The last ten years of fair-weather markets have spoiled us a bit, but storms do come, and they can be ferocious. Just as Hurricane Michael came out of nowhere, so did a stock-selling spree that shaved more than 5% from the S&P 500. We are once again reminded that stock markets do not move in straight lines, and that emotions often get the better of investors.
The US economy is strong. Corporate earnings have grown more than 20% for the past two quarters and are on pace to do the same for the third quarter of this year. Unemployment at 3.7% is as low as it was when we put a man on the moon – 1969.
Cuts in taxes and regulations, along with a growing willingness to take greater business risks following the worst recession the US has faced since the Great Depression, have all aligned to pull the US economy out of a stagnant 2% growth rate in gross domestic product or GDP to 3% and higher. By the way, that’s a 50% increase not a 1% increase or roughly an extra $700 Billion.
Many economists believe that 3% growth in GDP is near capacity for the US economy. They say that labor, capital, and raw materials become constrained, driving up their costs, and to the extent these costs are passed along to consumers, potentially causes inflation.
The Fed’s target for inflation in the US is 2%. For a lot of reasons our economy depends upon stable, yet slowly rising prices. It’s the Federal Reserve’s job to maintain price stability, but it’s not an exact science.
If inflation falls too much below their 2% target, they fear that prices could begin spiraling downward as they did during the Great Depression. Price deflation or price declines are to be avoided at all costs in our economy because we are a debtor nation. We borrow money to buy houses and cars and to build dams, airports, and factories. But as prices on goods and services sold fall, so do taxes to governments and incomes to individuals. As incomes fall, our ability to pay debts diminishes. Debts consume an ever-increasing share of budgets, so we buy less goods and services, and the vicious cycle of depression worsens.
Along similar lines, when economies grow faster than the economy’s ability to meet the needs of that growth in labor, capital and raw materials, price increases can spiral upward, which also slows consumer spending potentially resulting in recession.
Economists have argued that US inflation is closely tied to wage price pressures. With unemployment at 3.7%, a level we have not seen in nearly 50 years, inflation hawks are concerned that this trend, combined with rising fuel and food prices could spark a breakout in inflation. But as pointed out in a WSJ piece this morning, “Widespread fears of inflation are at odds with actual inflation behavior. In September, consumer prices rose by less than economists expected for the fourth straight month. Excluding food and energy, they’re up at a 1.8% annual rate in the last three months, the Labor Department reported Thursday.”
This market rout was driven by fears that the Federal Reserve could over-react by driving interest rates too high, thereby choking the economy’s growth. It’s investors’ out-sized growth expectations for earnings that has driven the stock market ever higher, and these expectations continue to be backed by proof. But throw the weight of higher borrowing costs onto a long-running bull market’s confidence, and you get what we got Wednesday and Thursday.
We have known for years that interest rates would need to be returned to normal levels to ensure price stability. The near decade-long stagnant economic growth of 2% following the Great Recession made it difficult for the Fed to rates sufficiently without smothering the relatively weak growth.
The Fed now faces the quandary of raising rates too quickly to hold inflation in check, but not so fast to cause the kinds of over-reactions we just experienced. As reported in today’s Wall Street Journal, Fed Chair Jerome Powell said last week “interest rates are far below historic definitions of normal. The Fed’s short-term target, at 2% to 2.25%, remains ‘a long way from neutral,’ a level that sustains growth without fueling inflation.”
There are no easy answers to the questions you might have regarding market direction or volatility other than to say, our model portfolios are designed with exactly these considerations in mind. When stocks are performing well, our low-cost, ultra-diversified stock holdings capture as much of the markets’ moves as possible to create wealth needed for our clients’ plans.
When stocks misbehave, our Treasury component typically bounces in value to offset declines in stocks. Even though the Federal Reserve is targeting Treasurys in their effort to increase interest rates (driving their prices down) our 7-10 Year Treasury (IEF) was up nearly 0.5% yesterday. For example, our Beacon 45 (45% stocks) experienced only a 2% loss Wednesday and Thursday, compared to the stock market’s 5% loss. Sufficient wealth-generation with less volatility means greater client and plan confidence.
Please call us if you would like to review your portfolio and plan in light of Hurricane Florence or Michael, or the stock market’s recent volatility.