Will Higher Interest Rates Derail Stocks?

Continued economic growth has led the Federal Reserve to raise the Fed Funds rate to 2.25%.  This is the biggest issue facing asset markets right now even though the rate remains well below levels that led to recessions twice during the last 18 years.  For that reason, I believe the Fed is going to be cautious with moves above 3%.  Remember, one of their stated goals initially was to be able to “normalize” short-term rates.  I believe they will have accomplished that goal when they reach 3%.

Stockcharts.com, Dightman Capital

The 30-Year Treasury bond broke price support with the latest Fed announcement which pushed up interest rates at the long end of the curve.  The silver lining for the current rate environment is a steepening yield curve.  The interest rate spread (the difference between short-term and long-term rates) makes it possible for banks to borrow at low rates and lend at a higher rate.  A strengthening banking sector should benefit the broader economy.

Here is a look at the Treasury market yield curve and 30-Year Treasury Bond price chart.

Stockcharts.com

Real estate price appreciation should also slow as financing costs rise.  There is some evidence in certain markets that price increases have slowed or stalled.  Stocks too, will compete with higher bond yields as rates move higher (more on this below).

In terms of Inflation, globalization has kept most inflation measurements in check (aside from asset prices like real estate and stocks).  Low inflation should provide the cover the Fed needs to slow rate hikes in 2019-20.  On the operational side, companies do benefit from low and stable input costs, which helps drive earnings growth.  An increase in input costs could result in higher prices.

Trade disputes may influence inflation but it could be temporary in many cases.   There remains a lot of capacity in the world so moving production, for example, out of a country is an option for some.  Other products might require special machinery or expertise and those product markets might see higher prices, potentially much higher.  Those individuals in the market for new electronics might want to make a purchase now if higher prices is a concern.  It is possible we could see higher prices in a wide mix of products from trade negotiations; so far the effects have been negligible.  Early 2019 is when we might start to feel the pricing pressure from ongoing trade disputes.

The U.S. Economy remains healthy; October started with a trio of good news.

  • The ADP payrolls report hit 230,000 in September, beating estimates
  • The Purchasing Managers Index for Services in September came in at 53.5, above the 52.9 consensus
  • September’s Institute for Supply Management hit 61.6 for the service sector, ahead of the view at 58

The U.S. Stock Market continues to like the economic environment.  Three months remain in 2018 and if stocks can hold on to the gains they have generated, it will be a decent year.

It is important to remember a diversified portfolio will have a mix of investment returns.  While certain parts of the stock market are delivering nice returns, some categories are under performing.  Many dividend stocks have not had a particularly strong year.  Bond yields are part of the reason.  The relative safety of bonds, combined with their now higher yields, compete with stock dividend yields.  Also, value stocks are not favored in the current environment; both of those factors should eventually become attractive as market character shifts.

Earnings-Growth Expectations for Q3 remain strong.  The view from FactSet  suggest earnings growth between 20-25% for the period.

So no, I don’t believe stocks are going to be derailed by higher interest rates in 2018.  We remain in a very constructive economic environment despite ongoing trade negotiations.  As we start Q4 stocks have pulled back; expect more selling in the days and weeks ahead.  This is a normal and healthy process which should eventually allow stocks to rally as 2018 comes to a close.  Don’t be surprised if this pullback ends up being 5-10% deep.  Primarily due to interest rates and trade talks.  As of the close on October 8th, the S&P 500 was down less than 2%.

The U.S. is Winning the Trade War

If the stock market is any indication, the U.S. is winning the trade war.  It is not just in stock prices.  The South China Morning Post recently published an article on The Bank of China’s move to cut the reserve ratio for lenders; a signal economic policy makers in China are starting to address the global trade challenge with an adjustment to domestic monetary policy.  Interpretation, they need to stimulate domestic economic activity to create more import demand.

Overall markets are holding ground or moving higher which may indicate trade tensions are starting to wane.  The bickering continues but ultimately nobody wants an all-out trade war.  One of the advantages favoring the U.S. is our economic recovery and overall strength; the U.S. is relatively better off than other countries.  If a trade war erupts, everyone suffers.  If we can find a way forward, we all benefit.

Here’s a look at global asset performance year-to-date through the first week of July (Stockcharts.com).

U.S. stocks are the sole winner in terms of global asset classes.

Here’s a look at the performance of specific trading partners (Stockcharts.com).

Here too the U.S. is on top with Mexico and the U.K. also turning in positive numbers.  Interestingly, the U.K. has performed very well over the last year, delivering twice the gains of European Union leader Germany.  It looks like stock investors are feeling a bit different about Brexit compared to the economist, analyst and politicians that have been attempting to undermine the move.  Being nimble and dynamic to maximize the unique advantages used to be rewarded in the global economy.  Not so much anymore but their’s still some hope.

There are risks to the U.S. in pursuing a more favorable trade environment.  China, Russia, EU, Brazil – many countries have established direct trading relationships in the 21st century.  A push for better trade deals for the U.S. could drive more trade between other countries and cut out the U.S. altogether.  It is a difficult to envision a Trans Pacific Partnership deal without the U.S.  Is the Yuan ready to support global trade?

If there was a time to make changes to trade agreements, now is a good.  A reduction in international trade always has the potential to slow an economy down.  Better to do it when other economic factors are improving.  If the U.S. can achieve some improvement in the process, all the better.

Trade Jabs & Big Tech Snafus

2018 has turned out to be a completely different investing environment from 2017. I have been reminded of debt market issues I thought I would not to have to address until 2019-20, beginning with interest rates.

We remain in a low interest rate environment, well below levels we saw before both recessions we experienced earlier this century. Short-term interest rates have started to move higher, primarily as a function of the Fed normalizing interest rates, but the yield curve for maturities between 7-30 years show only a slight increase over short-term rates. Overall, interest rates remain well below levels that have historically marked the start of a recession. We are reminded, however, that interest rates can rise swiftly and for reasons other than Fed policy.

Here’s a look at the current yield curve for U.S. Treasury Bonds which represents the rate of interest for different bond maturities.

April 2018 (Stockchart.com)

The current Treasury yield curve shows short-term rates just over 2% for two-year maturities and just over 3% for a 30-year bond!

Here is what the Treasury yield curve looked like prior to the 2000-2003 recession, where short-term rates were above long-term rates which created what is referred to as an “inverted yield curve”.

August 2000 (Stockcharts.com)

Prior to the Great Recession of 2008-09, the Treasury yield curve was flat and at much higher rates across maturities, compared to today’s levels.

July 2007 (Stockcharts.com)

The question investors should ask is, what besides the Fed could cause interest rates to rise in the current environment?

Ongoing deficits in the U.S. require the federal government to issue new debt to keep the government running. Have you noticed the increase in potential government shutdown warnings? It is not as though the economy stops if a shutdown materializes, but it is a reminder the federal government is chronically broke, which could eventually create a bigger problem.

In addition, existing government debt must be refinanced as it matures. As interest rates rise, the interest expense to the U.S. government increases requiring a larger amount of the federal budget (which may have something to do with why President Trump pushed some infrastructure spending to states and private partnerships). As of 2017, it was estimated that 70% of Treasury debt held by private investors will need to be refinanced in the next five years. (The Fiscal Times, June 7th, 2017, Lawrence Goodman) Much of the current U.S. debt was issued when short-term interest rates were near zero due to quantitative easing (QE). It wasn’t until 2016 they started to creep higher; the biggest move in short-term interest rates has happened in the past 12 months.

There are other potential challenges, recently highlighted by JP Morgan CEO, Jamie Dimon. He reminded investors in his annual letter to shareholders that rates may move higher than expected, as the Fed and other holders (China) move to sell more Treasuries (QE unwind, Trade War Retaliation), at a time when market structure (a reduction in market makers – broker/dealers making a market for specific stocks or bonds due to financial reform and other factors) may not be able to provide the needed liquidity. As asset prices adjust to a not so positive environment (swift moving interest rates), declining stock AND bond prices could lead to a market panic (which may end up being a terrific buying opportunity).

