Investors Don’t Believe Fed Guidance Because Of Disappointing Inflation

FOMC Transcript

The Fed’s recent statement and press conference saw the market respond as if they were dovish. That goes against the actions which were a rate hike, a promise of 3 hikes next year, increasing the balance sheet runoff to $20 billion per month, and increasing the dot plot by one hike in 2020. Overall, those were mostly expected, but it’s still unusual to see investors claim these hawkish actions were dovish. This is a stark contrast to when the market would go crazy over one hike in December 2015 and December 2016. Let’s look at the transcript to see if there’s any dovish statements in it.

The first few changes in the statement are neither dovish nor hawkish. It’s just a matter of the hurricanes being further in the rear view mirror. In the next statement, the Fed probably won’t mention the hurricanes. They hurt job growth in September and helped it October. All else being equal, there won’t be any major long term affects on the labor market because of the storms. Saying inflation is running below the 2% mandate is simply factual. You can argue that is dovish, but I think that would be a stretch. The 2nd paragraph is the same as the first as most of the changes reflect the rebound in activity and hiring after the storm. The 3rd paragraph change shows the labor market is strong instead of strengthening which is also probably because of the storm being further in the past. In conclusion, there’s nothing in this statement that materially changes the Fed’s stance in a dovish or hawkish manner. The changes were all caused by the storm no longer affecting economic metrics. The major changes were the rate hike, who voted for it, and the increased balance sheet unwind. Those were all known from just reading the headlines.

Disappointing Inflation

The reason the market didn’t believe the Fed’s guidance for 3 rate hikes in 2018 is because inflation decelerated in November. As you can see from the chart below, the core year over year inflation was up 1.7% which is less than the 1.8% inflation in October. Core inflation was up 0.1% month over month. CPI was up 0.4% month over month because of the increases in energy prices. Energy prices were up 3.9% from last month, gasoline was up 7.3%, and food prices per unchanged. CPI was up 2.2% year over year which is 0.2% higher than last month because of the increase in energy prices. As you can see, everyone is more focused on core inflation than the headline number. The slowdown in core inflation was caused by the slowdown in shelter inflation which I’ve discussed previously. Apartments were overbuilt which is putting pressure on rent price growth. Shelter inflation was 0.2% from last month which is the smallest gain since July. Owner’s equivalent rent was up 0.2%. Shelter is one third of the index since it is such a big cost for consumers. Medical care was flat which is down from the 0.3% inflation in October. Apparel prices were down 1.3% which is the biggest decline since 1998.

Yellen was blaming wireless service costs earlier this year for the low inflation; now she has new line items to blame. Individual price dynamics are causing the overall number to dip. I think this is great news for stocks in 2018 because it might mean the Fed will raise rates less. The Goldilocks scenario of low inflation, decent GDP growth, low unemployment, and rising profits could continue in 2018. Speaking of rising profits, JP Morgan came out with its estimates for S&P 500 profits which include the tax cut. JP Morgan is forecasting S&P 500 earnings of $153. That’s about $10 higher than the consensus. It sees the S&P 500 getting to 3,000. That is about a 13% increase. Without the tax cut, I’d expect a more modest improvement in stocks than this year, but with it, we might see that price target reached.

Biggest Winners From The New Tax Plan

Speaking of the beneficiaries of the tax plan, the chart below reviews the companies which will benefit the most form the repatriation tax holiday. Not surprisingly, Apple is at the top of the list. As I’ve previously mentioned, Oracle will see a benefit from the repatriation holiday along with the benefit of the lower tax rate because it is shifting its revenue recognition to America as the cloud grows as a portion of the business.

The table below shows the companies with the highest effective tax rate. This is a good starting point for further research, but the mix in where the revenues come from will affect the tax rates as well. As you can see, Amazon pays a very high tax rate. Some may joke about how Amazon doesn’t have much profits, but this plan might be in place for a decade, so by then they will surely have higher profits than now as the cloud business continues to grow.

Low Goods Inflation

Inflation missing targets has a lot of economists questioning their models. One of the reasons inflation is so low can be seen in the chart below. Goods inflation has been negative for most of the past 4 years. The infographic claims improved efficiencies in the global supply chain and online shoppers being more price conscious have caused goods prices to fall. Computer prices are down 3.3%, recreational products prices are down 3%, books prices are down 2.7%, and toys prices are down 8%. The other part of this trend is millennial consumers are less interested in physical goods as they prefer to spend money on experiences and digital goods. This trend could mean inflation is structurally low. That would mean stock multiples will be structurally high. The Shiller PE has already been above it’s median for most of the past 20 years, so that’s not a stretch. Wage inflation in 2018 remains critical to where the overall number goes.

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