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Worries about rising inflation have spooked stock and bond investors. As a reminder, inflation occurs when the prices of goods and services rise and as a result, every dollar you spend in the economy purchases less. The annual rate of inflation over from 1917 until 2017 has averaged just over 3 percent annually. That might not sound like much, but consider this: today you need $7,272.09 in cash to buy what $1,000 could buy in 50 years ago.
An administration in a seemingly constant state of chaos, escalating threats with North Korea, uncertainty over Iran, the potential unwinding of NAFTA, the dismantling of key components of the Affordable Care Act…and stock markets continue to rise. The MSCI World Index of large and mid-cap stocks from 23 countries hit an all-time high on Friday, as stock indexes in the US, Japan, Hong Kong, Taiwan, Germany, the UK and New Zealand all reached multiyear or record highs last week.
If you’ve been thinking that stock markets have been pretty quiet this year, you are right. Through the first seven months of the year, none of three major stock market indexes has fallen by more than 5 percent. And one gauge of market movement, the CBOE Volatility Index (VIX), which measures investors’ expectation of the ups and downs of the S&P 500 Index over the next month, recently dropped to its lowest level in 24 years. Low readings have tended to be equated with low anxiety and high stock prices. Amid this environment, you might be wondering what could go wrong? There are a number of risks to the US and global markets that persist. Their existence does not mean that long-term investors should change their game plans, but they are a reminder to guard against complacency and to always approach investing with caution.
"Why are stock markets at new highs?" The easy answer is that there are more buyers than sellers. The more complicated answer is that the Dow and the S&P 500 reached new all time highs last week, as investors shrugged off post-Brexit concerns and refocused on global central banks. In the case of the Bank of England, the Bank of Japan and the European Central Bank, the bet is that each will do something in the coming months to fight economic malaise. And in the US, the recent resurgent stock market is a result of investors’ belief that that the Federal Reserve will likely sit on its hands for the remainder of the year. Even if those assumptions are correct, the climate for investors is still riddled with danger. To earn anything approaching an acceptable return, many are turning back to risk assets, despite the bump in volatility seen over the past 18 months. In fact, since May 2015, when stocks previously saw new peaks, investors have endured two corrections (drops of 10 percent from recent peak) amid worries about slowing growth in China, plunging oil prices and fears over an emerging market debt crisis.
Those who gritted it out and stayed on course with their asset allocation, have done just fine. After dropping to 52-week lows in February of this year, the Dow is up a stellar 17 percent (and up 180 percent since the March 2009 nadir). But pity the market timers who sold at the various bottom points and then chased assets higher—they are likely licking their wounds and perhaps even sitting out this most recent leg higher.
There are also many investors who are on the sidelines because they see the world as a scary place. These folks likely stumbled upon the Economist Intelligence Unit’s updated list of Top Threats as a rationale for not feeling comfortable with any risk right now. Those top ten threats are:
My vote for number 11 on the list is “Corporate Share Buybacks halt”. As noted in the Wall Street Journal, “Among the most prominent drivers of the 2016 stock rally has been companies’ willingness to buy back shares. The strategy…drives up share prices and improves per-share earnings by reducing the number of shares outstanding. Some investors decry buybacks as financial engineering.”
The concept of companies buying back shares to drive prices higher is what Time business and economics columnist and author Rana Foroohar calls “financialization.” In her book “Makers and Takers: The Rise of Finance and the Fall of American Business,” Faroohar says that buybacks are a type of financial engineering that can juice short-term profits, thereby enriching shareholders. Unfortunately, waving a financial magic wand over a company’s balance sheet does nothing to serve the real economy, something that would occur by a company using its capital to invest in long-term growth.
Financial shenanigans may push the stock market higher for the foreseeable future, but they are unlikely to create a sustainable economic model that will produce results over the next several years.
MARKETS:
THE WEEK AHEAD:
Mon 7/18:
Bank of America, Hasbro, IBM, Netflix, Yahoo!
10:00 Housing Market Index
Tues 7/19:
Discover, Goldman Sachs, Johnson & Johnson,, Microsoft, Philip Morris, UnitedHealth
8:30 Housing Starts
Weds 7/20:
Abbott Labs, American Express, eBay, Halliburton, Intel, Mattel, Morgan Stanley
Thursday 7/21:
ATT, Chipotle Mexican Grill, GM, Starbucks, Visa
8:30 Philadelphia Fed Business Outlook Survey
8:30 Chicago Fed National Activity Index
9:00 FHFA House Price Index
10:00 Existing Home Sales
10:00 Leading Indicators
Friday 7/22:
American Airlines, General Electric, Honeywell, Schlumberger
Saturday 7/23:
China hosts the G-20 meeting of finance ministers and central bankers.