There is risk too in the Trump tax plan.  A reduction in federal government revenues would be a disaster further aggravating our already enormous deficit.  The administration is counting on tax cuts to stimulate economic activity, increase employment and wages, to make up the difference and then sum.

Other aspects of the current environment remain attractive. Throughout the 20th & 21stcenturies the stock market has moved to higher levels after severe market events. We may not see the Dow hit 30,000 before the next bear market (which is a shift from my previous view) but if long-term trends continue we are very likely to see it within the next decade.

The current selling in the stock market has been a typical correction. The combination of interest rates on the rise, big tech snafus (Facebook, Uber, Tesla) on high valuations, trade jabs between President Trump and Prime Minister Xi, it’s not surprising stocks have struggled. There are plenty of positive trends that even if the correction deepens, should help stocks find their footing.

We are about to enter Q1 earnings season which could be a positive diversion. Analyst expect strong sales and earnings growth which could provide the cover needed for current company valuations to push higher, especially if guidance remains strong. A record number of S&P 500 companies are issuing positive earnings per share guidance for Q1 (according to FactSet), on the back of steady and/or improving economic numbers. Combined with a renaissance in technology and consumer services, there are a lot of reasons this market has more upside.

Stock Market Anxious & Vulnerable

This was one of the most fascinating weeks in my career as a portfolio manager. Stocks were under aggressive selling pressure most of the week but ended the session on Friday recovering most of the days’ declines. Especially encouraging was the impressive advance Friday from the tech sector and small caps. Overall trading on Friday was supportive but action for the week is another reminder to investors, we have entered a new phase of increased market volatility.

Here is how the S&P 500 traded on Thursday and Friday.

The biggest issue at hand is not President Trump’s steel and aluminum tariff announcement. Time will tell how the policy unfolds. The biggest challenge has more do to with the new Fed Chair, Jerome Powell, providing both houses of congress his first testimony. Unlike prior Fed chairs, Chair Powell appears less concerned about what Wall Street thinks and more focused on executing his monetary policy. Here is what one of my Wall Street trading contacts had to say about the Donny & Jay Team…

“If you think Donny is going to pull back on this major announcement just because the mkt sells off a bit – think again……Like Jay Powell – Donny will not be led around by the nose when traders on Wall St. throw a hissy fit.” Kenny Polcari, Oneil Securities

The market was already anxious and vulnerable so testimony from Chairman Powell on interest rates, which are headed higher, and import tariff policy by President Trump, is bound to rattle markets. From elevated levels in a prolonged bull market, stocks are vulnerable to steep corrections.

I would suggest the interest rate and inflation dynamic is what is driving markets today. My ongoing research has caused me to change my view of whether an increase in rates from current levels can negatively impact the economy and stock market. I have suggested that interest rates rising from such low levels are not likely to have a negative impact our economy or the stock market until they move past normal levels. Most rate hikes in the past that have slowed the economy have occurred at much higher levels. However, a closer look at three different factors facing most central banks in the world has changed my thinking.

Those factors are:

1- Refinancing costs by treasuries (issuing new debt to retire maturing debt)
2- Treasuries issuing new debt to fund budget deficits
3- Central banks selling bonds from their balance sheets

Collectively these three factors represent a massive impact on the bond market. Central bankers and treasury officials do have options for managing these challenges. The Fed will increase their available tools after a few more hikes in the Fed Funds Rate. The playbook seems pretty clear for 2018, the Fed lifts the Fed Fund Rate to around 2% while the economy strengthens on Trump’s economic policies. 2019 is where it will get interesting and the stock and bond markets are already anticipating the environment 6-9 months in the future.

