With Labor Day weekend upon us, the summer season officially wraps up, children are back in school, and college football (one of my favorite sports) kicks off. I hope everyone had some memorable moments over the summer months and some personal down-time as well.
In San Francisco, I unfortunately couldn’t see the astronomical event of the year – the total solar eclipse. Seeing as locals often refer to the month as “Fogust,” most mornings felt like an eclipse was taking place! Maybe April 2024 will provide me the opportunity to see a total solar eclipse in the northeastern U.S.
On Wall Street, Labor Day demarcates a turning point in the markets. Even though September is often a volatile and down month, institutional money managers begin to shift from the current year and focus on the promise of what next year may hold. If that shift means future growth forecasts are lifted, valuations can be justified, and stock prices can rise.
Last fall’s elections brought the hope for much sought after fiscal stimulus and (still elusive) tax reform. In turn, domestic and foreign stocks, alike, have continued their advances, keeping the 8 ½ year bull run intact.
As I wrote prior to the elections, “Vote at the Polls, Not with Your Investment Portfolio” and shortly thereafter with “Extreme Election, Extreme Market Reactions,” investors’ focus should be on the economy and the fortunes of corporate America rather than reacting to the president’s incongruous tweets.
While the U.S. economy could, and should do better, underlying economic trends continue to be positive and any spikes from a looming federal budget showdown or any other risks sparking near-term volatility should be short-lived.
As the late Marty Zweig, an influential and highly respected Wall Street icon, noted in Winning on Wall Street, “The monetary climate – primarily the trend in interest rates and Federal Reserve policy – is the dominant factor in determining the stock market’s major direction.”
I often stress themes that are most important at any particular time; a perennial favorite is the Federal Reserve’s monetary policy. The Fed exerts enormous sway over the economy because the Fed controls the money supply and short-term interest rates, which in turn influences the price of stocks and bonds.
There is a confluence of events happening in September which is sure to heighten investor anxiety. For the Fed, it is about to embark on an unprecedented winding down of its crisis-era balance sheet, which happens to coincide with the European Central Bank (ECB) readying to scale back on its asset purchases as well. I believe the central banks will proceed cautiously in removing monetary accommodation, especially as fiscal stimulus has been disjointed and hasn’t fully materialized here in the U.S., Europe, Japan or elsewhere.
The Fed, Jobs, Interest Rates, and Slack
That’s a mouthful, but they are all intertwined, and I’ll explain.
Let’s start with the Fed. It is tasked, among other things, with setting monetary policy via its control over short-term rates. One only has to look as far as the meager returns on super-safe fixed income investments such as money market funds and CDs to see the immediate impact of Fed policy. Though such loose monetary policy has hurt savers and risk-adverse investors, the Fed’s super-easy monetary policy has been a boon to stocks – all you need to do is look back to March 2009 and compare where the S&P 500 or the Dow Jones Industrial Average was then, and where those indices are now.
Bonds & Yields
With inflation readings tame and the U.S. 10-year Treasury trading near a 10-month low of 2.13% (August 29th), frustrated investors targeting richer yields have been patiently waiting for rates to rise and are now aggressively going after dividend-paying stocks and funds, which sport higher yields, and hopefully price appreciation to boot. Treasury yields are also signaling that institutional investors are buying into the notion that interest rates are going to stay low for longer than anticipated.
Rallying Cry for Higher Stock Prices Remains
There are two clearly defined camps that see the bull market in starkly different terms.
The first declares that we are not even at the halfway mark for what will be a 20-year bull market because of the structural power of low interest rates. Companies are harnessing the debt markets to fuel record stock repurchases, to strengthen balance sheets, and to finance acquisitions. Adding to that, the stock market is shrinking due to the velocity of mergers, companies going private and the absence of Initial Public Offerings (IPOs).