“I expect that it will be appropriate at some point later this year to take the first step to raise the federal funds rate and thus begin normalizing monetary policy.” - Federal Reserve Chair Janet Yellen, July 2015
This week, the central bank will do something that it has not done in over nine years: raise short-term interest rates. With the economy growing at a decent, though not great 2.25 percent annualized pace, 2015 monthly job creation averaging 210,000 and unemployment sitting at a seven-year low of 5 percent, Yellen and her cohorts have reiterated that now is the time to normalize policy.
This will be the first of many Fed actions that will eventually return rates to somewhere in the vicinity of 3.5 percent. How quickly they get there is up for discussion. Today the bond futures market anticipates that it will take around three years, but Yellen has said that the future path of interest rates will be entirely data dependent. If inflation rears its head, hikes may be quicker than the expected pace of every other meeting for the next three years. If the economy stalls, the central bank could pull back and skip a meeting.
Considering that it rates have been sitting at zero for seven years, it is helpful to review where we were then and where we are now. Though Americans may complain about slow growth, how quickly we forget what rotten looks like.
December 2008:
December 2015:
HOW WILL THE FED’S ACTIONS IMPACT INVESTORS?
Another big difference between where we are today versus seven years ago is that the Fed will be increasing rates with a balance sheet that has more than quadrupled through three rounds of bond buying (quantitative easing). How various markets will react to the first hike is unknown, because of the very fact that we are entering unchartered and choppy water.
Stocks: Typically, stock markets have dipped after the first rate increase, but usually regain their upward momentum, as long as the rate increase is in response to stronger economic activity. Stocks usually top out after the final increase. The last tightening cycle began with interest rates at 1 percent in June 2004 and ended with rates at 5.25 percent two years later. The stock market peaked in October 2007 and you know what happened after that!
Emerging markets are already feeling the effects, as investors exit risky bets in once high-flying markets like Southeast Asia, Brazil or Turkey. At the same time, US stocks are feeling the weight of sliding corporate profits. And while continued improvements in the economy and the slow pace of rate hikes could help equities regain more solid footing, many investors have forgotten how low interest rates made their stocks look attractive, relative to bonds.
Bonds: Billions of dollars have flowed into global bond markets over the past seven years, as nervous investors sought the safety of fixed income. Many investors are now fearful that rising interest rates will destroy the value of their bond positions. While it is true that as interest rates increase, prices on bonds that have already been issued, drops, that is not a good reason to abandon the asset class.
For most investors who own individual bonds, they will hold on until the bonds mature and then purchase new issues at cheaper prices/higher rates. For those who own bond mutual funds, they will reinvest dividends at lower prices and as the bonds in the portfolio mature, the managers will reinvest in new, cheaper issues with higher interest rates. In other words, being a long term investor should help you weather rising interest rates, though you may want to consider lowering your duration, using corporate bonds and keeping extra cash on hand. (For more on bonds, check out this post.)
HOW WILL THE FED’S ACTIONS IMPACT CONSUMERS?
In the seven years since financial crisis, companies, governments and consumers have gotten used to ultra-low interest rates. Here’s how the change in policy could impact you:
Savers: Any increase in the Fed Funds rate will help nudge up rates on savings accounts, so savers will finally be rewarded. That said, rates will still be low and the likely slow pace of increases will mean that savers’ suffering is not likely to end any time soon.
Borrowers: While rates for mortgages key off the 10-year government bond, adjustable rates are linked to shorter-term rates, which means that consumers should be careful about assuming these loans and also should consider locking in a fixed rate now. Additionally, as rates increase, the availability of 0 percent credit card and auto loans could diminish.
MARKETS: Oil, oil everywhere…and nobody wants to stop producing. Crude oil saw its worse week of the year, as evidence continues to mount that supplies are expanding amid withering demand.
THE WEEK AHEAD: All Fed, all the time…
Mon 12/14:
Tues 12/15:
Fed begins two-day policy meeting
8:30 CPI
8:30 Empire State Manufacturing Index
10:00 Housing Market Index
Weds 12/16:
8:30 Housing Starts
9:15 Industrial Production
2:00 Fed rate decision/Economic projections
2:30 Yellen Presser
Thursday 12/17:
8:30 Philadelphia Fed Survey
Friday 12/18:
