Stocks staged a modest recovery on Friday and futures only show a small decline this morning signaling that maybe the worst of the decline in now behind us. But it will probably take another day or two for markets to regain any sort of equilibrium if, indeed, the major part of the correction is over. Earnings season gets going in earnest this week. Expectations are high for good third quarter results, but, as always, managements forward looking comments will count more than the earnings themselves. We all know that, because of the tax cuts, there is one more quarter of 20%+ earnings growth to come. But it is the 2019 outlook that now becomes paramount. Any clarity in that regard will be market moving.
But before discussing earnings and the economic outlook, I think we need to examine what happened last week in the context of the Federal Reserve Fed Funds rate increases that began in December 2015. That increase was the first since the great recession. It was only 25 basis points but it was a start. It signaled to markets that the Fed finally felt the economy had recovered enough since the Great Recession to begin to accept the beginning of a movement toward normalization. The Fed moved very slowly at the start. There was only one rate increase in 2015 and the next one didn’t come until the end of 2016. But as the economy healed, the pace of the increases started to increase. We witnessed three in 2017 and appear on a path to four this year. Four may seem like a lot but in past economic cycles the Fed more often than not raised rates at every FOMC meeting or 8 times a year. In some instances, the increases were 50 basis points or half a percentage point at one meeting.
Next, we must recognize that all financial markets are intertwined. Investors at all times have the option of holding cash, investing in fixed income instruments or buying stocks. And that only takes into consideration the liquid asset classes. I could add in real estate, art and gold among others. When one class is repriced to be relatively cheap, money will flow to it. As rates rise, the attraction of cash and bonds could increase. Of course, rising rates is a double-edged sword to bonds. On one hand, the higher coupons mean more interest income. But, on the other hand, existing bond prices fall as rates increase. Thus, as short term rates rise, while cash returns rise, longer dated bonds might have negative returns as the decline in bond prices more than offset higher coupon rates. In either case, however, higher rates, all other factors being equal, make stocks less attractive.
The other point to note is that higher rates serve to slow economic growth with a lag effect. It takes time for a series of rate increases to impact the overall economy. As I noted before, changes in interest rates may not be the only factor weighing on the economy. In 2018, the cut in the U.S. corporate tax and a more expansionary fiscal policy were certainly offsetting tailwinds to headwinds created by rising rates. As a result, growth in the U.S. accelerated. However, growth elsewhere didn’t benefit as much. Worldwide synchronous growth that seemed to be setting up in 2017 started to be less synchronous in 2018. Europe wobbled a bit, some nations around the world ran into country specific problems, like Argentina, Turkey, Brazil and Russia, while China began to feel the impact of a budding trade war with the United States.
In February 2018, U.S. stock markets fell 10% in just six trading sessions following the three FOMC rate increases in 2017 and a 45 basis point rather sudden increase in longer term rates in January. As long rates started to flatten in February and March, stocks regained their footing and resume their advance. But in September, the long rates rose another 40 basis points or so setting the table for a second correction witnessed last week.
That correction was simply related to changes in interest rates. The 10-year Treasury yield today is about 10 basis points below recent peaks and, therefore, the correction in stock prices might be near an end. However, one shouldn’t assume that 3.25% 10-year Treasury yields are a new ceiling. Two pressures are destined, at least in my opinion to move them higher. First, are slowly rising inflationary pressures led by rising wages, tighter capacity utilization and tariffs. Second, the support from central banks around the world stepping forward and persistently buying bonds on the open market is coming to an end. The obvious conclusion, therefore, is that rates are going to go higher providing a persistent headwind to stock prices.
Let me stop there and make one point perfectly clear. I am not predicting an imminent bear market. Rising rates will slow the rate of increase but as long as world economies grow and earnings continue to rise, stocks should do OK. OK means that they should do better than bonds. Obviously, the pace of increased earnings versus the pace of rising interest rates will govern whether stocks make modest gains in the coming year(s) or not. What I can conclude, with some conviction, is that the pace of stock price gains in a period of rising interest rates will be slower than the pace of gains when central banks are actively in the market pushing rates lower.
There are some who will argue that the grand QE experiment of massive central bank intervention will be prove in the end to be a massive failure and stock markets are destined to decline as central banks withdraw and start selling assets off their balance sheets. I disagree strongly with that conclusion. First, even if stocks stop going up for a relatively short period of time, that is a very small price to pay for saving our financial system and allowing for almost a decade of sustained growth. Second, nothing requires central banks to start selling assets they hold. Just by letting bonds mature, they can get the job done in a rather non-disruptive manner.
Thus, last week, as in February, the market correction makes perfect sense. It is and was a response to a short term pop in long term rates. It was a simple repricing of assets. Stocks so far in 2018, after last week’s correction are now flat to up slightly for the year. Earnings are up more than interest rates suggesting the market’s price-earnings ratio has fallen this year as it should with rising rates and slowly rising inflation expectations. Next year, I would expect more of the same. Moreover, I expect the pattern of gradual increases in stock prices followed by short and sharp corrections to be repeated. In a market that, in the short term, can see spikes in volatility with trading dominated by a relatively few quantitative trading firms, when all the major players are selling simultaneously, markets behave as they did last week. For that reason, investors have to stay disciplined. If stocks rise slowly but steadily to levels that appear not only fully valued but even a bit overvalued, some profit taking may be in order to protect gains. For longer term investors, less may be more. A characteristic of these sharp sell offs is that the subsequent recoveries are almost as sharp for most stocks.
With that said, I expect the pattern of slow increases and brief but sudden contra contractions to continue until the Fed has reached the point where further rate increases are no longer necessary. True bear markets, however, don’t start as long as the economy continues to grow. Unless you believe that Fed policy is going to create a recession in 2019-2020, then the worst assumption is that markets stay relatively flat until the Fed slows its pace of rate increases. That could happen as soon as the end of 2019.
There are three bull market killers to watch out for.
- The economy stops growing
- Inflation begins to accelerate meaningfully forcing the Fed to be more aggressive about raising rates
- Stocks become significantly overvalued as investors get euphoric as they did near the end of many bull market cycles.
At the moment, I see no signs that any of the three are relevant and, therefore, my base assumption is that the bull market remains in tact with periodic valuation adjustments necessitated by rising interest rates.
Today, Sarah Ferguson is 59. Penny Marshall turns 75.
James M. Meyer, CFA 610-260-2220
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