The number of publicly listed U.S. stocks peaked at a record 7,562 in 1988. By 2015 there were just 3,812 U.S. public companies. (CNN Money, “America’s Stock Market Is Shrinking” – July 9, 2015).
Simply put, there are more companies disappearing than entering the stock market. Granted, there was a massive wave of startup companies that peppered the new issue calendar leading up to the Dot-Com crash. But even since 2002, when most of the damage had been accounted for, the trend continued to show a pronounced move lower for the number of listed companies. Long-view bulls argue that there is just so much money sloshing around (supply) and fewer and fewer stocks to buy (demand).
The second camp claims the bull market for stocks is more than 8 ½ years old now, which makes it the second-longest bull market since the end of World War II. There has been a lot of change over that time, yet the one constant throughout has been the persistence of low interest rates.
Low interest rates, which have been an offshoot of low inflation, low economic growth, and a high level of asset purchases by the Federal Reserve have been at the core of the stock market’s success. The Fed has been the basis for every buy-the-dip effort and they have been the rallying cry for pundits who have suggested there is no better investment alternative than stocks. Low rates have helped rationalize lofty equity valuations and they have fueled corporate earnings expectations.
This second camp sees the market, in its late innings of bullishness, blowing the horn of the eventuality of higher interest rates because the global economy is indeed picking up speed and rising rates are only a matter of when and not if.
Under this scenario, the market would have to, in my view, undergo a reset that would be more of a garden-variety correction and nothing more unless, for some reason, inflation takes off, which is not foreseeable in the near term. Even still, the threat is always out there. Higher interest rates become problematic for stocks on several levels:
• They lower the present value of future cash flows
• They reduce earnings prospects for indebted companies by increasing their interest expense
• They can curtail growth prospects as investment projects get deferred due to higher financing costs
• They create increased competition for stocks by providing other investment alternatives
• They leave investors less inclined to pay up for every dollar of current earnings for slower-growing companies, which creates valuation pressure
When the S&P 500 bottomed on March 6, 2009, the yield on the 10-year note was 2.87% and the S&P 500 traded at 10.0x forward 12-month earnings. Today, the yield on the 10-year note is 2.13% (August 28th) and the S&P 500 trades at ~ 17.4x forward 12-month earnings. This goes to show how low interest rates can drive multiple expansion, yet it also exposes how rising interest rates can lead to multiple contraction.
For now, the inflation genie is still in the bottle. But it does warrant watching how certain inputs like industrial metals are making counter-intuitive moves in a direction that would indicate such commodity costs (outside of benign oil and natural gas prices) are worthy of being monitored closely.
Minutes from the July Federal Reserve Meeting showed an extensive conversation about inflation. While the Fed sees recent inflation weakness as transitory, the minutes indicate it remains the primary concern.
My take: I believe changes in monetary policy will be gradual, well telegraphed, and should not materially disrupt economic growth.
Jobs come into play because the Fed kept the fed funds rate near zero for 7 years (Dec. 2008- Dec. 2015) in order to release the animal spirits in the economy and boost employment growth.
That leads us to a new term being bantered about called “slack.” Fed Chief Janet Yellen is watching it closely, and it’s being debated by a number of economists as it relates to the job market. More importantly, it has a direct bearing on interest rates.
So what is slack? Let’s look at Yellen’s definition. She believes that there are still plenty of able-bodied men and women who can work, want to work, and have the skills to work in today’s job market if the economy can expand fast enough and create the necessary jobs to soak up the excess slack.
That’s where the Fed’s low interest rate policy comes into play. If slack truly exists and low rates can stimulate economic activity by encouraging consumers and businesses to spend, it can fuel faster job growth (and here’s the key) without adding much to inflation. Wage pressure is singularly the most important inflation-factor that the Fed cares about.
