Taxes Update, August 23, 2017

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What a difference a few days can make. By Thursday’s close, the S&P 500 was at a one-month low, and the prospects for any tax cuts or foreign profit repatriation tax holiday were dim.

Now, thanks to one Politico article, happy days are here  again, as the S&P 500 surged on the idea that the leaders in Washington are actually making progress on tax cuts! Hopefully, you can sense my sarcasm.

The lack of liquidity and attendance in the market is making these tax-related market mood swings worse than they otherwise should be, so I wanted to step back and provide a clear, unemotional update on the tax cut situation.

Starting with Tuesday’s Politico article, there were two reasons it was positive: The “Big Six,” and 22% to 25%. Starting with the latter, you know from this Report that right now, the market is expecting a corporate tax cut in Q1 2018 down to 28%. If that happens, it likely isn’t a materially positive or negative catalyst.

However, the Politico article implied consensus was coalescing around a corporate rate between 22% and 25%, obviously less than 28%. If that happens, it will represent a positive catalyst and a boost to corporate earnings, which will send stocks higher.

Now, on to the former. The “Big Six” is apparently the nickname that a key group of Republican leaders have given themselves in regards to tax negotiations. For clarity, the “Big Six” are: Treasury Secretary Mnuchin, National Economic Council Director Cohn, Senate Majority Leader McConnell, Speaker of the House Ryan, House Ways and Means Committee Chair Brady, and Senate Finance Committee Chair Hatch.

The Politico article implied the “Big Six” have been working much closer than previously thought, and that they have made a lot more progress on the structure of tax cuts (although plenty of details remain).

Bottom Line
The noise on this topic is officially deafening, but I want to cut through it and give you some hard takeaways on the outlook for tax cuts and the impact on the market.

1. Expect more tax-related volatility. If January through August is any guide, we can expect the ever-growing Washington soap opera to fully engulf the tax cut issue this fall. Like healthcare, there are multiple moving pieces, a lot of important, TV happy players (I’m not even including Trump), and a lot of pressure—as this is basically the Republicans’ last chance to get any legislative priorities accomplished before focus on the midterms starts in 2018.

2. The outlook for tax cuts wasn’t as bad as it seemed last Thursday, and it’s not as good as it seems right
now. The Politico article was positive, but it didn’t contain anything ground breaking. To boot, it appears that substantially controversial issues are being discussed in the tax cut package, including: Capping mortgage interest deductions, eliminating the deduction of state and local taxes against federal, corporate interest deductibility and other issues. These and foundational pieces of the current tax code, and removing them won’t be easy.

3. The sector winners from potential tax cuts remain the same as they’ve been all year: Super-cap tech (on foreign profit repatriation), healthcare (on foreign profit repatriation), retailers (they pay high corporate taxes) and oil and gas (high tax rates). FDN/QQQ, XLV/IBB/IHF, RTH and XLE/XOP are all ETFs that
should outperform if taxes surprise to the upside.

4. A prediction: Tax cuts happen in Q1 2018. I’m in the business of generating conclusions and opinions, so I’ll give one about this tax issue. I’d give it about a 65% chance that tax cuts/foreign repatriation holiday gets done by Q1 2018, and about a 50/50 chance those tax cuts positively surprise (i.e. the corporate rate drops below 28%). I do not expect any changes to personal taxes. The reason for this opinion, as I’ve said several times before, is self-preservation. Congressional Republicans are on the ballot in 2018, President Trump is not. If they fail to accomplish anything (no healthcare repeal, no tax cuts) and this Washington soap opera continues, then it’ll be Congressional Republicans who are out of a job. So, they have to get something done if they want to save their jobs. There’s no better predicator of action in Washington than the rule of self-preservation.

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Commodities Update, August 22, 2017

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Commodities were mostly higher yesterday as gold continued to benefit from risk-off money flows and a weaker dollar, which also propped up copper futures. Meanwhile, crude oil bucked the trend and gave back most of Friday’s rally. The benchmark commodity index ETF, DBC, fell 1.21% thanks to he declines in energy futures.

Yesterday’s pullback in oil was a textbook retracement of Friday’s very “squeezy” rally. Shorts that were run out of the market late last week repositioned yesterday morning, which influenced the heavy trading that was largely dictated by technicals. WTI futures fell 2.22% on the day.

