Dinner with Janet

By: Chuck Widger, Founder & Executive Chairman

Yellen_small-2On April 4, I joined a group of 15 private sector investors for a dinner with former Federal Reserve Chairwoman, Dr. Janet Yellen. It was a delightful, insightful, interesting, and informative evening. Below is a mix of her thoughts on the economy, Fed policy, and where we are headed. I am also noting important policy nuances raised by a couple of her core economic policy principles.

Yellen has a positive outlook on the economy. She sees economic growth in 2018 and 2019 at +2.5% and +2.8%, respectively. She described the economy and the labor market to be in excellent shape and expects tax cuts and spending to lift real GDP in 2018 and 2019 by one-half to three-quarters of a percentage point above the economy’s current growth rate of 2.6%. The labor market is almost at full employment, with the potential for the unemployment rate to drop another 0.6% to a level of 3.5%. However, the labor force participation rate may not improve because of structural reasons.

Absent extraordinary circumstances, the Fed will continue on its current path and pursue a total of three increases in the Fed Funds rate this year. What might those extraordinary circumstances be? While Yellen believes there is not a lot of pressure on margins from wage costs and thus no present inflation problems, overheating from all the stimulus is a possibility. Faster growth and a tighter labor market could cause the Fed to make a policy mistake. Significantly faster and greater increases in interest rates could (and they have in the past) chill growth and lead to a recession.

In discussing the economy and Fed policy-making, Yellen showed appealing humility. She acknowledged that our monetary leaders bring their best judgment not an absolute certainty to making policy choices. For example, while commenting on the natural rate of interest, she observed, “What if it’s higher than I/we anticipate? While I have a view on what it is, I do not have absolute certainty.” Humility combined with significant intellectual talent is always an appealing character trait.

So, what are the nuances? Two points stood out. First, her emphasis on the Phillips curve as the only actual framework for understanding the relationship between inflation and unemployment, and second, her view that tax reduction and full capital expensing will have little supply-side effect on economic growth. Both raise important policy distinctions between Keynesian and supply-side economics.

Keynesian economists put greater emphasis on the Fed’s ability to fine tune the economy than supply-siders. In contrast, supply-siders favor letting the natural forces in a market economy do their thing. Yellen’s emphatic statement endorsing the Phillips Curve as the only framework for predicting the tradeoffs between unemployment and inflation is quite Keynesian. For example, if unemployment is high, the policy choice is to reduce interest rates and increase the money supply to create demand and thereby reduce the unemployment rate with little impact on inflation. This is fine-tuning through government intervention.

phillips-curve-2Yellen similarly sees the tax reform’s rate reduction as increasing demand and thereby spurring demand because consumers have more to spend. Tax reform and full capital expensing will provide only a small spur to economic growth through increased production by businesses.

Supply-side economists, like the new Chair of the President’s Council of Economic Advisors Larry Kudlow, beg to differ. They believe when businesses produce and sell more because they have more after-tax cash, they create more demand through the purchases they make and the increased wages they pay. Supply-siders really aren’t interested in the demand side of the supply-demand equation because supply will create its own demand. Therefore, there is not much need for the Fed to “fine tune” the economy. Market forces will balance and grow the economy naturally.

These are important nuances. They reflect an economist’s view on the extent to which the Fed (and the federal government) should intervene in the economy.

The reality is there is something to each of these frameworks. The emphasis on application is, and should be, a matter of degree. There are very few absolutes in economics. The pragmatic application of theory works best.

Below are a few additional pieces of information from our discussion with Dr. Yellen.

  • For the GFC (Global Financial Crisis) there is plenty of blame to go around. The Fed failed to supervise the banking system and the shadow banking system. Our banking system engaged in poor practices and pursued unaligned incentives (bad behavior). And, the markets demanded high cash returns through CDAs and mortgage-backed securities.
  • The safety net placed under the financial system post-GFC has not been endangered by the deregulation pursued by the new administration.
  • Current worries are to the upside. An “overheating” economy is of more concern than undershooting the Fed’s inflation target.
  • Another worry is the Fed continues to conduct an accommodation experiment. As it increases rates, it must balance the different risks of slowing the economy and stoking inflation.
  • The Fed is now trying to engineer a “soft landing from below.”
  • Bitcoin is speculative excess according to Yellen. One dinner guest suggested interested investors should consult the 17th Century Dutch tulip bulb mania when considering bitcoin investments.

Yellen is to be thanked for her public service and her leadership as Chair of the Federal Reserve. A record of good stewardship of a vital US institution by a personable, highly intelligent public servant offers a refreshing reinforcement of public trust in a vital US institution.

The views expressed are those of Brinker Capital and are not intended as investment advice or recommendation. For informational purposes only. Opinions represented are not intended as an offer or solicitation with respect to the purchase or sale of any security and are subject to change without notice.  

Brinker Capital, Inc., a registered investment advisor. 

