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Dreamer Update For Clients and Friends of ArrowMark Partners

The Quarterly Update series was created to demystify Economics and Investing: First published on March 30, 2017 and last updated: January 26, 2018

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The Dreamer Update

January 15, 1929 – April 4, 1968

The Original Dreamer Martin Luther King, Jr. was shot dead while pursuing racial and economic justice in the greatest democracy in the history of the world. Not yet 40, he set in motion world-changing energy. But what would America be like today, if the Reverend Martin Luther King, Jr. had lived and preached a message of love for another 49 years? A historical counterfactual tragedy of unfulfilled potential.

What If

The Consumer Economy makes up two-thirds of U.S. GDP. Note that Personal Income growth has been fading over the past 20 years. What if Tax Reform did end up boosting Middle Class incomes?

The Red Arc above shows that Personal Income growth in the United States has been fading for 20 years. So far, under the Trump Administration, personal income growth is starting to pick up, last reading +4.1% in December 2017. Following the Tax Reform of 2017, some of largest American corporations announced $1,000 bonus payments to their rank and file employees. While these are only one-time payments, it represents a significant sum of money for millions of Americans.

What If the Middle Class Earned Decent Wage Growth?

The Big Picture

There is the Asset Economy & the Labor Economy

The Principal Policy Tools are Monetary Policy & Fiscal Policy

The Principal Actors are the Federal Reserve & the Government

Stock Market at All-Time Highs

Since the $676 low in 2009, the S&P has gained +319% through January 25, 2017.

When Boasting about Stock Market Averages, The President Prefers the Dow Jones

The Dow Jones Industrial Average. A former colleague of mine would refer to the shape of this strong upward trajectory as a prom night chart - it's just asymptotic!.

The Stock Market tends to steal the spotlight, but it is the Bond market that warrants attention. Everybody is watching the rise in 10-Year interest rates.

3%

3% is the obvious target, but the rapidity and violence of the move is what matters.

Goldilocks scenario involves the corresponding soft steepening of the yield curve.

The red line shows the downward trajectory of ten year yield since the Internet Bubble. Since the 7% yield recorded in the mid 1990s, the 10-year bottomed at 1.5% before recovering to 2.4%.

40-Year Old Reversal

If you’re less than Sixty, you’re a Virgin when it comes to Rising Interest Rates

's

The 40-Year Secular Decline In Interest Rates is Ending. From 1962 to 1979, America's insistence on both Guns and Butter (Vietnam and Lyndon Johnson's Great Society) exposed our economic flanks to the Arab Oil Embargo, and two oil shocks culminated in a nasty period of Stagflation. Fed Chairman Paul Volcker earned his spot in history with his decisive victory against inflation. In 1981, the yield on the U.S. 10-Year Bond set its generational high at 16%, and has since declined to 3%.

The Greatest Bull Market in Bonds fueled massive Bull Markets in All Asset Classes

U.S. Household Net Worth

  • Stagflation (1979) USD $8 Trillion with 10-Year around 16%
  • Cold War (1987) USD $18 Trillion with 10-Year around 10%
  • Y2K & Internet Bubble (2000) USD $42 Trillion with 10-Year around 6%
  • Housing Bubble (2007) USD $67 Trillion with 10-Year around 4%

QE Bubble (2017) USD $96 Trillion with 10-Year around 2.3%

In 1981, the U.S. 10-Year Treasury hit its generational high yield of 16% as Fed Chairman Paul Volcker tightened U.S. monetary policy to whip inflation. Falling interest rates boost asset prices (in all asset classes: stocks, bonds, real estate, etc.) through the discounting mechanism. By mathematical extension, zero interest rates would act as NOS (nitrous oxide system, a la Fast & the Furious).

The Situation on Wall Street

Wall Street is the Asset Economy

The Stock Market is at an All-Time High after years of QE, which is about to be reversed

After 7 years of Zero Interest Rate Policy, aka ZIRP, the Fed intends to gradually increase the Federal Funds Rate.

  • When the Irrational Exuberance of the Internet Bubble wore off, the Federal Reserve, under Chairman Alan Greenspan cut Fed Funds to 1% to relieve the U.S. Economy of the asset bubble hangover.
  • While conventional practice, 5 years of this medicine, dripped in steadily increasing doses, allowed another malady to gestate: the U.S. Housing Bubble. So when the Greenspan Fed finally took away the elixir of low interest rates, a swollen Housing Bubble finally bust.
  • This time, the throbbing of aftermath of the Financial Crisis pounded so hard, that the new Maestro tested unconventional medicine devised only in theory as an application to treat Japan's terminal deflation.
  • Under Chairman Ben Bernanke, the Fed administered a long and heavy dose of Zero Interest Rate Policy.
The U.S. Federal Funds Rate (also called "Fed Funds") is the interest rate at which Banks lend each other money on an overnight basis. The Fed Funds Rates is set by the Federal Open Markets Committee of the Federal Reserve (the "FOMC") and Fed Funds is a key determinant of the ultimate cost of borrowing for both Companies and Consumers.