Friday’s big rally essentially created a “gap” in the market as the bulk of the move occurred in less than an hour, and on very light volume. That set things up for a reversal, and because newswires were very quiet yesterday, algos and technical traders took control of the market and largely “filled the gap” as we ended the day near where Friday’s rally began.

As far as the longer-term trend in oil goes, yesterday’s session was rather insignificant. The market remains in a broad, sideways range with the $50 mark continuing to act as a stubborn resistance level.

Fundamentally, the OPEC/NOPEC meeting in Vienna was anticlimactic. The previous extraordinary meeting was a non-event as well, and the market is beginning to shrug off OPEC-related headlines more and more as the cartel has been largely ineffective in recent months.

The oil market remain bearish for now, as US production continues to grind higher and OPEC has so far failed at trying to offer material support to the market through their policy decisions. Looking ahead, the $50 mark in WTI is a very important technical and psychological resistance level that will not likely be violated in the absence of a legitimate bullish catalyst.

Natural gas rallied 2.42% yesterday as the market continues to show signs of life in the late summer. There was no real catalyst for the move yesterday, but nat gas is continuing to show signs of putting a bottom in and forming support in
the $2.80-$2.90 area.

Looking ahead, the bulls have their sights set on reclaiming the $3.00 mark, and a close above would be a bullish development on the charts. That would match the supply side fundamentals showing a potential long-term shift of supply levels turning lower.

In the metals, the weaker dollar was the primary influence on the market yesterday, as gold rallied 0.39% and copper rallied 1.36%. Gold continued to catch a bid from the cautious feel in the market after last week’s sharp pullback in stocks, but futures failed to close at a new high and above the $1300 mark despite rallying through the important resistance level briefly in Friday trade.

For now, we remain cautious on gold as the technical outlook is rather cloudy. If, however, bond yields break- down further (more on that in the currencies and bonds section) then gold will surely have the support to break out through $1300 and begin a new uptrend.

Copper continued to grind higher yesterday with futures hitting the highest level since late 2014. With the price action in gold and the bond market both flashing a warning sign for risk assets, copper continues to flash a positive signal for the global economy.

Looking ahead, the path of least resistance is still higher for copper, which is a positive for the global economic outlook and risk assets. Yet, the biggest thing to watch with regard to the rally is the dollar, as a reversal back higher in the buck could significantly damage the uptrend in all metals.

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Weekly Market Cheat Sheet, August 21, 2017

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Last Week in Review

There were some puts and takes from the economic data last week, but in aggregate it didn’t change the outlook for the US economy (still slow but steady growth) or the Fed (balance sheet reduction in September, a rate hike in December dependent on inflation).

I say puts and takes, because there were some decent economic reports last week, starting with a strong Retail Sales report. July retail sales beat estimates on both the headline (up 0.6% vs. 0.3%) and in the more important “Control Group” (retail sales ex-autos, gas and building materials), which rose 0.6% vs. (E) 0.4%, and saw a positive revision to June data.

That was a legitimate uptick in activity and an economic positive, although it remains to be seen whether that strength in consumer spending can be sustained past back-to-school and summer-vacation season.

The other highlights from last week were the August manufacturing surveys. August Empire Manufacturing surged to 25.2 vs. (E) 9.8 while Philly Fed Manufacturing also beat estimates at 18.9 vs. (E) 17.0. To boot, New Orders were strong in both reports (20.6 for Empire and 20.4 in Philly).

According to that type of data, we should see a big uptick in manufacturing activity in August, although I’ll again caution that these are surveys. And, unfortunately, with the exception of retail sales, the other “hard” economic data didn’t match these very strong survey results.

Specifically, July Industrial Production missed estimates, rising 0.2% vs. (E) 0.3%. But, more disconcertingly, the manufacturing subcomponent dropped -0.1% vs. (E) 0.2%. A lot of that decline was auto related, so it’s not quite as bad as it appears.

But, the overarching takeaway from last week’s data is that a wide gap remains between still-strong survey results (the PMIs) and actual, hard data (industrial production). We need that hard data to get consistently better if we have any hope of a rising economic tide carrying stocks higher for the rest of the year.