Chart source: The Economics Book: Big Ideas Simply Explained. DK Publishing, 2012. pg.203

February 2017 market and economic review and outlook

magnotta_headshot_2016Amy Magnotta, CFASenior Investment Manager

Markets were off to a good start in 2017 as risk assets posted modest gains for the month. After taking a brief pause from the post-election fourth quarter rally, risk assets continued to climb at a more tempered pace, with returns driven more by healthy fundamentals than post-election hype. Economic data leaned positive and a solid earnings reporting season helped bolster consumer confidence. Inflation risk continued to increase with rising wages and stabilization of commodity prices and will likely continue to rise as the new political administration begins implementing its pro-growth policies.

shutterstock_313473086 (3)

The S&P 500 was up 1.9% for the month. Cyclicals outperformed more defensive sectors with both materials and information technology up over 4%. Energy was down -3.6%, a reversal from the sector’s strong returns in 2016. Telecom was down -2.5% as income-focused stocks continue to experience pressure from the rise in interest rates. Growth outperformed value and mid cap led small and large cap equities.

International equities were up 3.6% in January. Economic data in the European Union pointed to signs of a modest recovery as GDP growth rose and unemployment fell. Progress, however, remains uneven amongst countries, creating headwinds for the European Central Bank to implement future effective monetary policy. Likewise Japan saw beginning signs of an economic recovery but no indication was given that the Bank of Japan is ready to start tapering it’s accommodate monetary policy. Emerging markets were up 5.5%, outperforming developed international markets. After experiencing a drawdown in the fourth quarter last year, the asset class rallied due in part to stabilization of commodity prices.

Fixed income was slightly positive with the Bloomberg Barclays US Aggregate Index up 0.2% and Bloomberg Barclays Municipal Bond up 0.7%. The 10 year Treasury yield ended at 2.46%, relatively unchanged from the start of the month, but down from the 2.59% peak in mid-December of last year. High yield was the best performing sector, up 1.5%, as spreads slightly contracted. Going forward we expect fixed income returns to remain muted as the Fed continues with its interest normalization efforts.

The Brinker Capital investment team remains positive on risk assets over the intermediate term, although we acknowledge we are in the later innings of the bull market and the second half of the business cycle. While our macro outlook is biased in favor of the positives and recession is not our base case, especially considering the potential of reflationary policies from the new administration, the risks must not be ignored:

  • Reflationary fiscal policies: With the new administration and an all‐Republican government, we expect fiscal policy expansion in 2017, including tax cuts, repatriation of foreign sourced profits, increased infrastructure and defense spending, and a more benign regulatory environment.
  • Global growth improving: U.S. economic growth is ticking higher and there are signs growth outside of the U.S., in both developed and emerging markets, are improving.
  • Global monetary policy remains accommodative: The Federal Reserve is taking a careful approach to policy normalization. ECB and Bank of Japan balance sheets expanded in 2016 and central banks remain supportive of growth.

However, risks facing the economy and markets remain, including:

  • Administration unknowns: While the upcoming administration’s policies are currently being viewed favorably, uncertainties remain. The market may be too optimistic that all of the pro‐growth policies anticipated will come to fruition. We are unsure how Trump’s trade policies will develop, and there is the possibility for geopolitical missteps.
  • Risk of policy mistake: The Federal Reserve has begun to slowly normalize monetary policy, but the future path of rates is still unclear. Should inflation move significantly higher, there is also the risk that the Fed falls behind the curve. The ECB and the Bank of Japan could also disappoint market participants, bringing the credibility of central banks into question.

The technical backdrop of the market is favorable, credit conditions are supportive, and we have started to see some acceleration in economic growth. So far Trump’s policies are being seen as pro‐growth, and investor confidence has improved. We expect higher
volatility to continue as we digest the onset of the Trump administration and the actions of central banks, but our view on risk assets remains positive over the intermediate term. Higher volatility can lead to attractive pockets of opportunity we can take
advantage of as active managers.

A PDF version of Amy’s commentary is available to download from the Brinker Capital Resource Center. Find it here >>

Source: Brinker Capital. Views expressed are for informational purposes only. Holdings subject to change. Not all asset classes referenced in this material may be represented in your portfolio. Indices are unmanaged and an investor cannot invest directly in an index. All investments involve risk including loss of principal. Fixed income investments are subject to interest rate and credit risk. Foreign securities involve additional risks, including foreign currency changes, political risks, foreign taxes, and different methods of accounting and financial reporting.

Barclays Municipal Bond Index: A market-weighted index, maintained by Barclays Capital, used to represent the broad market for investment grade, tax-exempt bonds with a maturity of over one year. Such index will have different level of volatility than the actual investment portfolio. S&P 500: An index consisting of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P 500 is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large-cap universe. Companies included in the Index are selected by the S&P Index Committee, a team of analysts and economists at Standard & Poor’s. World Index Ex-U.S. includes both developed and emerging markets. Bloomberg Barclays U.S. Aggregate: A market capitalization-weighted index, maintained by Bloomberg Barclays, and is often used to represent investment grade bonds being traded in the United States.

Brinker Capital Inc., a Registered Investment Advisor.