The Federal Reserve wants to "Normalize" monetary policy. "Normalization" also means the Fed must Reverse and Unwind QE by Shrinking the Balance Sheet from its All-Time High Level

During QE, the Fed injected *$5 Billion Per Day* into the markets. In Normalization, the Fed will remove $2 Billion Per Day.
Before 2008, the Federal Reserve balance sheet was a Pristine $755 billion, with the securities portfolio invested entirely in U.S. Treasuries. By 2015, the Fed balance sheet increased by 360% to $4.2 Trillion after 3 Rounds of Quantitative Easing. Of the $3.4 Trillion increase, the Fed purchased $1.7 Trillion in Treasuries to keep short term rates low, and another $1.7 Trillion in mortgage-backed securities to stimulate the effect of an interest rate cut below zero. By 2017, the Fed began to communicate its intent to "Normalize" its balance sheet.

Cognitive Dissonance

Despite the Unknown of Reversing QE, the cost of stock market insurance has never been cheaper.

VIX is the measure of stock market insurance. Unless specified, VIX is usually associated with the S&P 500 Index.

The Situation, Summarized

The Asset Economy benefited mightily from Low Interest Rates, then got turbocharged by Quantitative Easing.

The Situation on Main Street

Main Street is Our Middle Class

Denver Blue Bear at the Convenstion Center.

Consumer Sentiment

Is Wage Relief on the Way?

Apartment Rents

For many Americans, Rent, the largest living expense, has been increasing twice the rate of Inflation

Since the Financial Crisis, rental property values has increased significantly. This benefits owners of Rental Property, but squeezes Disposable Income for those who rent their housing. From 2011-2016, effective rent increased by 4.1% annually.

For Those Earning Hourly, Wage Growth of only 2.5%, Not Enough vs Rent increases of +4.1%

Source: Federal Reserve Bank of Atlanta

The Big Consumer Squeeze

Rent is rising faster than wages. In this example, if Rent took 45% of take-home pay in 2010, by 2016, Rent's share of the paycheck increased to 49%.

Here is the math to back up the illustration.

The Job Market

U-3 Overstates Economic Vitality

U-3 is the official Unemployment Rate. It measures people without work, but who have also been actively looking for work within the past four weeks. 1969: Unemployment got worse each economic recession, reaching 10% in 1982.

Underemployment is approaching All Time Lows. Is the Job Market tight?

U-6 Unemployment data series began in 1994. U-3 measures workers without jobs but who are still actively looking. A broader definition of Unemployment, U-6, also includes workers without jobs who have stopped looking for work, also known as discouraged workers. Finally, U-6 includes people working part-time because they are unable to find full-time employment. U-6 blew out to 17% during the Great Recession, but has improved significantly, approaching all-time lows.

For Both the Unemployed, and Underemployed, It has Never Been Better Time to Find a Job

U-6 Unemployment data series began in 1994, and it includes workers who may be working part time, but unable to find full time employment. U-6 blew out to 17% during the Great Recession, but has improved significantly, approaching all-time lows.

Yet The Labor Force Participation Rate is only 63%

At its Peak, Two-Thirds of Americans aged 16 and over were an active part of the Labor Force. Since that Peak, the Labor Force Participation Rate has declined steadily to 63% where it remains stuck. We deduce that as many as 10 million Americans are choosing not to participate in the labor force.

The U.S. working age population (defined 16 to 64 years of age) is approximately 200 million.

Confidence

The U.S. Consumer Drives 2/3 of the American Economy

This survey asks respondents to assess current business conditions and appraise their own income prospects. With U.S. GDP growth at 3% and U-3 unemployment at 4.1%, job openings are available, this survey should register strong results.

The Conference Board measures are surging with November 2017 reading 129, the highest scores since Y2K

The University of Michigan survey asks respondents to assess current business conditions and appraise their own income prospects. It is important to note that University of Michigan also asks about future buying intentions. Note that the Confidence of Finding Work may not necessarily equal the Intention to Spend Wages.

Each month, 500 individuals are randomly selected from the contiguous United States (48 states plus the District of Columbia) to participate in the Surveys of Consumers. In order for the results to accurately represent the opinions of the population of the United States, it is important that each person selected participates. The questions asked cover three broad areas of consumer confidence: personal finances, business conditions, and future buying plans.

Personal Spending

Data Set: Wage Growth > Personal Income > Confidence > Personal Spending

Personal Saving

Inflationary Pressures

CPI Has Not Achieved 3% in 20 Years

Reported monthly by the Bureau of Labor Statistics, CPI attempts to measure the change in prices paid by consumers for a market basket of consumer goods and services.