Turning to the Fed, the July meeting minutes were released last week, and while the market traded as though the minutes were slightly “dovish,” the reality is that they were neither hawkish nor dovish. The minutes confirmed that the Fed will reduce the balance sheet in September, although a rate hike in December seems very much 50/50.

Bottom line, it wasn’t a bad week for economic data, but we need evidence of economic acceleration to help push stocks higher, and that continues to be elusive.

This Week’s Preview

In aggregate, this is a quiet week for economic data (next week is the important week, as we get final global PMIs and the August jobs report), but there are still some potentially market-moving events to watch.

First, the Jackson Hole Policy Conference (i.e. conference/summer vacation) starts Thursday and runsthrough the weekend. The big names will be there: Draghi, Yellen, Carney, Fischer… but don’t expect anything that will move markets. It’s been made clear that Draghi doesn’t want to drop any hints about tapering until the ECB meeting in September (basically three weeks away). With the Fed, we know what to expect…balance sheet reduction in September.

Looking past central bankers, the key economic report this week will be the global flash PMIs, out Thursday morning. Again, we’re looking for the national PMI to match the strength we saw in Empire and Philly last week. If it does, that will be taken as an anecdotal positive. Internationally, there shouldn’t be any big surprises in this number.

Beyond the flash PMIs, July Durable Goods (Friday) is an important report, because it will give us greater insight into the state of “hard” economic data. If Durable Goods shows an uptick in corporate spending/investment, that might put upward pressure on expected Q3 GDP, which would be equity positive.

Bottom line, this week’s economic events should give more insight into the pace of the economy, but barring any big surprises, it’s likely the calm before the “storm” of next week.

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Why Taxes Caused Yesterday’s Selloff, August 18, 2017

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If there was one “reason” for the sell-off yesterday, it was taxes—specifically, the dying dream of tax cuts and a profit repatriation holiday.

That’s why the Cohn headline spooked stocks. It’s not that markets particularly love Gary Cohn. Instead, he’s important because he’s viewed as a key figure in pushing tax cuts through in early 2018, an expectation that market has held on to (until, perhaps, yesterday).

If Cohn resigns, then the prospects for tax cuts (and almost more importantly, the foreign profit repatriation holiday) dim… significantly.

The declining expectations for tax cuts and profit repatriation hit tech especially hard yesterday and it combined with the underwhelming CSCO/NTAP earnings to push that sector sharply lower—and falling tech dragged the whole market down yesterday afternoon.

Now, going forward, clearly there’s been some damage done on the charts (the S&P 500 closed at a one-month low), and momentum indicators are showing warning signs.

And, those warning signs are appearing at a particularly dangerous time for markets (in the short term) as late August is particularly favorable for “air pockets” to form in the markets given that a lot of desks are minimally staffed due to summer vacation. Point being, I don’t think we’re done with the uptick in volatility yet—again due mostly to the calendar.

However, Nasdaq, SOXX and FDN all remain above last week’s lows. So, while Thursday’s trading was clearly painful, I’m not ready to get materially more defensive just yet (although clearly we’re watching those indicators very, very closely going forward).

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FOMC Meeting Takeaways, August 17, 2017

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The FOMC minutes resulted in a “dovish” reaction in currencies and bonds, but in reality they didn’t reveal anything new.

Takeaway
The two big takeaways from Wednesday’s FOMC were 1) The Fed is united in reducing the balance sheet in September (which will be the start of the removal of additional accommodation) and 2) The Fed is divided on whether to hike rates in December because of low inflation. Neither of those takeaways should be surprising to anyone who has been paying attention.

The former (that the Fed is committed to reducing its balance sheet) was reaffirmed by the minutes yesterday, and while the market seems to be ignoring this event, I do want to remind everyone that the Fed will be reducing its Treasury holdings for the first time in a decade. That will, over time, have a “tightening” effect on the economy (although admittedly not at first).

The latter was where the market generated it’s “dovish” interpretation of the Fed minutes, but in reality the fact that “some” Fed members want to not hike rates again this year shouldn’t be a surprise. Bullard, Kashkari, Mester and others have voiced caution about further rate hikes in the past few weeks due to low inflation.

Conversely, Dudley, Williams and others have stressed very low unemployment and still-loosening financial conditions as reasons to continue with gradual rate increases. Otherwise, they risk getting behind a sudden upshot in inflation that forces them to raise rates very quickly.