For reference, here is a quick look at the Prime Lending Rate, Consumer Price Index and the S&P 500 over the last 20 years.

Much of the recovery from 2008 involved bond buying by central banks: Bank of Japan, European Central Bank and the Federal Reserve. The Federal Reserve was the first to start selling bonds from their balance sheet last fall. Keep in mind, the bonds on a central bank balance sheet are in addition to bonds a treasury department may issue to fund government operations. Central bank balance sheet bonds are already issued bonds, treasury bonds are newly issued bonds. As I have communicated many times, the world is swimming in debt from decisions made during the last financial crisis and a consumption driven economy.

Japan has even hinted they may stop purchasing government bonds soon. Once a central banks shift to selling bonds from their balance sheets, while government treasuries continue to issue new bonds to fund operations, the supply of bonds very well may push prices down further and interest rates higher. Some traders are expecting the U.S. Treasury to issue substantially more 30-year bonds around this time next year. Combined with ongoing sales from The Fed (which holds several trillion dollars’ worth), some traders believe bond prices will have to be much lower to get new bonds sold, driving interest rates higher. Higher interest rates mean government debt servicing costs are going to rise which will increase the deficit (which shows no end in sight). As I have said before, I would not be surprised if the next crisis comes once again from the bond market. What policy makers are dealing with now is the other side of Quantitative Easing, the strategy used to address the last financial crisis.

The White House is hoping economic growth accelerates and tax revenues increase to cover costs and reduce the deficit. If the economy grows too fast The Fed will be under pressure to raise short-term interest rates, where most of government debt is financed. This will cause debt servicing costs to shoot up. This is another concern I have mentioned in prior commentary. Debt servicing costs as a percent of the Federal Government expenditures is a risk to the economy. Unfortunately there are not many good options for policy makers.

Markets have pretty much priced in 3-4 increases in the Fed Funds rate for 2018. Now the attention is focused on 2019. It should be clear President Trump and Fed Chair Powell have a very delicate balance to maintain but their style of communicating their policy is decidedly different than previous administrations. They can’t really afford to let markets dictate their moves (many analysis and commentators believe The Fed waited to long to raise rates). They have to take actions based on what they believe will be the best path for navigating the U.S. economy through the current challenges.

The key appears to be maintaining a steadily improving economy of moderate GDP growth around 3%. Here is where Economic Cheerleader Trump may run into problems. The harder he pushes for 4% growth the more trouble he may create in debt markets. The good news here is innovation is alive and well at a time where money is plentiful, financing relatively cheap and government policy is generally favorable.

From a portfolio management perspective, there are clearly better areas of the stock market to be invested in right now and even some undervalued assets to consider bringing into portfolios to reduce risk levels. 2018 appears to be delivering a market where investors may be rewarded for making the right changes to their portfolio. Let me know if you are interested in discussing how I handled the 2008 bear market and how I am addressing the current set of challenges and opportunities.

Stocks Finally Correct, What’s Next?

After an outstanding 15-month stock market advance, last week stocks experienced a significant pullback.  The S&P 500 declined 3.9% but all three major U.S. stock indexes remain in positive territory so far in 2018.  After outstanding performance in 2017, U.S. stocks started 2018 on an even more accelerated run with the Dow Jones Industrial Average gaining 7.6% during January, before last week’s pullback.  The stock market rally needed to slow down.

In terms of earnings, Factset reports as of February 2nd approximately 50% of the companies in the S&P 500 have reported actual results for Q4-2017.  Of those, 75% are reporting actual earnings-per-share above estimates compared to the five-year average.  In terms of sales, 80% are reporting actual sales above estimates; the sales and earnings health of U.S. publicly traded companies appears to be good.

The likelihood of additional interest rate hikes in 2018 may have been the trigger for last week’s stock market correction.  Jerome Powell is the new Fed Chair and futures markets are expecting another 75-basis point increase in Fed Funds in 2018, which would bring the rate to around 2%, still below the historical average.  Investors also saw declines in bond prices last week as the 10-year Treasury yield shot up to 2.92%.

