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The Beginning of the End

By Ari Charney on February 10, 2017

Last year was another year of the utility. This year? Well, maybe not.

At the very least, 2017 promises to be a challenging year for income investors of all stripes.

After all, the Federal Reserve is poised to end the bond market’s 30-year rally. If so, that will weigh on rate-sensitive sectors ranging from real estate to utilities.

But as we’ve pointed out a number of times in recent months, much of the market’s action since Election Day has been fueled by speculation of imminent inflation more so than actual events.

True, the unified GOP government’s policymaking could reinvigorate growth.

We’re already seeing a rollback in regulations, with the promise of more to come. And corporate tax cuts could also give a big boost to the economy’s job creators.

However, we’re less certain about the prospects for President Trump’s proposed $1 trillion infrastructure plan. Regardless of what form it takes, infrastructure spending tends to take a lot longer to boost economic growth than tax cuts.

Sentimental Mood

Nevertheless, the promise of these goodies seems to have changed business sentiment for the better. And that could be a big deal.

Our gut feeling has been that the economy’s doldrums since the downturn have been due in part to psychology: Everyone got burned so badly during the financial crisis that they’ve been afraid to take on risk ever since.

So if rising sentiment presages a return of so-called animal spirits, then that alone may be enough to bring new vigor to the economy.

But while business sentiment may be rosier than it was a little more than three months ago, sentiment is almost always based on what happened in the recent past, in this case promises made during the election.

If the government fails to deliver on those promises or simply moves too slowly in fulfilling them, then that could dampen sentiment.

Indeed, from the market’s perspective some of the bloom could already be coming off that rosy sentiment. As Jefferies Senior Economist Thomas Simons told Bloomberg, “We need to see something real—we can’t just continue to base current pricing on some nebulous fiscal policy we don’t have any details on.”

One sign that the inflation trade might be faltering? The yield on benchmark 10-year U.S. Treasuries, currently just below 2.41%, is nearly 19 basis points off its December high. That might not sound like much, but in the world of bond trading it’s a sizable move.

The Fed’s Football

Meanwhile, we remain skeptical about the true health of the job market, which is one of the main factors driving Federal Reserve policymaking and the potential for higher interest rates.

Beneath the strong headline data are less reassuring trends, including lackluster wage growth and mediocre job quality.

The latest U.S. employment report showed that average hourly earnings had climbed just 2.5% from a year ago, the slowest pace since August.

That rate is at least a full percentage point below where it would be if the economy were truly firing on all cylinders. And other wage-growth indicators show a similar slowdown.

Additionally, the number of Americans who are employed part-time for economic reasons is still nearly 50% higher that it was during past rebounds.

Does that mean the economy is about to yank the football away from the Fed again? It’s entirely possible.

At its December policy meeting, the central bank forecast three quarter-point rate hikes for 2017. With the market fixated on the inflation trade at the time, traders’ expectations were largely in line with the Fed. But now the market expects just two rate hikes this year, based on futures data aggregated by Bloomberg.

The Bond Whale Is About to Blow

In addition to rate hikes, the Fed also has other policy considerations that could have significant implications for the economy. As part of its extraordinary stimulus, the central bank vacuumed up about $1.75 trillion worth of mortgage-backed securities, or about a third of that market.

While it’s only reinvesting the interest and principal received from these bonds, that was still enough to fund the purchase of $345 billion of mortgage debt last year.

The Fed is still debating how to unwind this massive position, but some economists expect the Fed could make its first move by the fourth quarter. Morgan Stanley estimates that if the Fed trims just 20% of its mortgage-bond holdings through 2019, then the effect on the economy could be equivalent to two more rate hikes.

Put all these factors together, and this could be an unusually volatile year for income investors. But that also means there will be opportunities to pick up our favorite utility stocks at more reasonable prices.

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