Point being, we know there is this divide, and it will be resolved in the coming months based on inflation data. If inflation data bottoms and heads higher, they’ll hike rates in December. If it doesn’t, they probably won’t. That’s no different than it was Wednesday at noon.

From a market standpoint, the reaction was “dovish” as the dollar and bond yields dropped, and stocks rallied modestly. But, yesterday’s FOMC minutes should not be enough to elicit a material rally in stocks, nor should it be enough to push the dollar or bond yields to recent 2017 lows.

About the only notable takeaway from the minutes is that it’s likely anecdotally bullish for the “Stagnation” portfolio…(withheld for subscribers only—unlock specifics and ETFs by signing up for a free two-week trial).

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Brick and Mortar Retail Update, August 16, 2017

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From a single-stock standpoint, retail was again a quasi-disaster thanks to earnings (the strong retail sales number is more positive for credit card companies like V, LC and AXP than it is the retailers). Now, you would think at some point this year expectations for retailer results would get so low and the outlook so pessimistic that we’d start to get post-earnings rallies in retail on “not-as-bad-as-feared” results. Unfortunately, that’s just not happening.

Of the 10 biggest decliners in the S&P 500 Tuesday, six were retailers: Advance Auto Parts (AAP) (down more than 20%!), Coach (COH), Urban Outfitters (URBN), Bed Bath & Beyond (BBBY), Ulta (ULTA) and Foot Locker (FL). Even Home Depot (HD), which posted strong numbers and raised guidance, couldn’t overcome the negativity. After an initial rally, HD fell 2.65%.

The contrarian in me is all over retail, as I’ve seldom seen a sector where there’s more pervasive negativity. However, I also remind myself that whale oil was once a contrarian opportunity… and we saw how that turned out.

I’m being a bit silly, as brick-and-mortar retailers aren’t whale oil, but the point is that these names simply aren’t cheap enough, and the outlooks aren’t negative enough—which is a scary thought from an industry standpoint. The contrarian in me will continue to watch the space, but for now, I see nothing to do.

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Weekly Market Cheat Sheet, August 14, 2017

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Last Week in Review

There was more underwhelming economic data last week, especially on the inflation front, as the prospects for an economic reflation in 2017 continued to dim.

From a Fed standpoint, the disappointing CPI and PPI reports further reduce the chances of a rate hike in December, although importantly the Fed is still expected to begin to reduce its balance sheet in September.

Starting with the headline numbers, CPI and PPI, they were both disappointing. The Producer Price Index declined to -0.1% vs. (E) 0.1% while the core figure was flat vs. (E) 0.2%. Meanwhile, the CPI report was slightly less underwhelming at 0.1% vs. 0.2% on the headline, and the same for the core.

While these aren’t horrible numbers, they aren’t good either, and the bottom line is that statistical inflation
remains stubbornly low, and it is appearing to continue to lose momentum. Again, for context, that’s a problem because in this environment, with (supposedly) strong economic growth and low unemployment, inflation should not be going down. Period. And the longer it goes on, the more it sparks worries that eventual deflation or disinflation will rise, and that’s not good for an economy with still-slow growth and extended asset markets.

Bottom line, even before the uptick in North Korea jitters this was a market in need of a positive catalyst to spur further gains. Unfortunately, the economic data (ex-jobs and sentiment surveys) has been consistently underwhelming, so the chances of a rising tide driven by an economic reflation continue to dim. And while a “dovish” number may be good for a mild pop in the S&P 500, soft data and a lower dollar/bond yields aren’t going to drive the market to material new highs.

This Week’s Preview

This week is busy, with mostly anecdotal data that will give us a better overall picture of the economy and inflation—and the main risk to stocks now is that the data comes in light, and along with low inflation that spurs fears of an economic loss of momentum. If that happens, stocks will take out last week’s lows.

The most important report this week will be tomorrow’s Retail Sales report. Consumer spending has been lackluster for most of 2017, but around now we see a typical seasonal uptick. That will be welcomed by markets if that appears again this year. If the number is soft, it’s going to spur worries about the pace of economic growth (remember, hard economic data hasn’t been great all year, it’s been the PMI surveys that have been strong).