The continued improvement in economic numbers along with the overall optimism and rapid pace of innovation currently underway could suggest we are a long way from interest rates causing a sustained decline in the stock market.

Don’t be surprised if stocks are up big on Monday.  We could see more selling but a lot of cash remains on the sidelines and some investors have been looking for an opportunity to enter this market; one of the reasons stocks have not given much ground since President Trump ushered in a new set of economic policies aimed at broad sustained economic growth.

I have said this before and I will repeat it here.  We could very well see the the Dow at 30,000, the Nasdaq at 10,000 and the S&P 500 at 5,000 before we see the next bear market.  For those that do not understand how this could be, let me remind you; stocks went nowhere for 14 years from 2000 – 2013.  In the four or so years since the S&P finally regained a new all-time high in 2013, the stock market spent 18 months in a trading range between 2015-16, as the U.S. teetered on the verge of falling into a recession.

We have a combination of conditions that are conducive to a continued market rally:

  • Low Interest Rates
  • Positive Economic Policy
  • An Innovation Renaissance

Unlike prior market cycles, this one may not last as long as those previously for a couple reasons.  First, this expansion comes on the heels of a recovery that started 8 years earlier.  Second, a tremendous amount of debt was created in the U.S. and globally as the primary policy for recovering from a debt crisis.  If you are shaking your head, you should be.  Eventually we will pay a price for policy mistakes used to address the 2008 financial crisis.  Until then it is a race between economic growth and debt growth.  The next crisis could very well come from a country needing to restructure their debt.

In terms of interest rates, it appears we have some breathing room.  The 10-year Treasury yield remains well below levels of the last 20+ years.

In terms of short-term rates, if the Fed Funds rate were to rise above 3% the economy should be doing exceedingly well.  However, government debt funding is more sensitive to short-term rates, so policy makers are likely to take funding costs into consideration as they move rates higher.  Fortunately, other broad economic factors appear to be holding inflation in check which should allow The Fed to keep short-term funding rates at or below normal levels.

Until The Fed has turn up interest rates to a point of slowing the economy, the stock market is likely to continue rallying…there are amazing investment opportunities in the next generation of biotechnology, materials, software, and much, much more.  It is truly an exciting time to be an investor which is another reason I believe more money will find its way into the stock market over the coming years.

Please let me know if you are interested in learning more about investment opportunities from innovations in finance, travel, technology and more in a risk-managed, proactive approach.

Stock Index Performance Calculations, Stockcharts.com

Yield data from Stockcharts.com, Investors Business Daily.

The Fallacy of Weak Productivity Growth

Models of the economy are pretty useful tools.  And simple models are some of he most useful.  They help people envision how the world works.  They help organize thinking.

For Example, the model that says the potential U.S. economic growth is determined by “population (labor force) growth” plus “productivity” is an elegant model that shows how adding workers, or having them become more productive, leads to more economic growth.

But, event an elegant model can lead people astray when the inputs are misunderstood.  As they say, [Click To Continue]

Clearing a Path for Tax Reform – Brian Wesbury, First Trust

In the article linked below, Brian Wesbury – Chief Economist at First Trust, explains how U.S. tax policy over the last several decades has move from an environment where cutting taxes makes new spending difficult to a situation where government spending is so high tax cuts are hard to pass.

From a macro perspective, President Trump’s plan seems to do much of what Democrats have asked for by shifting a larger portion of the tax burden on individual high-earners while just about everyone in the bottom 60% gets a tax cut.  This is hardly an ideal supply side tax cut.  Republicans on the other hand, have lost their way.  Even with a majority in the house and senate, republicans have shown little enthusiasm for helping President Trump with his agenda.

This is a unique time in our history where a confluence of events have come together unexpectedly and produced an accelerating economic environment.  I believe tax reform could be another factor potentially leading us to the strongest economy so far in the 21st century.

Wesbury_Clearing a Path for Tax Reform