By 11am yesterday, the Dow had dropped almost 1600 points in about 1 ½ trading sessions. Then it rallied into the close reducing yesterday’s losses to less than 80 points. The NASDAQ Composite actually closed higher.
What causes such volatility? The question itself denotes uncertainty. It is also important to note that while the volatility causes a lot of angst, the moves have been largely directionless with stocks still within a trading range since Labor Day. Today’s labor report isn’t going to be very helpful for those trying to decipher whether the U.S. economy is weakening and, if so, by how much. Non-farm employment growth of 155,000 was modestly below expectations but not by enough to matter. Construction labor growth was subdued, probably weather related. The unemployment rate remained at 3.7% and wage growth year-over-year was 3.1% as predicted. Given that productivity growth remains above 1%, the real impact of higher wages won’t move the overall inflation number far from the Federal Reserve’s 2% target. The net of all this is that the expectation that the Fed will raise rates on December 19 in less than two weeks with rise from the 70-80% range it has been in. The economy is clearly strong enough to sustain one more rate increase.
However, based on recent statements from Fed officials, including Chairman Jerome Powell, subsequent increases will be data dependent. Bond markets, which have risen sharply over the past week, have pretty much priced out any further rate increases. The stock market, judging from recent weakness, still frets that more than one increase is coming next year. I believe the general consensus within the Fed is that one or more may be necessary next year but that judgment can be deferred at least until March. By then the impact of 4 increases in 2018 will have begun to work their way through the economy.
The overall big fear of the moment and the greatest cause of uncertainty I alluded to above, is whether we are simply set to grow at a slower pace or whether we are beginning the process of going from robust growth to recession. There are certainly early indicators of a slowing economy. The stock and bond markets themselves are leading indicators. Housing starts have started to decline. Auto sales have plateaued. Commodity prices are weakening, particularly oil. That may help that part of the economy that consumes oil and other commodities but it will reduce investment spending among independent oil companies if prices fall any further below $50 WTI and stay there for any length of time. There is a big OPEC meeting set to conclude this morning. At the moment, it appears OPEC plus Russia have agreed to production cuts of close to 1.3 mm barrels per day. Add in an announced Canadian cutback of close to 300,000 barrels per day and one can see how inventories of crude, now close to 40 mm barrels worldwide, will begin to come down. That should stabilize crude prices. Add the OPEC announcement to a benign labor report this morning and perhaps some near term calm can be restored to markets.
Finally, one can add in a tweet from President Trump this morning that said trade talks with China are going well. I suspect that is code to say the asset of Huawei’s CFO last week isn’t stopping negotiations. Whatever the President might say in a one-line tweet to try and calm markets, trade negotiations with China are going to take a very long time and any comment this morning, while psychologically helpful to markets, has no real meaning.
Getting back to the market’s uncertainty, times of transition always bring with them an enlarged list of worries. Before addressing some of them, let me reiterate one point emphatically. Economic growth cycles don’t die of old age. They die when imbalances occur. Too much debt, overuse of toxic derivatives, and sloppy banking practices led to a financial crisis that caused the Great Recession of 2007-2009. Excessive exuberance surrounding Internet stocks caused a stock market bubble in 2000. Ditto 1987. Double digit inflation forced the Fed to step on the brakes hard in 1980 causing back-to-back recessions.
One can argue that at the start of 2018, markets were a bit overly enthusiastic. Corporate profits were about to rise by more than 20% courtesy of a huge corporate tax cut. Stocks reached 18-19x estimated 2018 earnings, about 20% above historic norms. You can do the math; in 2018 20% growth in earnings has been offset by a repricing of assets back toward historic norms. We can look at this in another way. Stocks, bonds, and other financial assets became overpriced as central banks flooded markets with excess liquidity and priced credit below the rate of inflation. As a result, asset prices became artificially inflated. As rates have moved toward normal and the Fed gradually reduces the size of its balance sheet, asset prices also move toward normal.
I can’t say the process is over, but it should be close. Whether a December rate hike, virtually certain after today’s labor report barring an unexpected collapse in financial markets over the next ten days, more Fed officials believe we will be close to a neutral interest rate. Note that if no further increase happens in 2019, the Fed will still be tightening via the planned reduction of its balance sheet by $600 billion. If I had to guess right now, and it would only be a guess, I would expect 0-2 further rate increases next year. Zero would be operative if the rate of economic slowdown intensifies. Two could happen if growth remains about 2.5% and wage increases accelerate from the current pace.
Gradually, the uncertainties are unwinding. Oil markets should find some price stability in the $45-60 range. The Fed will almost certainly take a more dovish tone at its next meeting. World economies are slowing and the pace of deceleration is an obvious concern. But unlike 2007 when ticking time bombs, like the collapse and bankruptcies of sub-prime mortgage lenders were taking place and the use of CMOs and related derivatives were exploding, I don’t see anything similar this time around.
Rather, I believe we have been in a rolling bear market where over half of the S&P 500 is now 20% or more below recent highs. The declines started in the second half of 2017 when retail stocks collapsed. Auto and housing stocks started to fall early this year as interest rates started to rise. Banks quickly followed. Industrials fell as tariff fears rose. Oil stocks collapsed this fall as oil prices tanked. One can argue whether or not the process is complete (we never seem to know exactly until after the fact). But barring a recession, most of the damage appears to have been done and most stocks are now at or below historically normal P/E ratios. Perhaps the last shoe to drop is a resetting of 2019 profit expectations to account for slightly lower growth expectations and very strong currency headwinds in the first half of 2019.
Thus, my conclusion is that we are well along in the process of resetting expectations to (1) normalized interest rates and central bank policy, and (2) more modest growth ahead. All this week and last week, investors were fixated on the possibility or even the likelihood of an inverted yield curve. While it has been flattening for several months, the 2-10-year Treasury or, more important, the 3 month-to-10-year Treasury spread do not appear ready to invert. Moreover, while credit spreads have widened a bit, there have not blown out the way one would expect if a recession was pending. While I don’t rule out a recession, I think the odds are far greater that we are simply transitioning to a period of slower growth. The transition requires some adjustments and the markets have been making them since February. I believe we are much closer to the end than the beginning. If there is “bad” news, I think it is that markets have gone from overvalued to fairly valued. If 2700-2800 in the S&P 500 is an expected normal value, we effectively are at the bottom end of that range right now. That limits both the upside and downside. I still see a market struggling for a couple more months before resuming an upward path in line with historic growth, i.e. rising 5-10% per year including dividends. All this presupposes no major escalation of a tariff trade war with either China or Europe.
Today, Terrell Owens is 44. Larry Bird turns 61.
James M. Meyer, CFA 610-260-2220
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