October 2018 – Market Commentary
In recognition of the strength of the economy Fed Chairman Powell delivered the most hawkish speech of any Central Banker in the last ten years on October 2nd. Speaking before the National Association of Business Economists he described the economy as operating with “limited slack” and that “the Fed would act with authority if inflation expectations shift.” There are many observers who would describe the Fed’s current pace of rate hikes as already acting with authority. One wonders if that is a warning that the Fed is prepared to raise the Fed Funds above the 3.0% to 3.5% neutral range that is the current expectation.
It would appear that equity investors fear that to be the case. October was a dreadful month for stock prices and has been dubbed “Red October” for the viciousness of the selloff. At its nadir, the S&P 500 index touched 2603, more than 11% lower than the 2940 peak reached just a month earlier. That drop masks some of the even larger price corrections in individual stock prices, with Biotech and Financial shares taking more than their share of the punishment. Investors have latched on to a narrative that rising interest rates are going to cause financial services firms to suffer a decline in net income, despite actual results showing otherwise. As we pointed out several months ago, the relative flatness of the U.S. Treasury yield curve is not what drives bank results. It’s their net interest margins and we’ve seen them mostly expand through this earnings season.
Of course none of that matters with the results of the mid-term election and the retaking of the House of Representative by Democrats. With a Democratic House and a Republican Senate, the President is going to face an uphill battle to get anything done. There had been grumblings that if the Republicans had been successful, Trump would continue with Keynesian policies by cutting taxes further and quite possibly revive his desire for an infrastructure plan. Now the Democrats have the votes to block any future plans and gridlock is likely for at least the next two years.
The impact to the market has been mildly favorable, with the Dow Jones Index rallying more than 500 points on the day after the election. Equity investors, it would appear, believe that gridlock is the most favorable outcome. Bond investors seem to have come to the same conclusion, as well. Namely, that the expected rate of growth will not accelerate and, therefore, the Federal Reserve will not be forced to push the lending rate above its equilibrium rate.
Indeed, we agree with the immediate reaction as we view the economy as being on a self-sustaining course and that the expected gridlock will actual be beneficial to that sustainability. It’s important to remember that the U.S. Government is already running a $1 Trillion deficit and there is an enormous amount of stimulus still in the system from years of bond buying. Moreover, with the economy at full employment and the number of unfilled jobs continuing to total more than seven million, we are still at risk of overheating. Especially going in the holiday season. Again, one wonders if the Fed will need to raise their targeted neutral interest rate.
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