Unemployment Level, Labor Force Stats Current Population Survey (Aug. 30, 2017). Source: Bureau of Labor Statistics (BLS), U.S. Dept. of Labor
If the steep drop we’ve seen in the unemployment rate since the recession ended is an accurate reflection that many folks who want jobs have been able to get jobs, low interest rates may not do a whole lot and rising inflation becomes a risk.
Some of the indicators Yellen uses to measure slack include the large number of longer-term unemployed, which suggests there is a ready supply of labor available to satisfy the hiring needs of businesses if growth was to markedly accelerate.
The Fed also looks at wage and salary increases, and here is where it got a little tricky.
In theory, a large supply of labor would likely give employers leverage over current and potential employees. Simply put, it’s the law of supply and demand. If the supply of labor exceeds demand, then businesses don’t have to offer much in the way of wage concessions.
American Business: 1 – American Labor: 0.
But if the available pool of labor is shrinking, then we should see upward pressure on wages and benefits.
American Business: 1 – American Labor: 1.
Job growth has accelerated since the start of the year, with over 200,000 new jobs being created in each of the last six months; that hasn’t happened since 1997.
Included in the labor report is what’s called average hourly earnings; it was unchanged in July and is up a muted 2.0% year-over-year.
You’ll get no argument from most Americans that wage growth has been weak, and the rate is showing no signs of accelerating within Bureau of Labor Statistics (BLS) data. If that’s the case, we still have plenty of slack in the labor force, and the Fed can be patient with its (s)low-rate policy.
Unfortunately, investors clamoring for higher returns on CDs or bank savings won’t be seeing much relief.
On the other hand, a more comprehensive gauge of labor costs released just prior to the July employment data may be suggesting otherwise. The Employment Cost Index (ECI), which takes into account benefits, jumped 0.7% in the 2nd quarter of 2017, its biggest one-quarter rise since 2008.
Now it’s possible that the 2nd quarter’s more robust increase is simply payback from the first quarter’s anemic 0.3% rise in the ECI, but worries about rising employee compensation seemed to be a good excuse to lop 317 points off the Dow on the final day of July.
Why? Because upward pressure on labor costs suggests dwindling slack. If that’s the case, price stability may be threatened, potentially fueling a sooner-and faster-than-expected series of Fed rate hikes. It’s Wall Street’s way of saying good news is bad news.
My take on this: While I’m careful about assigning too much importance to one data point and preferring to look at trends, I would say the evidence suggests businesses aren’t grappling with labor shortages and rising wage pressures yet (being in the Bay Area jades my view to an extent, seeing as Silicon Valley wealth has bucked the trend). With that said, I do see overall wage growth steadily accelerating over the next 2-3 years, assuming the overall economy continues to expand.
So far, Fed Chair Yellen has been in no hurry to boost interest rates. In early July, she noted that that faster-than-forecast job growth could push the Fed into a quicker-than-expected series of rate hikes. However, late July’s Fed meeting produced no indication that monetary officials are considering such a faster path. Given that September has lots in store for us, the Fed will most likely pass on being a political lightning rod and raising rates on September 20th, during their Federal Open Market Committee meeting. That will provide either November 1st or December 13th to once again raise (or normalize) interest rates.
In addition to Fed policy, there are other factors that will come into play in September for market participants to grapple with – heightened domestic and geo-political uncertainty is sure to stoke increasing investor nervousness.
A fractious U.S. Congress needs to agree on a budget for fiscal year 2018 by the end of September (or at least temporarily through continuing resolution – CR) and raise the $20 trillion debt ceiling that limits government borrowing. The debt ceiling is basically political posturing as it’s money that’s already owed, and excludes new monies having yet to be borrowed. I suppose that’s why we have a huge military – to stymie our nation’s creditors from calling in our debts!
The U.S. budget showdown could be contentious, especially seeing there were Republican led government shut-downs in 2013 and 2015, tying it to a repeal of Obama’s Affordable Care Act.
