Perspectives & Commentary

Avalon produces a variety of investment commentaries.

Our perspectives and quarterly commentary are issued throughout the year and cover a range of investment-related topics.

Monthly Note

May 2018

 From the Federal Reserve’s shift toward inflation “symmetry” to Italy’s bond market, May proved to be a far more entertaining month than expected. The yield on 10-year U.S. government debt fell this month following the Italian disruption after reaching a fresh multi-year high. The global economy also moderated, though still remaining in growth mode. Italy’s governance issues flared, and this will likely continue. Moderating Growth? The release of the April ISM report gave us insight into the health of the U.S. economy at the beginning of the second quarter. In general, the report showed a healthy moderation in the pace of growth. It is worth remembering that any reading above 50 is associated with an increase in activity, and the direction of the index from one month to the next is indicative of an acceleration or a deceleration of activity. Source: Bloomberg So, the current deceleration from exceedingly high readings is nothing to be overly concerned about and remains consistent with relatively rapid growth. One side-effect of the ISM figures pointing toward moderating activity is that a slower pace of growth is typically associated with falling 10-year yields. It may take some time for the 10-year to react to the data, but the pressure for higher long yields appears to be moderating, if not reversing. The Fed The May Federal Opening Market Committee meeting was supposed to be dull, but the Fed threw a curveball in the form of subtly altering its inflation mandate.Most of the changes from the March to May statement were innocuous with expected shifts in the language around inflation approaching the Fed's 2% target and business investment picking up. The one phrase that was not innocuous: "Inflation on a 12-month basis is expected to run near the Committee's symmetric two percent objective over the medium term." This doesn't sound interesting, but it signals a different regime than is usually expected from the Fed. A "symmetric inflation target" would indicate that the Fed is willing to put up with higher inflation without fighting too hard. It means, since inflation ran below target for an extended period, the Fed will allow inflation to play catch-up. There have been a number of Fed officials and commentators (including this author) who have advocated for this type of policy. This is the first time the FOMC has endorsed such a regime. In many ways, the Fed is now back in "prove it" mode. Inflation readings are likely to come in higher than the 2% target for at least the next couple months. It is worth remembering that symmetry means a “sustained, but contained overshoot of inflation," something the Fed may struggle to explain to an apprehensive market. Symmetry is a crucial part of the argument that follows. If the Fed is going to operate with a tolerance for inflation overshooting, it will need to set policy accordingly. To set policy in a manner that allows inflation pressures to build (but reduces the likelihood of a significant flare-up), it should maintain a near-neutral stance for an extended period. The nominal natural rate (at the end of 2017) was about 1.6% using the Fed's favorite inflation measure of core PCE. Following the Fed's hike in March, the fed funds rate is sitting about neutral with the range of 1.5% to 1.75%. With inflation pricking-up a bit and the economy doing better, the neutral rate should move higher toward the cycle peak slightly shy of 2.5% over the next year or so. At the end of 2018, neutral should be close to 2% to 2.25%. That is only three hikes away. But maybe that is the point the Fed is attempting to make by asserting symmetry. By shifting toward a neutral stance in a couple hikes, it will only slowly raise rates going forward. That is far different from the current expectations of Fed members on the dot plot, but it is very consistent with the market's expectation for hikes to stop at 2.75%. Might the Fed be admitting the market is correct? Italy Italy is likely to have a populist government in power soon. While there is a good chance that the government does not last long (the chance of the coalition falling apart is high), Italy is the Eurozone's third-largest economy, and its political rhetoric will have consequences. Of note, Italian GDP growth on a year-over-year basis appears to have peaked in 2017. The Five Star Movement is populist and Eurosceptic at its core. The populist side of the rubric is likely to drive the deficit higher. A couple of the reasons for increasing the deficit are positives (lowering taxes) but others (such as reversing pension reforms) are not. Of note, there is a 3% fiscal deficit limit for EU members, and the proposals would far exceed those limits. On the Eurosceptic side, proposals have ranged from leaving the European Union to the more current recommendation of running a parallel currency. The Euroscepticism is somewhat difficult to justify given that the European Central Bank (ECB) has bought hundreds of billions in bonds--about 340B euros worth with a current 8-year weighted average maturity For the ECB, the threat of “Italeave” poses a problem. It has a tremendous amount of exposure to Italian debt, and the proposals from the Five Star Movement have pushed yields higher. With the ECB looking to scale back monetary easing, this could throw a wrench into that equation.  In the end, it will be difficult to implement the agenda. It is easy to be a Eurosceptic party. It is not simple to act on those impulses. The ECB has made life easier for Italy during the recovery, and it is unlikely that markets will lend money to a fiscally irresponsible Italy at rates near today's levels. The rhetoric will be loud. But the execution will be difficult (just ask Greece). When Greece made threats about leaving the Eurozone, the ECB took steps to restrict liquidity. The ECB was anything but kind in the process. Italy may want to take heed from a lesson learned in that debacle. Conclusion There are risks, and some (Italy) have become more obvious, but the global economy remains healthy and growing. Italy, flaring trade rhetoric, and an off again on again nuclear summit are all things to watch. At the moment though, there are no existential threats to the global economy. *All graphs sourced from Bloomberg Sam Rines

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Quarterly and Monthly Notes

Monthly Note

May 2018

Monthly Note

April 2018

Quarterly Note

First Quarter,  2018

Monthly Note

February 2018

Yearly Outlook


Monthly Note

November 2017

Quarterly Note

Third Quarter,  2017

Monthly Note

August 2017

Monthly Note

July 2017

Quarterly Note

Second Quarter,  2017

Monthly Note

May 2017

Monthly Note

April 2017

Quarterly Note

First Quarter, 2017

Monthly Note

February 2017

Monthly Note

January 2017

Quarterly Note

Fourth Quarter, 2016

Monthly Note

December 2016

Monthly Note

November 2016

Quarterly Note

Third Quarter, 2016

Monthly Note

August 2016

Monthly Note

July 2016

Quarterly Note

Second Quarter, 2016

Monthly Note

May 2016

News | Press

Avalon Advisors Announces San Antonio Expansion

December 21, 2016

Avalon Advisors Announcement

December 16, 2016

Sam Rines

April 11, 2016

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