When Fed Tightening Meets Equity Overvaluation
That equity markets have been relatively price volatile thus far in 2018 may be an understatement. By early February the S&P 500 had made more 1% daily price swings than all of 2017, and has made 27 total so far in 2018 (versus 8 in 2017). Some intra-day price swings in the Dow have been in the magnitude of 1,000 points plus.
We wrote, on several occasions over the last few years that when the Federal Reserve began to “normalize” interest rate markets, and slow or stop their quantitative-easing (QE; attempting to revive an economy by lowering interest rates) effort, it would have an adverse effect on equity markets. As lower rates allowed equity valuations to get well ahead of themselves during QE, the opposite would be true as those rates rose. But to be sure, we also wrote the Fed would not do so until they were satisfied that our economy was strong enough to withstand the inevitable price volatility that would ensue. We believe this is where we find ourselves today; equity markets searching for equilibrium valuation against a backdrop of rising rates, all within the context of an economy growing much closer to its capacity to grow. The following two graphs, the Institute for Supply Management (ISM) Manufacturing and Non-Manufacturing (service sector) reflect a great deal of health in our economy. In particular, the Manufacturing Index has sustained a powerful move since the election, as businesses believe a much more business friendly environment in Washington provides them cover to again make capital investments in their businesses. That’s what jobs are made of.
We’d also point out that the lack of price volatility during 2017 was the anomaly, not the gyrations of the last few months. 2017 was a year in which the great economic expectations of November 2016, fueled by ongoing QE, were met and perhaps exceeded by renewed vigor in business capital investment, a front-loaded personal and corporate tax reformation, and a concerted global economic recovery. By all accounts 2017 was as good as it gets, and now it seems odd that a hard fought, average-year equity return of 7-8% would feel like a letdown and be so hard to come by. We believe we have simply stepped back into reality, where no pain means no gain, and capital once again comes with a price tag attached.
Though economic signals in Europe have begun to reflect some slowing, and retail sales in the U.S. is trending more slowly, we still don’t see a recession over the near term, which would surely put a damper on the stock market. Recessions normally are the result of an economy growing past its capacity to grow for a sustained period, and though we see tightness in labor markets and in transportation, at this point they are not enough to cause us to believe a cost-push inflation (the effect of rising costs to corporations being pushed through to consumers) might be a result. Though the Fed has a 2% inflation target, we still believe they would rather allow inflation to run “hot” for some reasonable period of time, rather than pre-empt inflation by raising interest rates too quickly and/or too much and risking suffocating the economy.
Earnings for the S&P 500 may prove to be a two-edged sword, however. Due to recent tax reform the forward Price/Earnings ratio for the index is as low as it’s been in years. However, we are mindful that there are times when the volumes of goods sold are more important than earnings growth by itself. In other words, it would be great to see earnings grow in 2018 by the predicted 19%. But if the volume of goods sold doesn’t match earnings growth, then the increase in EPS would be more due to the financial stimulus of tax reform than an expanding economy. We’ll see.
In short, our opinion is that the intersection of rising rates and overvaluation is where we find ourselves. Like oil and water, they never mix well, and are the driving force behind price volatility. Add talk of a trade and tariff war, news that China is studying whether or not to devalue the Yuan again, increased corporate leverage, and rising default rates in auto loans and you have a market getting a little more nervous. As long as the business environment remains friendly in Washington and our economy continues to respond by generating jobs, we will continue to view volatility as a required, albeit uncomfortable component of a successful long-term investment plan.
Jamie Wright, CFA, Portfolio Manager,
Research Director
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