Stocks finished higher yesterday led by energy names as Florence threatens the Atlantic coast and two more hurricanes churn in the Atlantic basin. Otherwise, it was a relatively quiet day spent reflecting on the events of 9/11 seventeen years ago.
Next week the Fed is likely to raise interest rates 25 basis points. At the moment, the spread between the 2 and 10 year Treasuries is about 22 basis points. Most observers expect that to narrow next week. The 2-year Treasury yield will rise somewhat in sympathy with the expected increase in the Federal Funds rate but, since we all know it is coming, don’t expect a full 25 basis point rise at one time. Some large part of the impact is already baked in. As for the 10-year, it tracks inflation much more than the trend in short term rates. It saw a bit of a bump upward late last week into this week after the wage component of the August employment report rose more than expected. We will get PPI and CPI data today and tomorrow respectively and they could provide more light on the inflation outlook. To date this year, however, inflation expectations have been anchored within a very narrow range and, except for the wage surprise last Friday, there has been little suggesting an acceleration in inflation. Rising productivity is offsetting wage pressures. While we expect another rate increase from the Fed in December and at least two more next year, those increases aren’t written in stone. If wage increases moderate and no other inflationary pressures arise, the pace of future increases could slow.
Everyone is watching for a rate inversion where the 2-year rate begins to exceed the 10-year rate. In the past, such an occurrence has been an excellent precursor to a recession 12-24 months hence. Note that stocks don’t anticipate events that far ahead. So, even if the yield curve does invest, the bull market could still have 1-2 years to go. And often the best part of a bull market in terms of price gains is the euphoric end. Thus, even if the curve inverts, and be mindful that I said if, such an event is not a signal to sell stocks today or to moderate one’s asset allocation. Moreover, inversion doesn’t define what a future recession might look like. It only means the odds of one occurring are higher. Finally, a flattening yield curve, as opposed to an inverted yield curve is not an indicator of economic troubles ahead. So, let’s not put the cart before the horse.
However, that leads to a basic question. With an economy growing near 4% and with inflation still well contained, how can we even be thinking of a recession in 1-2 years? How could that even happen?
I have noted many times that recessions happen to correct economic imbalances. The Fed, which has a very poor record of predicting economic futures, could either step on the brakes too hard prematurely or it could wait too long, let inflation get out of control, and then be forced to increase rates fast enough to slow the economy. Right now, it is hard to find any imbalances or even any pending imbalances. Growth is solid, the corporate tax cuts are spurring investment, productivity is rising, and inflation seems tame. If there is one concern it could be that the Trump administration is so focused on growth that it actually creates imbalances where none presently exist. Debt levels 2
today, for instance, are at or near record highs. But in a world of low interest rates, debt service levels remain within a comfort zone. One could, however, imagine a world over the next two years where $1+ trillion dollar deficits combine with rising interest rates and balloon debt service costs to a point where stress begins to occur. At the Federal level, annual debt service costs have already risen from just over $250 billion per year to near $450 billion. Depending on the pace the Federal Reserve chooses to reduce the size of its balance sheet and the course of future interest rates, one could easily forecast debt service requirements of $500-750 billion per year in a very short time. That means an increase of as much as $500 billion per year over a span of less than 5 years. Debt service costs can’t be legislated away; they have to be paid for. Ultimately, that will force a reduction in entitlement spending. That is the only pocket large enough to fund that gap.
The problem of expanding debt service isn’t just a Federal government problem. Corporations have been heavy borrowers at low rates. Some borrowed at variable rate. They will be hurt first. Student debt is at record levels. Higher rates would pinch there as well. Finally, unfunded prior service pension costs would take a hit. I should point out that countries around the world would face many of the same issues. Rising debt service costs isn’t just a U.S. concern. The bottom line is that if there is to be a recession in 1-2 years, the culprit is almost certain to be rising interest rates. That suggests it is paramount to the Federal Reserve and the Federal government to be vigilant protecting against inflation. The risks of slowing growth a percentage point or two are not nearly as great as letting inflation (and interest rates) rising too quickly. 4% growth is wonderful but probably not sustainable without igniting serious inflation pressures. The Fed is doing, in my opinion the absolute right thing to get rates up to at least a neutral level fairly rapidly and then be vigilant to keep inflation at bay. Inflation is not going to spike if our economy grows at as sustainable moderate pace. But if fiscal policy focuses on growth without economic balance, it will be making a similar mistake to that of the Bush Administration which focused on home ownership for all Americans regardless of one’s ability to service their debt obligations.
I want to reiterate that, at the moment, the economic environment is as good as it gets. Growth is good, inflation is well contained, and profits are rising. That is a great environment for stocks and I expect the stock market to be higher at year end than it is today. But investors should always be vigilant and so should regulators. The Fed is on the case. Tariffs, our course, bear watching. Perversely, if tariffs slow the rate of growth, they might extend the economic boom longer. I want to watch and make sure that if the Federal government passes an expanded spending authorization for fiscal 2019, it finds a way to pay for increased spending. Future deficits need to be reduced, not expanded. In conclusion, we should watch for warning signs. That means we have to know where to watch. At the moment, I don’t see any but the yield curve obviously commands attention. Stocks at the moment are more attractive than bonds. I wouldn’t change asset allocations. Rather than try and predict problems ahead, I want to monitor future events for any signs of trouble. Until they appear, cautious optimism is problem the best approach.
Today, Jennifer Hudson is 37.
James M. Meyer, CFA 610-260-2220
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