As measured by the Real Gross Domestic Product (GDP), the value of the production of goods and services in the United States (US) advanced by an annualized growth rate (AGR) of 3.5% during the third quarter of 2016. This was an increase from the 1.4% AGR during the second quarter of 2016. The Federal Reserve (Fed) met strong third quarter GDP and an improving labor market by increasing the Federal Funds Rate (FF) to 0.50 - 0.75%, from 0.25 - 0.50%. At the December 14, 2016, Federal Reserve (Fed) Open Market Committee meeting, the Fed released the following statement, in part: “In view of realized and expected labor market conditions and inflation, the Committee decided to raise the target range for the federal funds rate... The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a return to 2% inflation.” Interestingly, the Fed asserts that it remains accommodative even though it has increased the FF rate twice in the past year. We believe there are two main reasons the Fed considers their position to be accommodative even in the face of rising rates: first, over the near term, the Fed will most likely allow short-term measures of the money supply to continue to grow near their historic mean; second, the FF rate is still well below the inflation rate as measured by the Consumer Price Index (CPI). Normally, a change from an accommodative stance to a neutral or restrictive posture includes a FF rate above both short-term treasuries and the CPI. The Fed’s recent actions and its planned policy response to future economic metrics will likely be measured. Therefore, we believe the Fed will take its time to unwind its expansive balance sheet, leaving the banking system well capitalized for lending to the private sector. One of the reasons we expect restraint from the Fed is our view of inflation, which we think should remain at a low-to-moderate rate of growth over the intermediate term. Historically, the employment private service providing sector’s (EPSP) weekly earnings 12-month percent change and its direction have correlated well with CPI. CPI has been trending up from the middle of 2015, and it has come close to the EPSP level. However, over the past several months the EPSP started to trend down. One other sector that has a long-term effect on inflation is the manufacturing sector. When there is strong pricing pressure from the manufacturing sector it tends to lift most associated prices; this tends to help wages grow, triggering an inflationary cycle. Currently, these metrics are modestly affecting inflationary pressures in our economy. The S&P 500 price to earnings ratio (PE) measures the price of the S&P 500 divided by its 4-quarters earnings sum. The valuation of the market is usually referring to the S&P 500’s PE. For now, we believe the S&P 500’s PE reflects a fairly valued stock market. If earnings increase, with a fair valued PE, the stock market could still have upside potential.
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