In this article, I will discuss my prediction of what the Fed will do on Wednesday. I am writing this article before the announcement, but you may be reading it afterwards. It’s still valuable insight because it gives you an idea of where the Fed is in the monetary cycle. The three parts to discuss are the Fed’s decision on rates, it’s guidance for future changes in rates, and its guidance on what it will do to its balance sheet. The other aspect of the Fed’s presentations is its opinion on the state of the economy. Usually there’s nothing new on the economic front because it is simply rehashing publicly available data. I’m not knocking the Fed with that point because a lot of the data is there’s; the FRED website is very useful as I’ve used its charts in my posts many times.
One thing the Fed probably is aware of is the secular decline brick and mortar retail is in. The bright side of this situation is that weak retail sales doesn’t necessarily imply the economy is weak. However, it makes retail a black hole sector which hurts S&P 500 earnings. The decline in oil and the manufacturing downturn brought down earnings in 2015. It shows that the overall growth is weak enough that one sector can drag it into the negatives. In a previous article, I mentioned that historically online retail takes more share from brick and mortar stores prior to a recession because consumers are searching more studiously for the best deal which is usually online. This hypothesis is still in play although, for it to work this time, we’d need to see a recession quickly.
The chart below shows the large increase in expected bankruptcies in retail in Q1. You can see the increase in Q1 2016 which supported my hypothesis that a recession was coming. While it didn’t portend a recession in late-2016, it did signal more weakness to come for retail. I want you to ignore the estimate for Q1 U.S. GDP growth because Hedgeye’s GDP estimate for Q1 is far outside the reports we’ve seen thus far. On Wednesday, the Atlanta Fed will update its model which now shows 1.2% growth. I disagree with the title of this graph because retail is weak and the overall economy is weak. The signal isn’t as direct as last cycle, however, as there are more bankruptcies than in 2008, yet the economy isn’t in a major recession.
The reason for the secular decline is online sales taking market share. This hurts the U.S. particularly because it has the highest retail space per person. Admittedly, I used to not believe these tables’ conclusion because I thought America’s high consumer spending per person would justify the retail space. While that may have been the reason why America gained so much retail space, it hasn’t stemmed the weakness.
The proof that America is over-retailed is in the bankruptcies and store closings. As you can see from the chart below, retail space per capita peaked before the recession and has been falling since then. At some point, retailers will become better off for these tough decisions, but there will be more pain to come before the benefits are seen. In terms of aggregate S&P 500 earnings, I expected energy and retail to be weak. Bulls are hoping the financials can make up for their weakness as the banks will be getting a boost in net interest margins when the Fed raises rates.
This brings me to my expectation for Wednesday’s FOMC meeting. I think the Fed will raise rates 25 basis points which will be a shock to no one. As far as guidance, I’m expecting it to reiterate the projection for three rates hikes in 2017. Even if the Fed doesn’t plan on raising rates three times, it likes to maintain the guidance up until the last minute. Now that it’s raising rates in March, its guidance has more credibility than last year. I wouldn’t be surprised to see the market selloff on the news, but I’m not expecting a major crash since this ‘should be’ priced in. Sometimes events which you think are priced in aren’t so.
The most important part of the Fed’s statement is the commentary on the balance sheet. The reason why I say if the Fed talks about the balance sheet, it will be in a hawkish tone is because the Fed is acting hawkish with rate hikes. It would be inconsistent to be dovish on the balance sheet. I have seen arguments to raise rates while doing another round of QE, but I’d categorize that as outside of mainstream thought. It’s a policy which can be discussed in theory when determining the correct course, but it doesn’t have a realistic shot at occurring in the near-term.
Therefore, the options are to discuss the elephant in the room or avoid it. Avoiding it would be a meticulously made decision. It’s not something Fed ‘forgets’ to talk about. Even if there’s no material change in opinion, it still should be discussed. In fact, unwinding it in the next 12-months would be an immaterial change in its position. The key here is filling in the details of how it will work.
I expect the Fed to discuss unwinding the balance sheet which would make Wednesday’s announcement very hawkish. That’s not to say I think the Fed will go through with the policy because I’m expecting the market to sour on this rising rate environment shortly. This would give the Fed reason to push off the unwinding policy for another 6 months.
Conclusion
I reviewed the issues physical retail is seeing, namely it is losing share to online and has too much of a presence in America. It’s also worth keeping in mind that if the Fed raises rates, it may lead to consumers having a tougher time borrowing money which will only hurt sales.
I reviewed my thoughts on the FOMC statement. I expect more discussion on how the Fed will unwind the balance sheet, a rate hike, and a reiteration of the three-hike guidance for 2017.
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