My take: There will be a Band-Aid budget through a C.R. appropriations bill, the debt ceiling will be lifted and the president will have to acquiesce to Republican leaders that funding FEMA and Houston/Hurricane Harvey relief efforts are more important than building a wall along the Mexican border.
Fodder to the media (and late-night talk show hosts) is an increasingly frayed relationship between the president and Congress with little help of bipartisan collaboration, which only increases the potential for unpredictable outcomes such as a temporary government shutdown. While such political obstructionism has sparked volatility in the past, it has had no lasting impact on the markets.
September could offer up many surprises. Surely there will be a near-term uptick in volatility. However, I see it as short-lived and a potential buying opportunity, unless political events materially bruise business and consumer confidence.
On August 30th, U.S. 2nd quarter GDP growth was revised upward to the fastest pace in 2 years on stronger household spending and a bigger gain in business investment, putting the economy on a strong track for sustained economic expansion. This indicates greater momentum going in the 2nd half of 2007 and continues to favor investors willing and able to accept risk taking, I believe. I still prefer stocks (and, a healthy weighting to developed and emerging markets in addition to domestic stocks) over bonds in this current environment.
August was more like March – “In like a lion, out like a lamb.” The sell-out off at the end of July portended a poor showing for August, but at the end of the month U.S. stocks were on a winning streak once again with the U.S. dollar once again strengthening as the American economy found firm footing. This was even as the nation was in turmoil during the month – Charlottesville, North Korea, Hurricane Harvey.
I want to reiterate that neither me nor my fellow advisors have a crystal ball. But then again, no one does. Not even those smooth-talking sales professionals (and I the use the term professionals loosely) who claim they can successfully move you in and out of the market at just the right time (let alone the tax hit for taking drastic moves in taxable investment accounts).
I’m not alone in my thinking. The legendary investor Warren Buffett sums it up this way:
“We’ve long felt that the only value of stock forecasters is to make fortune tellers look good. Even now, … I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children.”
Whoever said Mr. Buffett doesn’t have a sense of humor, especially as he just turned 87 on August 30th?!
Unforeseen events can and do influence asset prices, and my goal is to manage risk by allocating the funds my clients have entrusted to me. As the famous economist and Nobel Prize winner Harry Markowitz once stated, “diversification is the only free lunch in finance.”
Simply put, I diversify and seek out quality.
Think of driving a car – we will sometimes run into unanticipated bumps in the road and there will be other times when a traffic jam will unexpectedly delay one’s financial journey. If you are driving from San Francisco to New York, how important is that ½ hour traffic delay you had on the Bay Bridge?
A market sell-off every once in a while is part of investing. If in September the markets turn down, it won’t be the first time we’ve experienced a decline and it won’t be the last. But the investment plan I recommend to investors incorporates these slowdowns as part of the trip.
Investors need to know where they started but more importantly they need to know that they’ll end their journey safely, and hopefully enjoying the ride along the way. We drive by looking ahead through the windshield not through the rearview mirror.
Again, following Buffett’s philosophy, “I try to buy stock in businesses that are so wonderful that an idiot can run them because sooner or later, one will.”
It’s not that quality isn’t affected by any day-to-day volatility; it is, but it’s something I don’t get too concerned about, and I hope you won’t either.
If you’ve read this far, I congratulate you. You should earn some continuing education credit! In all seriousness, I hope you’ve found my macro-thematic view of the Federal Reserve’s impact on the markets and my commentary to be both educational and helpful. If you have any questions or would like to discuss any matters, please reach out to me; happy to take your call or email.
As always, I’m honored and humbled to those that have given me the opportunity to serve as their personal financial advisor.
I hope you enjoy your upcoming Labor Day weekend and take a moment to reflect on the contributions that American workers have made to the strength, prosperity, laws, and well-being of our country. And the work that has yet to be done, especially along the Gulf Coast to recover from Hurricane Harvey’s impact. My thoughts and prayers go out to those affected by the storm.
Eric J. Linser, CFA