Under normal circumstances the markets do well in November and December. Since 2009, we have not seen normal economic circumstances, and we are playing catch up in uncharted waters. Normally, in the wake of a recession we see three major strategies taken by Washington to reduce the recession's severity, but after the great recession, we saw just two of the three strategies implemented. Washington increased spending and lowered interest rates; now, nine years later, we are seeing the results of the third strategy with tax cuts finally getting implemented. The length of the recovery, and the significant increase in growth have the markets questioning the future.
Looking back, we believe the economy would have been greatly helped by a tax cut in 2009 and 2010, but it did not happen. Instead, we got a tax increase and health care reform. The Federal Reserve wanted to keep the economy growing, so they decided to institute an unprecedented policy of quantitative easing (effectively causing negative real interest rates). With this strategy, the Treasury printed more money, and Federal Reserve in turn bought Treasury and mortgage backed bonds to hold on their balance sheet. What this strategy did for the Federal Reserve was keep the bond market rally going (keeping both short and long-term interest rates low), and it helped create anemic economic growth to keep us from falling into recession again.
Fast forwarding to December 2017, tax relief was finally passed, and the economy hit on all cylinders again. Economic growth in the US finally returned to more normal rates of 3 to 4 percent annually. In accordance with the economy's growth returning to more normal rates, the Federal Reserve felt the need to normalize interest rates and decided to broadcast its rate hikes (because clear and open guidance worked to keep the economy going over the last few years). So, with all the good economic data, why aren't the markets on fire like the economy is? Is the Federal Reserve causing a stall in market growth? We will look at some of the facts below.
The economy, and the markets, have had spurts of growth, but the economy only grew by 1 to 1.5% per year from 2010 to 2017. Washington and market pundits alike declared this was the new normal, with some even venturing to state the economy would never grow at 4% again. Washington and the Federal Reserve told us they were doing everything they could to foster growth in our economy, and growth was unlikely to achieve levels above 2%. The Federal Reserve was truly committed to fostering growth, walking a high wire act trying to revive the economy with its quantitative easing without going too far. In doing so, their balance sheet went from approximately $700 billion in assets to more than $4.5 Trillion. The debt the Federal Reserve was taking on was unsustainable.
With growth finally returning, the Federal Reserve decided now is the time to unwind its over-bloated balance sheet. The task ahead of the the Federal Reserve is significant. They are reducing their balance sheet $50 billion each month by selling bonds while they are raising short-term interest rates 0.25% each quarter. Because there are no strong signs of inflation, the Federal Reserve's actions are causing uncertainty; historically, the Federal Reserve only raised rates to slow inflation. With the Fed's new behavior, the markets are taking a pause, like they did in 2011 and again in 2015, to evaluate the expected economic impact of the Fed's actions. In 2011, the Federal Reserve announced its quantitative easing strategy, and the markets did not know how to take the news. GDP was positive (barely), and companies were making money. However, the markets had never seen quantitative easing and did not know what to expect, so the markets paused to evaluate. Then in 2015, as the Fed began winding down its easing programs (which the markets had grown accustomed to), the markets paused to evaluate the uncharted waters ahead. Today, we are again seeing the markets pause and evaluate. The Federal Reserve tightening rates at the same time it is reducing its balance sheet is uncharted territory.
The President has been saying that the Fed is raising rates too fast, and they are stalling growth. What we believe he should be saying is that the Fed is tightening too fast. Not just by raising rates, but also buy selling bonds in the open market (forcing market interest rates higher). The Fed is actually tightening twice as fast as they are saying, and the markets are not buying this strategy. So, just like in 2011 and 2015, the markets have decided to pause and evaluate. So far, it appears that the markets believe rates are going up too quickly, and unnecessarily so without any evidence of inflation.
So what might the Fed to do? We believe the Fed will raise rates in December, but then they will make an adjustment. We think they will either pause raising rates or stop reducing their balance sheet until they see signs of true inflation. Once this happens, we think the markets will reflect the current strong economic growth. Until then, we think the economy and corporate earnings will continue their strong growth, but that markets may not keep up in the short-term. There are signs that if the Fed does not slow its tightening, growth may subside, which is what the markets are currently reflecting.
We do not think the Fed wants to be a party pooper and ruin our current growth environment. However, if they do not slow their tightening that is exactly what they may do.
The good news is the holidays are finally here, and we think we will see record spending this holiday season because most American’s have more money in their pocket. Hopefully the markets will appreciate this and show us a little holiday cheer before year's end.
Source: Pacific Global Investment Management Company
Chart reflects price changes, not total return. Because it does not include dividends or splits, it should not be used to benchmark performance of specific investments.
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