Market Shrugs off Fed Rate Hike Warning
The Fed’s signals that rate increases could soon come seem to fall on deaf ears. U.S. stocks continue to climb as bond yields decline. Although recent data reflect accelerating economic growth, which is necessary to justify frothy valuations, structural challenges and unclear policy outcomes remain. Caveat emptor.
After leaving its benchmark interest rate near zero for eight years and then lifting it just once in each of the last two, the market has grown accustomed to discounting U.S. Federal Reserve indications that rate hikes are in the offing. Investors could be forgiven for doubting the Fed’s tightening resolve, as it has consistently overestimated growth and inflation since the financial crisis and subsequently pushed out its own rate hike projections. Indeed, the Fed has cried wolf so many times that its latest warning of potential rate hikes “fairly soon” hardly registered in asset prices.
Apart from its long-standing reluctance to prematurely raise rates, though, the market may have good reason to doubt the Fed’s forecast of three hikes in 2017, possibly starting at its next meeting in March. But it’s not an easy call.
On the one hand, a slew of recent monthly data—from employment and wages, to inflation, housing, retail sales and manufacturing—suggest the economy is gaining steam. On the other, structural constraints may crimp President Donald Trump’s goal of doubling economic growth from the anemic 2% of the last eight years. Faster growth requires increased productivity, which has been declining for some time: annual growth of labor productivity, defined as output per hour, has averaged 1.3% over the last decade, less than half the 2.8% rate in the ten years to February 2007.
Thornburg’s Jeff Klingelhofer points out that increasing productivity will require more fixed capital formation, which won’t be easy to finance with corporate debt levels currently at all-time highs. Moreover, corporate profits may have peaked, while rising wages will continue to pressure profits, he points out. On the consumer side, although household balance sheets are in considerably better shape—with the ratio of debt-to-disposable income near 100%, down from more than 130% a decade ago—consumers still appear unwilling to spend more or take on fresh debt.
Growth of the U.S. labor force, the other factor needed to drive productivity growth, has been in structural decline since 1980, Klingelhofer adds, a decline that looks set to accelerate with the retirement of baby boomers, not to mention the prospect of a more restrictionist U.S. immigration policy.
The “data-dependent” Fed, of course, must take into account both the recent upturn in economic indicators as well as these longer-term structural challenges to productivity growth. In its January monetary policy meeting minutes, which were released February 22, the Fed also alluded to Trump’s vows to cut taxes and boost infrastructure spending. These fiscal initiatives, along with his push to slash regulation, have driven the “reflation trade” fueling the market advances.
Fed officials suggested a rate hike “potentially at an upcoming meeting” could be appropriate, prompting many observers to suggest that the Fed’s March policy meeting is “live,” meaning that the next rate increase could come in less than a month. But investors were unimpressed. The Dow Jones Industrial Average finished marginally higher in the wake of the minutes, hitting its 9th straight record close and raising it more than 2000 points over its 200-day moving average. The S&P 500 Index, which is up 10% since the election, ebbed just a tenth of a point lower. In bond land, the 10-year U.S. Treasury yield actually slipped a couple basis points to close the session a smidgeon lower at 2.42%. Fed funds futures, meanwhile, priced in 38% odds of a March rate hike.
Stock valuations are rich, while both investment grade and high-yield corporate bond spreads remain tight. Investors seem to think the economy can accelerate materially under new management at the White House and continued timidity at the Fed, despite the recent firming in data. Maybe easy financial conditions and faster growth will enable a ramp in corporate earnings that justifies the lofty valuations and low spreads. But the structural impediments facing productivity growth won’t go away anytime soon, and tax reform, infrastructure spending and substantial financial sector and health care reforms may take longer than investors are bargaining for, and may be watered down in the process. Such an outcome would imply that asset prices face more potential downside than upside.
Alongside diversified risk exposures, relative valuation appraisals that aim to secure sufficient, if not attractive, compensation for investment risks are key to participating in buoyant markets and protecting capital in downturns. After all, lopsided bets on uncertain policy outcomes don’t usually pan out for long.