatility will increase because the low correlation with REITs provided diversification.

Dividend Yield: REITs have a higher dividend yield (~3.5%) vs. 2.4% for the financial sector. So, taking out REITs will lower the dividend yield of financial ETFs to between 1.5-2%.

Performance: Financials ex-REITs will have a higher weighting of interest-rate sensitive sub-sectors such as banks, which will be negatively impacted by rate hikes.

Increased Demand: Most U.S. equity funds significantly underweight real estate, especially in value strategies.  Based on a December 2015 JP Morgan report (1), there is pent-up demand of $100 billion for real estate funds, as long-only mutual funds have an average real estate underweight of 2.1%. Plus, new tax incentives for foreign investors in U.S. REITS may drive demand.

Outlook for Banks and Financial Stocks: Banks and financial stocks have more than recovered from the temporary sentiment-driven sell-off led by the Brexit uncertainty as well as concerns about the Fed’s policy stance. Yet financial stocks remain undervalued relative to other sectors, based on estimated P/E 2016, price/book and long-term debt/capital.

Unless economic conditions deteriorate significantly in the next few months, we expect a stable to steeper yield curve and higher rates by early 2017.

 

 

 

(1) J.P. Morgan Research, 17 December 2015, “2016 REIT Outlook: Remain Constructive as Growth/Valuation Stack Up Well and GICX Change Could be Boon; Risk is Rates.”

All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information.

308161-473

STAR Gazing

We see several themes playing out this year for US domestic sectors, with regards to sector fundamentals, factor selection and the overall direction of the US economy. In our STAR mid-year update, we seek to answer following questions:

  • How have the sector economic fundamentals evolved and how does that guide allocation?
  • So far this year, why are sectors not performing in line with fundamentals?
  • Why is value still underperforming growth & is the reversal expected to continue? Is this related to small caps underperforming large/mega caps?
  • What are the implications of market uncertainty from Brexit, monetary policy, elections etc. for domestic equity?

The Stock Market appears to be placing value on the following sectors in particular; Energy, Materials, Utilities and Industrials – laggards from last year as well as ones projected to perform well in a risk off environment. However, given that we are fundamentally driven, our analysis believes that Economic indicators are pointing toward a weaker growth environment in these particular sectors compared to others such as healthcare, financials and technology.

Our view is that there is a disconnect between the fundamentals and sector performance, implying that the rally is being driven by expanding price multiples rather than economic outlook

Star Gazing Chart 1

Sectors ranked by Composite Valuation Indicators as of June 30, 2016. The ranking shows average of ranks for Estimated P/E 2016, Projected 5-year Earnings Growth, Price/Book and Long Term Debt/Capital. (Source: Bloomberg, Factset) Past performance is no guarantee of future results. See definitions and disclosures here for additional information

 

We believe that as political and economic uncertainty dissipates, the risk-off trades will unwind bringing market performance in line with fundamentals, which could help the following;

  • Value converges in performance to historical patterns versus growth stocks
  • Large caps give way to small and mid-cap leadership
  • Defensive sectors flows subside & market corrects to reflect relative economic strength.

However, as long as the external headwinds remain, being able to pare down overall exposure to equities, in our opinion, reduces volatility and drawdowns in the long run.

StarGazing Chart 2

Sector Economic Index used in STAR for July 2016 compared to July 2015 and July 2014. (Source: Astor Calculations) Past performance is no guarantee of future results. See definitions and disclosures here for additional information

READ MORE HERE

 

 

All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information.

 The Sector Tactical Asset Rotation Composite is a tactical strategy focused on the generation of returns through shifts in domestic equity sector allocations. The Composite exclusively uses exchange-traded funds (ETFs) and focuses on investing in domestic equities during economic expansions while reducing equity exposure for fixed income and cash in weak economic periods. Prior to May 2014, the Composite previously invested in various other asset classes, including commodities, international equity, and currencies. The Composite includes a minimum 15% domestic equity allocation and does not invest in inverse funds. The benchmark is the S&P 500 Index. The S&P 500 Index is an unmanaged composite of 500 large capitalization companies. S&P 500 is a registered trademark of McGraw-Hill, Inc.

 308161-464

U.S. Manufacturing Update

The report on Durable Goods today:

  • New orders for Durable goods decreased 4% in June making this the biggest drop since August 2014. The core measure of new orders for non-defense capital goods excluding aircrafts is up 0.2% in June but still down -3.7% YoY.
  • While the overall new orders decline of 4% looks bad, we believe it is not as meaningful as a measure of manufacturing activity. The reported decline is attributable to a -59% change in commercial aircraft orders.
  • The core capital goods number is used by economists as sign of business investment activity. It has been negative since Dec 2015 but the pace of decline has been slowing.
  • This measure tracks private fixed non-residential investment, a measure of business investment which declined for two consecutive quarters (Q4 2015 & Q1 2016) for the first time since 2009.
  • It can be seen as leading indicator, but revisions & volatility may make it less reliable.
  • These numbers don’t fully take into account the uncertainty and the strengthening dollar post-Brexit and we expect next month’s release to reflect further deterioration in business investment activity.

Astor’s View

Since 2014, there has been ongoing weakness in manufacturing sector and US PMIs, led by the domestic energy sector & a strong US $.  We have been seeing gradual recovery in 2016- the July Markit Flash Manufacturing PMI released last week was highest since October 2015.  But, we expect headwinds to remain from political & global markets uncertainty.

Durable goods

Data Source:  Bloomberg

 

 

All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information.

307161-453