Markets are pricing in at least one more rate hike before the end of 2019.
Normally, the Fed cuts rates to stimulate the economy. That is a likely outcome of a rate cut in July. But it isn’t normal behavior for the Fed to try and stimulate an economy growing at 2% or better in the 11th year of economic growth. The Fed’s primary mandate is to maintain a stable pricing environment. Many times the Fed has said that means a 2% inflation target. Inflation has persistently been below 2% since the recovery began. Over the past several months, the yield curve has started to invert. Today, the Fed Funds rate of approximately 2.35% is significantly higher that yields for bonds and notes issued by Treasury with maturities out past 10 years. Moreover, the Fed continues to pay banks 2.35% on its excess reserves deposited at Federal Reserve Banks. The incentive, therefore, today is for banks to earn 2.35% on deposits risk-free rather than lend the money out to any but its highest quality and largest customers. The result is that monetary velocity, the rate at which money flows through the banking system, has reversed course and begun to head back down toward record low rates, hardly what the Fed want to see.
Lowering interest rates may stimulate animal spirits and increase loan demand. The Fed could further accelerate demand if it cut the rates banks receive for excess reserves faster than the pace of any future rate cuts. If the challenge is to get banks to lend, paying them excessively to park money at a Federal Reserve bank would produce contrary results.
With all that said, reducing interest rates isn’t risk-free. One reason the Fed and other central banks around the world are being forced into easier monetary policies is that governments are doing their fair share via fiscal policy. The U.S. is more expansive that most. In Europe, Germany is the 800-pound economic gorilla and the Germans have been reticent spending since its currency collapsed after World War I. While fiscal prudence is an admirable trait, it could be counterproductive to the task of stimulating both growth and inflation. Central banks can reduce the cost of money but central banks can’t force spending directly. Obviously, if you reduce the rate to borrow, especially if you lower it below the real cost of money, there will be increasing loan demand. But the amount of debt, both sovereign and corporate, is at record levels and expanding at a healthy clip. Advocates of all this borrowing suggest there is no problem if interest rates are low enough and attendant debt service costs are manageable. That’s true, but only as long as interest rates stay low. If they rise (and undoubtedly some day they will), the damage to the economy will be felt quickly.
Indeed, one can argue that the slowdown from 3%+ growth in mid-late 2018 to levels below 2% today in the U.S. and Europe may related directly to the four rate increases the Fed made last year. With so much borrowing tied to variable rates, relatively modest changes may have an outsized impact economic activity.
Think about this. A very modest 50 basis point increase in Fed Funds rates, which briefly pushed the 10-year Treasury yield up to 3.25% crushed the U.S. housing market, stopped auto sales in their tracks and rather quickly reduced real growth by a full percentage point or more. Of course, monetary policy wasn’t the only factor. The pace of fiscal expansion has slowed in recent months and President Trump’s tariff policies have negatively impacted growth rates as well.
I don’t want to sound overly negative. There are many positive attributes of low interest rates for equity investors. Lower rates mean the P/E ratio for stocks can move higher. Indeed, the impact of the yield for 10-year Treasuries going from 3.25% to around 2.00% has had more to do with rising stock prices that any change in the earnings outlook. But for stocks to continue their run past old record highs, rates have to continue to move lower or earnings growth must accelerate. There are good reasons to believe earnings growth in the second half of 2019 will improve. The dollar today is very close in value compared to a bread basket of foreign currencies to what it was a year ago. Currency translation, therefore, should be a much smaller headwind for multi-nationals than it was in the first quarter of 2019 and it could even become a slight tailwind later in the year. The U.S. consumer remains confident. Layoffs are few and far between. While manufacturing has weakened, it should recover if the pace of final sales continues strong. There are prospects of some sort of pause in the trade war between the U.S. and China. For now, the threat of tariffs against Mexico and Europe remain but there are no imminent tariffs scheduled to be implemented.
Along Wall Street, we often talk of risk-off and risk-on. When times are gloomy, investors become risk averse. With stocks back at record highs, this market is clearly risk-on. Nowhere are those animal spirits more evident than in the new issue market where stocks are now selling for 10-50 times revenues (yes, I said revenues, not earnings). A significant number of newly public companies have no earnings and no imminent prospects of making any money. You can look back at history. When this happens, it doesn’t continue forever. No one, including myself, can tell you whether we are in the 7th, 8th, or 9th inning of this saga. Leaving the party too soon may leave a lot of opportunity on the table. But leading too late can be very painful, not for every stock but certainly for those stocks that are in the hottest demand.
I think we should remember last January and September. In January 2018, stocks soared to new record highs only to face a 10% correction in just a few trading days in early-mid February. Twice within a week the Dow lost over 1,000 points. After recovering to record levels around Labor Day, equities went into another swoon that lasted to Christmas eve. This time the decline was about 20%. The good news is that in both cases, thanks to a strong economy and favorable interest rates, recovery was reasonably quick, both times within roughly 7 months. Indeed, one can look at the market today and say it is up 15%+ year-to-date or that it is roughly unchanged from levels at the end of January 2018.
So, what are the conclusions we should reach?
- One may be able to argue that given current low interest rates stocks are fairly valued but clearly they aren’t cheap based on historic P/E ratios.
- The new issue market is heating up and that will draw in lots of speculators. With rates so low, a lot of that speculative money will be borrowed money. The next $50 move in any of these hot names could just as likely be up or down. But real justifiable prices are generally well below today’s prices. If you want to play in the IPO market, caveat emptor.
- Markets are pricing in a rate cut by the Fed in July and at least one more this year. They are pricing in some sort of tariff truce with China and Mexico. It is assuming only limited military engagement in the Middle East. I would suggest all these assumptions carry more than trivial risk.
- Managing investments is all about matching risks to reward opportunities. You want to buy a stock when the 20%+ upside compares favorably to the 10% downside. Stocks don’t move in a straight line. Today the market is celebrating new highs, waiting for a rate cut in July and hopeful that the tariff war with China is winding down. It assumes government appropriations for fiscal 2019 will be enacted smoothly and the debt ceiling will be raised without commotion. It has few current concerns. Complacency is creeping in. We know market mood swings can change overnight and when everyone decides to sell, there are few stabilizers. Stocks fall rapidly. I am not predicting a correction today, tomorrow, next week or next month. But I have seen this happen too many times over the past 18 months to get too euphoric. I am not a seller in long term portfolios but I am certainly not inclined to chase this market either. Earnings season is just around the corner. That could be a catalyst for the next move…in either direction.
Today, Prince William is 37.
James M. Meyer, CFA 610-260-2220
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