January 2018 – Monthly Commentary
The Federal Reserve, in managing the U.S. economy, is tasked with the dual mandate of ensuring full employment and stable inflation. The mandate is somewhat contradictory in that at full employment the tight labor force is likely to force wages higher which, in turn, risks pushing the overall level of inflation higher. That is, of course, if the numbers accurately reflect the actual rate of inflation, which we regularly argue is not the case. By focusing on an underreported rate of inflation the Fed has fallen dramatically behind in adjusting interest rates and now finds itself facing an overheating economy. Evidence is abundant in fourth quarter earnings reports, with strong revenue growth, rising cost of goods sold, and rising labor costs. In short, business is good but the cost of doing business is rising and output is at risk of being constrained by a shortage of goods and labor.
Prior to the most recent expansion, conventional wisdom held that the economy was operating at full capacity when the unemployment rate reached the theoretical level at which a further decline would cause a rise in inflation. The measure known as the Non-Accelerating Rate of Unemployment or NAIRU, was a completely subjective measure, but was considered to exist at approximately 5.2%. Economists would debate the precise level of NAIRU while bond traders sold bonds when unemployment approached the feared 5.2%. It was understood that the Federal Reserve would raise rates in advance of achieving full employment, so as to not let the inflation “genie” out of the bottle. Of course, that was thirty years ago and the inflation nightmare of the 1970’s was still fresh in the minds of most Americans. Fast forward to the current situation and the concept of NAIRU has all but disappeared. So much so that as we start the New Year and financial firms put forth their 2018 economic forecasts, some have called for the unemployment rate to fall below 3%. Applying the logic of NAIRU, if 5.2% unemployment is a sign of a strong economy, isn’t 3% a sign of an overheating economy? Despite that, the Fed continues to keep interest rates low, and notwithstanding the recent market volatility, the appetite for stocks remains strong. Indeed, the S&P 500 generated a positive return in every month last year; the first time that’s ever happened. Moreover, with the recently passed tax reform, corporations are likely to repatriate the vast sums of cash that they hold overseas. The hope of the President is that they’ll use those sums to fund research, development and expansion. The worry, instead, is that they will use the repatriated cash to buy back shares of their stock. We suspect that corporations will do a little bit of both. With every sector of the economy running at peak performance and the tax cuts putting more money in the pockets of consumers and corporations, and the stock buyback machine continuing to operate at full speed ahead, what could go wrong?
Investors have contemplated that question in the last several trading sessions and the answer seems to be concern that the Fed will finally begin to move more aggressively in raising rates. To be sure, the risk always exists that a mild selloff could develop into something more significant creating a material pull back in stock prices, greater than the 9% drawdown we’ve seen this month. But that’s seems unlikely to happen for two reasons. First, the Fed is not going to suddenly become hawkish. Despite the economy running at full capacity, there are some members of the FOMC that are still arguing against normalizing interest rates. Secondly, since 2009 the Pavlovian response to any market weakness has been to “buy the dip.” That goes for individual investors and corporate buybacks. But that’s not to say that stocks are cheap. We’d argue otherwise and that the selling is justified by the valuation. But anecdotally, the first quarter has started on a healthy note and there’s a very strong likelihood that first quarter earnings will surprise to the upside which is likely to embolden the bulls.
Then where is the risk? If the Fed is supportive of stock prices and there is a seemingly insatiable demand from investors, what could hurt the market? The answer is the hidden in plain sight, and it’s the climbing debt load. Every year during his eight years in office President Obama ran an enormous budget deficit. It became an issue for about a political “minute” when the now-defunct “Tea Party” Congressmen tried to fight it, but it’s since decidedly become a non-issue. So much so that the $1.5 trillion price tag for the Trump tax cut was merely a minor issue in negotiations. Currently the value of outstanding U.S. government debt stands at $20 trillion, that’s more than double the size of the debt when Obama took office. And with some forecasting $1 trillion annual deficits in the coming years, the bond market could be headed toward a point of saturation. The biggest question of all will be how the Fed will respond if the saturation point comes at the same time that inflation becomes a problem. The bigger question is how close are we to that point?