Over the past two sessions, stocks have given back most of Tuesday’s rally and I wouldn’t be surprised if they probed the recent lows before today’s session ends. The catalysts for the decline was a very weak overnight market in China after talks between that nation and the U.S. relative to trade and tariffs broke off once again. There is no reason for President Trump to give any ground before the mid-term elections and it is unlikely China will concede on the important issue of intellectual property rights before then. Logically, when Presidents Trump and Xi are in Buenos Aires for the G-20 meeting in late November they can get together and probe whether there is room to find some common ground that could deescalate the trade war. One day, when there is optimism that a breakthrough might be forthcoming, stocks rally. Today, after news that talks broke off, they fall back. Given the current state of heightened angst, volatility is high feeding the computer program trades that accentuate moves in either direction.
During this period of heightened volatility, it is easy for market pundits to aim criticism at the Federal Reserve. Of course, the President has weighed in with his own characteristic bombastic tweeting to add to the criticism. While it is unlike that the President will force the Fed’s hand, the FOMC members will watch all input factors. Market reaction is one of them. But volatile 4% moves in either direction is not the sort of input that will move the needle speeding up or slowing down the pace of rate increases. Chairman Jerome Powell has indicated that he expects one more increase this year, almost certainly in December, and probably three more next year before the Fed either stops, slows down, or reverses course.
Those are current expectations. Even the December increase isn’t carved into stone. The Fed will always be responsive to data. Right now, demand is strong, unemployment is low and GDP growth is a healthy 3%+. Those numbers virtually insure an increase in December. As for early next year, if the numbers stay reasonably close to what they are today, there will be at least one more increase before spring.
There are lots of ways to interpret data but the only conclusion about an interest rate increase is that it raises borrowing costs and deters some level of borrowing. It is a headwind to economic growth. That doesn’t mean growth has to slow, however. If other forces, like expansionary fiscal policy, less regulation, etc. are strong enough, then small gradual rate increase won’t matter all that much. We have had four rate increases over the past 12 months and growth has accelerated, for instance. In the real world, there isn’t a pure linear relationship between interest rate changes and economic growth. As I noted Wednesday, unwinding QE of the size implemented by the Fed and other central banks isn’t going to be easy and probably won’t be painless. The Fed’s job isn’t made any easier by expansionary fiscal policy that will add roughly $100 billion to the deficit this year and more next year. Congress is very good at spending, handing out the goodies. It isn’t very good about creating ways (e.g. raising taxes) to pay for them. Republicans wanted everyone to believe that the surge in growth associated with last year’s corporate tax cuts would result in a massive expansion in revenues that would pay for the tax cuts. So far, which revenues are up, they have risen insufficiently to allow the deficit to decline. Instead, it seems to be going in the wrong direction fast.
Back to the market. The recent correction and rise in volatility has all of us looking for something or someone to blame. Since the President never accepts any blame, the Fed is a convenient target. But the Fed didn’t pass a spending bill that boosted expenses without commensurate offsets of higher revenues. The Fed didn’t enact open ended entitlement programs. No, the Fed simply has to act as the counterweight and protect against runaway inflation. Of course, we don’t have runaway inflation and, perhaps, we never will. But, given that it takes 6-12 months for interest rate increases to work their way through the economy, the Fed cannot simply be backwards looking. It must make its best guess and move accordingly. Wednesday, I offered three possible alternatives;
- The Fed could overshoot, cool the economy too much and have to reverse course.
- It could be too slow to move, find inflation accelerate and be force to raise interest rates even faster
- It could hit the bulls eye and get it right.
I will leave it to others to set the odds but hitting the bulls eye is hard and the odds of being perfect are low. At the same time, the odds of being reasonably close are good and that will allow the economy to continue expanding and the bull market to continue.
The stock market has been issuing caution flags. Among this year’s worst performing groups have been banks, housing stocks and auto companies. These are all early cycle companies. But markets are also famously wrong predicting many more recessions than actually occur. Rising mortgage rates do impact affordability. But the majority of potential buyers can still afford to buy a home. I see no reason for a housing collapse. I do see a period when price increases pause, or even reverse a bit, and buyers then resume purchases. Markets like New York or Southern California went from hot to cold. After a period of rebalancing, growth can resume. It won’t take a 2008-style crash to do that. We aren’t talking about a market of excess speculation and massive flipping (buying homes when then go up for sale and selling them for a profit at closing). It’s just an old fashioned mid-course correction.
We can’t let the market dictate. We have to think for ourselves. There are clearly disruptive influences including higher interest rates and tariffs. But there are major positives as well. Millennials have jobs and are having babies. If you don’t watch CNBC and don’t fester about politics, life today is good.
In the end, that is what matters. This correction will run its course. After earnings season, corporations will resume stock repurchases and be active buyers. By the end of next week, about half of corporate America will be buying once again. I give this correction another week to flush itself out. It could be a nasty week or it could have ended last night. Emotions are tougher to predict than rational behavior. Build your buy list. Take advantage of major brakes. And stay calm and disciplined. Heck, it even stopped raining!
Today, Evander Hollyfield is 56. John Lithgow is 73. One of the great character actors of all time, Michael Gambon is 78.
James M. Meyer, CFA 610-260-2220
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