Excluding Food & Energy

Inflationary Expectations

The 5-Year, 5-Year (5Y5Y) is the market's guess for the 5-year outlook for inflation, 5 years in the future. This rate also influences the price for U.S. Treasury Bonds.

Interest Rates

The U.S. Federal Funds Rate (also called "Fed Funds") is the interest rate at which Banks lend each other money on an overnight basis. The Fed Funds Rates is set by the Federal Open Markets Committee of the Federal Reserve (the "FOMC") and Fed Funds is a key determinant of the ultimate cost of borrowing for both Companies and Consumers.

To calm the Financial Crisis, The Fed and the United States Treasury led rescue efforts. The Treasury provided immediate relief with Bailout capital, to both Wall Street and Detroit. The Federal Reserve responded by implementing Ben Bernanke's Helicopter Money philosophy of the Zero Interest Rate Policy. Under Bernanke, the Fed lowered the Fed Funds rate to 0%. The Fed also purchased nearly $2 trillion of U.S. Government Bonds as well as nearly $2 trillion of Fannie Mae and Freddie Mac mortgage bonds from Wall Street.

Z.I.R.P. The Fed ZIRP-ed the American public to subsidize bank recapitalization.

Reflexively, changes in the cost of borrowing simultaneously impact the level of interest income earned by Savers in instruments such as savings accounts and certificates of deposit. American Savers continue to shoulder the cost of recovery from the Financial Crisis as interest rates have languished near 0%.

20-Year History of U.S. Federal Funds Rate: Fed Funds at 5.5% implies an American with $100,000 in savings earned, each year, at least $5,000 in (safe, consistent) interest income. Fed Funds Rate is starting to rise, but #Lift-Off has been under-powered relative to the lost savings income over the past decade.
  • Alan Greenspan served as Chairman of the Federal Reserve from 1987 to 2006. Greenspan was appointed by President Ronald Reagan and later reappointed by Presidents George H.W. Bush, Bill Clinton, and George W. Bush.
  • Chairman Ben Bernanke, served two terms as Chairman of the Federal Reserve (from February 1, 2006 to February 3, 2014). He was appointed by President George W. Bush and reappointed by President Obama.
  • Chair Janet Yellen, has served as Chair of the Federal Reserve since February 3, 2014 since her appointment by President Obama.
  • The New Incoming Chairman of the Federal Reserve Bank is Jerome Powell.

<3-Month LIBOR>

The London Interbank Offered Rate (LIBOR) is the reference interest rate for trillions of dollars of financial derivative contracts. LIBOR continues to climb higher each week.

Under Alan Greenspan, 3-month LIBOR declined from 5.5% to a low of 1% in 2003. Coincidentally, and perhaps causally, the U.S. home market started to boom. Interest rates (3-month LIBOR) normalized to 5% by 2006. Then, in 2007, the Housing Bubble began to burst, creating a Financial Crisis and the Great Recession. Fed Chair Ben Bernanke then introduced the Zero Interest Rate Policy, or ZIRP.

<U.S. 10-Year Treasury Yield>

Depicted above is the U.S. 10-Year Treasury Yield, going back to 2009, the Housing Bubble and the Financial Crisis.

U.S. Dollar & FX

The U.S. Dollar Index is the trade-weighted basket of major foreign currencies. The Canadian Dollar is 12% of the Dollar Index. The Japanese Yen makes up another 12%. The remaining ~75% is comprised of the Euro and other European currencies.

Since 2012, the Dollar Index has surged to 100, but failed to break above this level

<U.S. Dollar Index & 10-Year Treasury Yield>

Since 2015, the Dollar Index (in Red) has poked above "100" several times, but each time, the Dollar has failed to break out above this level.

In Red, the U.S. Dollar Index which peaked at 151 in 1984 and hit another high at 119 in 2001. In white, the U.S. 10-Year Treasury Yield over the same time period.

China

After joining the World Trade Organization in 2001, China accumulated USD 4 Trillion in foreign exchange reserves in just 12 years

"I don't blame China. Who can blame a country for being able to take advantage of another country for the benefit if its citizens? I give China great credit,” Trump joked (Fox News)
After years of tariff negotiations, China joined the World Trade Organization on December 11, 2001. China pursued an Export led economic growth strategy which led to the accumulation of USD 4 trillion of foreign exchange reserves. Note that China's FX reserves have stabilized at $3 trillion.

<China Oil Demand> This is the most important demand chart for oil, the world's most important commodity.

In 2002, China used approximately 4.9 million barrels per day of crude oil. By 2012, China daily oil demand grew by 5.7 million barrels to 10.6 million - a rate of annual increase of 570,000 per year. From 2014 to 2016 Apparent Demand topped at 10.6 million barrels per day, but has recently broken above this previous high.

Oil

The World's Most Important Commodity

It is about the U.S. Energy Renaissance

Gold

This is a current writing project

The Barbaric Relic

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