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FUNDAMENTALS, MONETARY POLICY, AND THE INFLATION GOAL

The equity market has performed well in Q2 2017 following strong Q1 results and is entering Q3 on a constructive note. Fixed-income securities provided underlying support as long-term yields stabilized in the 2.25% to 2.35% range, even in the face of rising short-term rates. More importantly, the earnings recession has ended and a recovery has begun. Q3 2016 generated the first year-over-year positive result in five quarters; Q4 2016 followed with a similar gain; and Q1 2017 has shown double digit increases. Revenue is showing a similar pattern.

Discussions surrounding various aspects of fiscal policy (spending, healthcare, tax reform, etc.) have dominated the investment landscape for months with many pundits attributing the market’s behavior to various likely outcomes. In our judgement, it appears that the fundamentals are the driving force. The lack of specificity, the likelihood of success varying constantly, and the vitriolic political environment offer investors little to pin their hopes on. What does appear to have emanated from Washington that is having a positive impact is the halt to endless regulation. A breath of fresh air has blown through the halls of businesses and a sense of relief has helped restore investor confidence. However, it cannot be overemphasized that the driving forces behind the fundamentals remain the aggressive nature of global monetary policy.

The major Central Banks around the world continue to pursue an accommodative money policy. The European Central Bank (ECB) remains committed to its quantitative easing program, making monthly purchases of bonds and expecting to do so the rest of the year. There is some anxiety that a change is in the offing as economic conditions continue to improve in Europe. Mario Draghi has indicated that job growth requires the persistence of low interest rates. At the same time in Germany, business confidence is at a near all-time high, while Italy prepares a potential bailout of the Veneto banks. Interest rates in the euro community remain very low despite the recent increase. 10-year bonds in Germany yield 54 basis points; in France 85 basis points; and in Italy the rate is 2.04%. Additionally, Japan continues to pursue a zero-interest rate policy.

At the same time, the U.S. is wrestling with an emerging dilemma. Job growth and the low unemployment rate suggest that the full employment goal is at hand. However, the inflation target remains elusive. The Fed has continually missed the 2% rate with recent indicators moving in the opposite direction. The May PCE core deflator on a year over year basis rose only 1.4% vs. April’s 1.7%. Also, wage gains remain subdued (in the 2.5% area). This divergence in the two goals suggest that the Fed is likely to move cautiously on its next rate move. Chair Yellen in her testimony before Congress has made it clear that the process is data dependent with rate changes linked more to the inflation rate than other factors. Moreover, the timing of the program to begin a slow contraction in the Central Bank’s balance sheet by reducing the reinvestment of some maturing debt is just beginning to get attention and clarity. The data dependent Fed remains committed to a slow and methodical approach toward interest rate normalization, with the expectation that the neutral rate is significantly lower than the historical rate. The Fed is making it increasingly clear that the balance sheet adjustment is being separated somewhat from the rate decision and likely to be conducted before additional rate increases ensue. Understanding the nature of the inflationary trends in the face of consistent forecasting error and an uncertain time line to achieving a lower neutral interest rate, suggest a cautious approach will be employed. Consequently, rate increases are likely to follow the inflation path, not lead it.

Despite rate increases and changing expectations, there has not been any discernable change in the 5-6% growth rate of the monetary aggregates (MZM and M2) which, in conjunction with low inflation, continues to generate real monetary growth in the 3-4% range. This level is supportive of continued economic growth. Furthermore, even with the recent rate increases, the nominal rate is below the inflation rate, suggesting that a negative real rate persists and should remain for some time. This development is also supportive of growth.

With economic growth improving in the European Community and Japan, and while China remains in the 6.5-7% range, earnings and revenue growth for the multinationals in particular should continue to improve. Recent weakness in the dollar could provide additional impetus.

As earning season unfolds, individual stock volatility should be expected. However, the bias should be toward the upside for earnings and revenue for most companies. Guidance will take on greater significance.


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By: Frank Mastrapasqua, Ph.D.
Principal, Chairman & Chief Investment Officer


If you have a question or need further information, please contact:

Patrick Snell, CFA, Principal & Portfolio Manager in Nashville at 615-244-8400, Patrick.snell@mastrapasqua.com

Claude Koontz, CFA, Principal & Portfolio Manager in San Antonio at 210-353-0519, ckoontz@mastrapasqua.com


The information and opinions contained in this report should not be treated as fact or as insight that will produce desired investment results over time. Investment conclusions always bear risk, and that risk may not be reasonable for any particular reader. Obviously the writer, even assuming good intentions, does not know of the reader's particular financial circumstance and therefore is not able to assess the propriety of whether a named security makes sense as part of a given individual, family, or institutional portfolio. Mastrapasqua Asset Management clients may, from time to time, own some of the companies mentioned. We hold out no duty to give readers of this column advanced notification of when we may change an opinion. To our knowledge, none of the information contained in our column would, when it becomes publicly available, have an influence on the valuation of a particular stock. Investors should receive investment advice based on an assessment of their own particular investment circumstances and not on the basis of recommendations in this report. Past performance is not indicative of future returns.

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