Beyond retail sales, we also get a first look at August economic data via the Empire and Philly manufacturing indices. Both numbers haven’t been highly correlated to the national PMIs lately, but it’s still our most-recent economic data and it could move markets, especially if we see any weakening in the data. Empire comes tomorrow and Philly comes Thursday.

Turning to central banks, we get the Fed minutes from the July meeting on Wednesday, and the ECB minutes from the July meeting on Thursday. The Fed minutes are important because we will be looking for clues as to how eager or committed the Fed is to September balance sheet reduction. With the ECB, the key will be seeing how committed or eager the ECB is to announce tapering of QE in September. As is usually the case, there shouldn’t be any big surprises in these minutes, but they could slightly shift expectations for those two events (balance sheet reduction/announcement of tapering), and as such also move Treasury yields and Bund yields.

Finally, July Industrial Production and Housing Starts also come this week (Thursday and Wednesday,
respectively). Again, these are an opportunity for the hard data to rise and meet strong soft data surveys, and in doing so reassure investors that the economy’s accelerating.

Bottom line, none of the numbers this week are “major,” but in aggregate they will give us a lot more insight into the pace of economic growth and the outlook for the Fed and ECB. And, this market needs some economic reassurance to help bolster sentiment after last week. Better data and steady Fed/ECB are a needed boost markets this week.

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Why Yesterday’s Decline Wasn’t Just About North Korea, August 11, 2017

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Why yesterday's decline wasn't just about North Korea

Thursday was another risk-off day in the currency and bond markets thanks to North Korea, but there were some underwhelming economic reports that shouldn’t be missed, either. The Dollar Index fell 0.09% and never strayed too far from unchanged, in part due to the looming CPI report out this morning.

Starting with the obvious, North Korean angst again kept a lid on most currencies and pushed the yen higher, in classic risk-off trade (although importantly, the moves were mild and currencies and bonds did not confirm the angst in stocks).

However, beyond North Korea there was important economic data that did also impact currencies, and again I maintain that unless we get a big deterioration in the North Korea situation the data remains more important for the remainder than the geopolitical landscape.

First, US PPI was soft, declining for the first time in months and again reinforcing the idea of slowing inflation. Now, PPI isn’t as important to the Fed or markets as CPI, but the bottom line is that if we are in (or approaching) an economic reflation, we shouldn’t see these types of underwhelming inflation reports.

That soft PPI weighed slightly on the dollar and bond yields, although again it was largely overshadowed from a market standpoint by North Korea and today’s CPI.

Looking internationally, the euro was flat all day vs. the dollar amidst little news, while the pound dipped 0.26%. The reason for the pound weakness wasn’t just risk off in the markets. It also was due to an underwhelming Industrial Production report. While the headline number beat estimates (0.5% vs. (E) 0.2%), the manufacturing sub-component was flat vs. (E) 0.2%. That was why the pound dipped back below 1.30 vs. the dollar.

The big gainer vs. the dollar yesterday was, again, the yen, which rallied 0.55% on a standard risk-off move. Economic data in Japan yesterday was, at best, mixed, but the yen isn’t trading off data right now… it’s trading off sentiment. And, the North Korea news is causing a flight to safety, and that means higher yen, higher Treasuries and, for now, higher gold.

Turning to bonds, Treasuries rallied as the 10 year rose 0.11% and the 10-year yield fell below support at 2.22%, although that drop happened into the close.

Bottom line, this flare up in North Korea has put the 10-year yield at a critical technical crossroads. If CPI is light this morning, the 10-year yield will likely drop below 2.20%. At that point, a test of the 2017 lows certainly isn’t out of the question. And, we’d find that disconcerting for multiple reasons, chief of which because it would imply too low inflation and largely destroy the chances for a reflationary rally in stocks in 2017.

We maintain that an economic reflation (higher growth, higher inflation, higher rates) is the only path to a sustainable medium- and long-term rally. While it may cause more of a decline short term, the medium- and longer-term investor in us is hoping for a strong CPI report later today. Unfortunately, I have a sneaking suspicion I will be disappointed. I hope I’m wrong.

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North Korea Update, August 10, 2017

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Stocks are down again this morning on this topic, and the reason is because North Korea said it will shoot a missile within “30 or 40” miles of Guam in mid-August. That would be another escalation because it would extend the range of the North Korean missiles—and at that point the US might actually shoot one down. Undoubtedly some of you are getting calls from nervous clients about North Korea, and while I don’t view this as a major market issue, I do want to briefly cover the situation so you can handle any client calls.

