Christmas Eve Faux Pas

After Federal Reserve Chairman Powell’s Christmas Eve faux pas in 2018, the language and tone of the Fed, regarding the prospects of rising short term interest rates, has become decidedly more-friendly to both stock and bond markets. As a result the Standard and Poor’s 500 increased by 13.62% in the first quarter, and added another 4.29% in the second. Bond yields declined significantly; the 2-year US Treasury yield dropped from 2.49% to 1.76%, and the 10-year from 2.68% to 2.01%. Because the value of a bond changes inversely with interest rates, virtually all bond portfolios now have a gain rather than a loss. The Bloomberg Barclays Aggregate Bond Index, consisting primarily of U.S. Treasury and Agency debt, and corporate and mortgage bonds, returned 6.11% for the first six months of this year.
On July 31 the Federal Reserve reduced the Federal Funds rate by 0.25%, to 2.25%. There are different ways to view this. While some real-time indicators such as freight and packaging rates have declined, some industrial production measures continue to show declines in activity, and the economies of other countries continue to weaken, we note that the consumer in the U.S., responsible for approximately 70% of Gross Domestic Product (GDP), remains in a very healthy state overall. A very low unemployment rate, rising wages in excess of the rate of inflation, the continuation of the demand for labor outstripping its supply, and consumer confidence indexes near all-time highs should continue to provide economic momentum the rest of this year. Gross Domestic Product for Q2 was reported at 2.0%, down from the 3.1% rate in Q1 but still a reasonable, non-inflationary rate of growth, probably consistent with our capacity to grow.

Given the strength of the U.S. consumer and the domestic stock market near all-time highs, some market participants have questioned the Federal Reserve’s impetus to cut rates. It wouldn’t do for the Federal Reserve to be seen as a pawn of the stock market by implying a rate cut because the stock market would likely throw another tantrum (Christmas Eve was not a fun day). Nor would it do to be viewed as bowing to the Administration, which insists on lower rates because they believe the economy could be doing even better. And it might be, in my 33 years in this business, the first time the Fed made a pre-emptive reduction in rates when the economy appeared to be performing well. There is one thing to consider: The party that negotiates with the stronger hand will typically achieve more of what they want. In the middle of tense trade negotiations with China it would be problematic to have a weakening economy as a backdrop.

We’ve written before a fairly accurate estimation of the non-inflationary rate of GDP growth can be calculated by adding the percentage increase of people entering the work force with the percentage increase of productivity. The global demographic of aging will continue to take an increasing toll on one side of that equation, lowering the potential to grow. In the U.S., the 70-79 age group is expected to grow by 38.4% over the next decade; those 80 and over by 46.7%. In China, those figures stand at 62.3% and 40.4% respectively, and globally they are 45.0% and 38.6%. This is, and will continue to be a serious challenge to future generations, as the chance to enjoy the same standard of living as prior generations will likely be harder to achieve (if you get a chance, I urge you to re-read Stuck in 2nd Gear, penned by our colleague Travis McEowen. In it Travis makes several points regarding future growth that we continue, as a group, to take into consideration).

Regarding the productivity side of the equation, we were asked to provide and narrate a topical discussion of Artificial Intelligence (AI) for a foundation client. We’ve had the chance to read quite a bit relating to the subject, and saw it as an opportunity to see if and how our client’s portfolios might also benefit. In short, we found that though demographic trends will pose a major challenge to our future economic expansion, advances in AI may be the key to maintaining future growth.
AI has its roots in mathematics, philosophy, and computer science (at some point, ethics will also have to be a goal, if not already). The aim is twofold; one, to provide the means to do increasingly complex, but repetitive tasks very quickly and, two, to be able to process existing information and new information (for instance, changing the direction of a thought process with regards to incoming information or stimulus) much like a human needs to do while driving on an expressway. The former can be described by a chess match between a human chess master and a computer; having predetermined rules and being within the confines of chess pieces that can only move in certain ways, raw blazing computer chip speed can make millions of computations a second, while a human, well, is human. This isn’t thought or imagination on the part of the computer, rather overwhelming computational capacity amidst predetermined rules. Game over.

The latter is the topic that’s come to the fore and gains a lot of attention. More specifically, can a computer process information (learned and stored, from the past, and newly considered, as the future unfolds) like a human, by having the ability to change direction with regards to new information, and also to learn and teach itself by both disappointments and successes. The idea of an autonomous automobile is a hot topic, and perhaps the best illustration. With slight variance from state-to-state, the rules of the road are defined and can be coded, stored, and digitally accessed virtually simultaneous with the need to do so. The problem is that simply driving to work on any given day has its trials and tribulations, which are random, and can be instantaneous and potentially deadly. Random might, or can be handled by computer capacity and speed; surviving random, instantaneous, and potentially deadly situations depends on everything going right, as in optical/radar recognition, the ability to translate that recognition into a format that queries a database for like situations, resurfaces with a response, which is then translated into a mechanical response like slamming on the brakes. At the moment, autonomous test vehicles have difficulty distinguishing between a human walking in front of the car and an evening newspaper inadvertently blowing in the wind.

To the point, many years ago a picture of the inside of a General Motors assembly plant was on the cover of Barron’s magazine. It reflected an enormous room full of yellow robotic welders. My first thought was of the efficiencies gained; they didn’t call in sick, they couldn’t demand raises or go on strike. But the second thought was also quite clear, that not one of those would ever buy a car. Efficiencies gained and a future sale lost. That hasn’t proved to be true, and it is a part of why we believe the pursuit of AI and its potentialities must continue, with all due speed.

If the part of the GDP equation that relates to human effort as a contributing factor to GDP growth has a dim future, and if future generations wish to enjoy the standard of life their parents and grandparents enjoyed, productivity has to improve. Autonomous cars are but one example. Incredibly fast computer chips, parallel processing, access to large and growing databases, cloud storage which provides and improves access to those databases, advances in algorithms, and an increasing ability to couple algorithms and databases such that they become self-teaching feedback loops can be used in many applications. Such advancements would not necessarily supplant humans, but serve to increase their productivity. As robotic welding machines did not displace all automotive workers, we doubt an economic future aided by AI productivity will result in massive human displacement.

We’ve enjoyed an incredibly solid year thus far from an investment point-of-view, and see no immediate reason why we won’t be writing the same at the end of the year. However, we continue to have almost-grave concerns over the European financial system, which could become a global systemic issue. And the European Central Bank has left them almost bereft of any meaningful response should an issue surface, unless ignoring the problem qualifies as something positive. We will continue to closely monitor this and take active measures if we feel it necessary. As always, we would communicate our actions directly.
Thank you for being a client. We appreciate your confidence in us and the opportunity to be of service and grow our relationship. Best regards…

Jamie D, Wright, CFA
Portfolio Manager, Research Director

First Merchants Private Wealth Advisors products are not FDIC insured, are not deposits of First Merchants Bank, are not guaranteed by any federal government agency, and may lose value. Investments are not guaranteed by First Merchants Bank and are not insured by any government agency. This material has been prepared solely for informational purposes. First Merchants shall not be liable for any errors or delays in the data or information, or for any actions taken in reliance thereon. Any views or opinions in this message are solely those of the author and do not necessarily represent those of the organization.