Tighter monetary policy is affecting the economy and markets, and the stimulus from last year’s tax cuts is fading. Yet the Fed is determined to continue tightening money, explains Bob Carlson, editor of Retirement Watch.
Economic growth has slowed from its robust rate of the second quarter, and there are clear decelerations in housing and vehicle sales.
Growth in manufacturing also is slowing as businesses reduce their investments in new capital and equipment. Exports also were lower in the latest Gross National Product (GDP) report, thanks to a combination of tariffs and slower growth outside the United States.
Investment markets also show classic signs of tighter money and the late stage of the business cycle. Bond prices are lower, and the dollar is rising, working toward its high of late 2016. Higher volatility is another sign of the late stage of the cycle.
Commodities are falling, especially oil. Oil prices now are more than 20% below their recent highs and show no signs of approaching the elevated 2014 prices. With the decline that began in late September, U.S. stocks joined the global equity downturn that included all but a few markets.
Unlike the February 2018 correction, worrisome indicators of market momentum and investor sentiment accompanied the October tumble. These indicators include moving averages, advance-decline lines, the percentage of stocks participating in rallies, investor surveys and more.
Going forward, investors should be concerned about earnings growth. A foundation of the bull market has been increasing earnings faster than GDP. Now, rapid earnings growth is at risk. Wages are rising. Tariffs are increasing the costs of commodities and other inputs, while making it more difficult to sell overseas.
Higher interest rates raise business costs. Productivity remains low, so businesses can’t offset higher costs by operating more efficiently. Also, financial engineering, such as stock buybacks and dividend increases, supported stock prices. Buybacks declined through 2018 but surged in early November. We’ll have to see if the surge in financial engineering continues or if November was a last gasp.
China has a range of economic issues to navigate, and problems in China are felt in the rest of the world. Problems include high debt, over-investment in real estate and a transition to a domestic- oriented instead of an export-oriented economy.
Its lingering trade conflicts with the United States adversely affected China’s currency and foreign exchange reserves. China’s growth has slowed, and its central bank already is stimulating its economy.
There are three likely scenarios for Fed policy, the markets and the economy in the next year or two. Since 2009, whenever the economy and markets faded, the Fed stepped in to reverse the declines. That’s less likely this time.
Fed officials made clear they believe the economy is self-sustaining and they aren’t concerned about stock prices. It would take a sustained downturn for the Fed to reverse policy.
Another possibility is the Fed realizes tighter policy already is affecting the economy and markets. Then, it would stand pat for a while to see how much of recent growth is sustainable at the higher interest rates. If the Fed stands pat, the likely result would be a sustained period of slower, but solid growth.
The third possibility is the biggest risk. The Fed might continue to raise interest rates as long as the labor market is strong. That could lead to a recession that the Fed would have difficulty reversing.
Like the growth stage and bull market, this late stage of the cycle could last a long time if the Fed doesn’t tighten too much. While most investors worry about the next crash, investors also should be prepared for a long period when both economic growth and stock price increases are flat or sluggish.