Ignoring the rhetoric and bluster on both sides for a moment, two important things happened with regards to North Korea this week.

First, in what was a major positive, the UN passed very harsh sanctions on North Korea with a unanimous vote. That unanimous vote part is key, because both China and Russia supported the sanctions, implying the international community is finally on the same page regarding North Korea’s nuclear program.

Second, in what was a negative that resulted in the recent escalation of tensions, North Korea has apparently learned how to miniaturize a nuclear warhead and place it on an intercontinental ballistic missile. If true, that means they could theoretically strike Japan with a nuclear missile.

Those two events, one positive, one negative, are why this situation has escalated so quickly.

Going forward, despite the escalation in rhetoric, the net events of the past weeks need to be viewed as a positive. If China and Russia stay on board, then the chances of resolution (peaceful resolution) go up significantly. So while things seem bad now, in reality, the chances of a lasting solution have gone up since this time last week.

However, if you have clients who are worried about this and want to hedge up a bit, basically the “North Korea Defensive Playbook” would be as follows: 1) Buy Treasuries (belly and longer dated, so IEF or TLT), 2) Buy defense stocks (TRN, LLL, LMT, NOC ) and 3) Buy the yen via FXY and sell Japanese stocks (i.e. DXJ or EWJ). Now, to be clear, I don’t think you should do this now, but this is the playbook if any clients are asking what to do in case of a conflict.

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Why the Phillips Curve Matters to You, August 8, 2017

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Pushing unemployment lower should, eventually, cause inflation—unless this entire theory (upon which most of monetary policy is based) is incorrect.

Pushing unemployment lower should, eventually, cause inflation—unless this entire theory (upon which most of monetary policy is based) is incorrect.

The Phillips curve is a term you’re likely seeing and hearing more recently than at any time previously in your career (regardless of how long it is). The reason the Phillips curve is being discussed so much is simple: There’s a growing school of thought that thinks the Phillips curve is broken, and if that’s the case, then the Fed and other central banks may be largely powerless to spur inflation (which is a potential negative for the broad markets).

Before we get into this issue, though, first lets get a bit of background on the Phillips curve. Basically, the Phillips curve is just a graph of this simple idea: Low unemployment creates higher inflation.

From a commonsense standpoint, it is logical. Less available workers and robust business activity (so low supply and high demand for workers) will cause salaries (the “price” of a worker) to rise, and that in turn will flow through to the entire economy and spur price inflation.

So, put simply, the Phillips curve says low unemployment will spur inflation. And, this idea has been the cornerstone of Fed policy for decades and largely explains the Fed’s strategy post financial crisis.

Plunging unemployment: At some point, this must create inflation, or at least that’s what Yellen believes.

Plunging unemployment: At some point, this must create inflation, or at least that’s what Yellen believes.

But, there’s a small problem: It doesn’t appear to be working in today’s economy, as historically low unemployment is failing to spur inflation.

Now, this may seem like a theoretical, academic conversation, but it has real, near-term market consequences.

For instance, the entire mid-July rally in stocks came because the Fed began to note low inflation more than low unemployment.

That caused the decline in Treasury yields and exacerbated the drop in the dollar—and that helped spur a rally in stocks.

However, that may have changed with Friday’s jobs report. The unemployment rate hit 4.3%, matching a fresh low for this expansion (i.e. since the financial crisis). And, unemployment that low will get the Fed’s attention (at least Yellen’s attention) because while there is a debate about the Phillips curve still being accurate, the bottom line is that the Fed still follows it. At some point, if unemployment continues to drop, the Fed will have to continue with rate increases regardless of what’s happening with inflation.

And, that could have an important impact on returns and performance.

Here’s why: If unemployment grinds towards 4% or below, the Fed will have to get hawkish or either 1) Abandon decades of monetary policy that has largely worked, or 2) Risk a significant rise in inflation down the road (according to the Phillips curve) that would require a sharp, painful increase in interest rates—a move that almost certainly would put the US economy into recession.

The practical investment takeaways are this: (withheld for subscribers of the 7sReport—sign up for your free two-week trial to unlock).