February 9th, 2018
The rapidness and sheer magnitude of the market’s recent reversal might have you feeling a little queasy. This is, after all, understandable following 15 months of steady gains and low volatility. While there may be no shortage of opinions on the underlying factors driving the recent decline, and along with it the typical prognostications for what lies ahead, for investors the only thing that really matters is how these opinions ultimately influence how you react. To that end, we will depart from our typical Friday format this week in order to share with you some perspectives that Probity’s research staff has been providing to investors in response to many of the questions we’ve received over the past week.
Obviously, a lot seems to have changed over the past week. What has caused the sudden reversal in the market?
The proximal trigger, at least if you listen to the mainstream financial media, is that there is a deep and growing concern that rising interest rates, and inflation in particular, are a bigger concern than the market had realized. If true, the natural conclusions are either that higher inflation will erode the value of future earnings, dividends, and interest (i.e. making the current value of assets less valuable) or the Fed will need to raise interest rates faster than expected to cool the economy in order to stave off high inflation (i.e. slowing growth and risking recession). Either way, neither is good for asset valuations.
Do you agree with this view?
Not entirely. We think it’s fair to say inflation concerns may have been the initial catalyst, but volatility begets more volatility and what we are seeing is a shakeout in response to a lot of money having come off the sidelines over the last several months. While we’ve just crossed in to correction territory (-10% decline from highs), it is important to remember that the Dow had risen nearly 7% year to date prior to last week. Despite the very positive economic backdrop, frankly, markets had gotten a little ahead of themselves. Whenever these types of dislocations occur, we think it is important to remember that the market is composed of all sorts of investors, each with different motivations and time frames. While the marginal trade is what sets the market “price,” that price only applies to those traders needing liquidity at that moment. You don’t look at what your neighbor may have just sold their house for and get concerned about the value of your house if you’re going to live in it for the next ten years. The same applies to investment assets. Just because they are priced every second doesn’t mean that is your price. When the Dow closes down -1032 points as it did on Thursday, naturally that feels shocking. One could search for meaning in it, but any underlying interest rate concerns at this point are being overshadowed by sheer momentum.
What is the basis for your views?
The rising interest rate or high inflation argument is just not persuasive right now. Yes, rates are rising. The Fed plans to hike three and maybe four times this year. That is old news. Furthermore, the Treasury market is doing part of the work for the Fed by going ahead and selling off, which effectively raises interest rates. In doing so, this ripples to other bond classes and debt since Treasuries are often the benchmarks for other rates. So, yes, rates are going up. However, rates going up are not a problem if growth and earnings are going up as well, and right now global growth is accelerating. We won’t belabor all the positive metrics. In fact, the bears’ case actually accepts that premise because the newest twist is that growth is so strong that prices and inflation are accelerating more quickly than anticipated. In other words, the concern is either that real interest rates or real growth (the difference between the nominal interest rates and inflation, and the difference between the rate of economic growth) will actually decline relative to expectations because inflation is accelerating faster than economic growth. The ancillary is that the Fed will be more aggressive than anticipated and raise rates to slow the economy, risking a recession. There are precedents for both scenarios — so it can happen. Furthermore, no one ever expects inflation, and by the time it is recognized, it requires more aggressive actions to contain. So, we accept the validity of the argument, just not the underlying indicators and data on which it is based.
The two items that sparked the so-called inflation and interest rate concerns were: 1) a relatively minor change in the Fed’s guidance with respect to inflation and interest rates and 2) the wage growth figures in the most recent jobs report. In the case of the Fed statement, it was the addition of an emphasis word “further” that caught traders’ attention. The actual context for that was,
“The Committee expects that economic conditions will evolve in a manner that will warrant further gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.”
Let’s be clear. Everyone should want normalization for interest rates — that is, everyone except those that are levered to risk. It goes hand and hand with higher growth. Since 2010, this economy has averaged a nominal GDP growth of 3.8% or real growth of 2.2%. Ignoring the financial crisis as an outlier, if you look at average nominal and real GDP growth from 1990 to 2008, those annual average growth rates are 5.2% and 2.8%, respectively. So just using that as a rough target for what the economy is capable of, then you have to accept +0.75% to 1.0% more of inflation to get the 1.25% to 1.5% nominal growth. Interest rates will follow, and to us, the Fed’s statement is just an acknowledgement of that reality while still being very sensitive to the gradualness with which this needs to take place. Apparently, the market felt differently.
The most obvious smoking gun in the bear case right now is the strength seen in the most recent wage number. This is truly one of those situations where good news is interpreted as being bad. Throughout this recovery, everyone has been asking the question, “When will wages begin to rise given the tightness in the labor market?” It seems we have finally found out. January’s report showed an annualized wage growth of 2.9% which was a considerable acceleration from the 2.1% trend we’ve averaged over the last 10 years. To put this in context though, from 2001 (the earliest data available from the Bureau of Labor Statistics) through 2007, wages grew roughly 3%. There was no inflation, and GDP did fine. So while January’s report has markets concerned that we are creeping up on the average at a time when the economy is starting to accelerate and the labor market is at full employment, the reality is that actual wages are still way below where they ought to be historically.
Lastly, the proof is ultimately in the tasting of the pudding, which means you need to look at inflation directly. The last reading we had was in December where CPI rose 2.1%. Stripping out energy and food, the core inflation rate was 1.8%. This is a level that has been holding in the 1.7% to 1.8% range for the previous eight months ending in December. Clearly, January’s CPI numbers that will be released on February 14th are going to be important given what has been going on, but the concerns over inflation are simply a notion at this point.
So if you don’t buy into the fundamental concerns, what are you doing during this downturn?
Our basic premise remains that economic conditions globally remain supportive of earnings, profits, and ultimately equities. We continue to believe rates will rise, but inflation over the intermediate term will be contained. Most importantly, we’d be very surprised to see the Fed unexpectedly change course from their telegraphed path.
To give some relative sense on what we think of the market’s path and potential magnitude, we analyzed historical similarities. When we look back for similar conditions, three periods jump out: 1964-1966, 1988-1990, and 1994-1995. Within each of these periods you had specific concerns related to the particular era, but the core conditions were similar (i.e. positive economic growth, a rising Fed funds rate, and increasing inflationary concerns). In the case of 1964-1966, markets fell about -20% from peak to trough, taking about eight months to bottom and an additional six months to recover. From there the market rose for another 16 months before a mild recession occurred in late 1969, where the market revisited the previous trough. In the case of 1988-1990, markets were generally resilient throughout the rate tightening cycle and GDP remained strong, up to the point that the Fed overtightened and caused a recession in 1990. The recession caused a -15% drop in the market but it recovered in about four months before continuing on a long expansion. Lastly, in 1994-1995 you had about a -8% decline while the Fed was turning aggressive with their hikes. Here again, the market recovered in a relatively short time frame and ran another five years before the dot.com bubble burst (which is another story).
As we stand today, we are about 10% off our highs. If history is any measure, concerns of this nature cause a 10%-20% correction, with the latter end of that range coinciding when recessions actually occur. We’re not there. While the market may be automatically jumping to various conclusions, the basic precursors for the market’s conclusion have yet to materialize (namely the Fed actually becoming more aggressive and/or inflation actually showing up). That is not to say that they won’t but the downside from here would seem manageable. The greater likelihood is that this is either a temporary mindset or complete head fake altogether the way it was in 2016 with the China/global slowdown theory and the recurring European deflation episodes. Incidentally, those episodes were far more concerning because they were actually rooted in deteriorating data. So given all that, we remain focused on putting assets to work for our clients, rather than trying to play defense to phantom concerns and their associated momentum.
Do you have any final insights for investors?
Hopefully, this has helped to frame our position and has provided some perspective. The market is only back to where it was in November of last year, so when we see declines of -10%, you have to look at that relative to where we’ve been. We’re clearly dealing with a more skittish environment, and we’d expect this to take a little longer to shake out. Just remember, though, that losses are only losses if you sell. Longer term this episode will likely prove to be just another footnote.