Volatility returned to financial markets with a vengeance in October. In the 12 market sessions between October 4th and October 19th, eight were negative (a total of -2,324 Dow Points) while four were positive (+940). In those 12 sessions, seven were triple digit; unfortunately, five of those triples were negative. Why the sudden turn and burst of volatility?
Wall Street is abuzz with worries about decelerating economic growth (a theme I have discussed for several months), and there now are worries that the Fed will raise rates too high and kindle the next recession. The former would simply mean a correction in the PE ratio; but the latter is a real worry, as recessions are usually accompanied by large equity market drawdowns.
The U.S. Economy Cannot Decouple
The large brokerage firms have adopted the mantra that the economy remains strong, and that the current negative market sentiment is just a normal correction, one that comes around every so often in a bull market. According to this narrative, we might have some growth deceleration, and there are always things to worry about, but nothing appears to be too distressing, so go ahead and buy the dip.
The U.S. is not an isolated island. Issues in other parts of the world do have a significant impact.
• The biggest of these is the meaningful slowdown in China’s growth rate. According to the official data releases, the third quarter was the slowest since the Great Recession. At one point in October, their equity markets were down 30% from their peaks; auto sales are down 12% year over year (YoY) and even infrastructure spending is negative. Worse, this slowdown appears to be driven by weakening domestic demand, rather than by slowing exports. Looking forward, if the slowing in world economic growth continues, exports there are certain to fall, and the tariff and trade issues can’t help but have a negative impact;
• In Europe, Germany’s major sentiment index fell hard in October to its lowest level since August, ’12. Passenger car registrations in the EU are off 23% from year earlier levels due to new emission control regulations that have both demand and supply side issues. Then, there is Italy’s budget crisis. Its proposed budget with a 2.4% deficit/GDP will almost certainly be rejected by Brussels because the assumptions are deep in left field;
• Emerging Market (EM) debt issues have been swept under the carpet, but they are still real. National and corporate debt and accompanying interest payments, denominated in U.S. dollars, can’t be repaid when local currencies, like the Turkish lira, have depreciated 40%!
Now to the U.S. itself, where the economy is still strong, but market PE ratios are correcting due to the emerging recognition that, while growth is still positive, it has decelerated. While all the sentiment indicators continue to show strength, the hard data tell a different story:
• Housing, which used to be the quintessential leading indicator, is all but ignored today. That’s because the data don’t confirm the growth narrative. Some still stick to the “lack of supply” theory despite the huge impact that rising interest rates and rising home prices have had on affordability. Each week, both refi and for-purchase mortgage applications continue to fall. New home sales, existing home sales and housing starts have fallen for several months, and national homebuilder stocks have collapsed 35% from their peaks. More pain will occur in this sector as interest rates continue their upward ascent;
• The headline on page B1 of the October 22nd issue of the Wall Street Journal (“Soft Sales Cast Shadow on Stock Rally,” Michael Wursthorn) says it all. “Firms from asset manager Blackrock, Inc. to computing giant International Business Machines Corp this month have reported disappointing quarterly sales, citing such factors as cautious consumers, risings costs, and a stronger dollar;”
• Q3 GDP, (reported on Friday, October 26th) is likely to still be above 3%, but nearly 2 percentage points of that growth was inventory accumulation, much of which was done early to avoid announced tariffs. The real underlying economic growth rate appears to be closer to 2% which will reveal itself after the sugar high of the tax cut stimulus passes, likely this quarter or next.
The Real Worry
The underlying issue for the markets isn’t so much the economic deceleration story, which is the current narrative, but anticipated future monetary policy. The recently released September Fed minutes were quite hawkish with regard to interest rates: “a number [of Governors] judged that it would be necessary to temporarily raise the federal funds rate above their assessment of its longer run level.” That longer run level is 3% which can be gleaned from the Summary of Economic Projections, also known as the “dot plot,” wherein the policy makers reveal their individual interest rate projections over the next few quarters. To get above that 3% neutral rate would require four or five rate hikes from current levels. Markets are currently only priced for two or three.
That Magic 3% Number
Ultimately, it is inflation that will determine how far the Fed goes. The current theme on Wall Street is that inflation has remained benign, and, therefore, the Fed can and will pause in its rate hiking regime (the reason markets are only priced for two or three more hikes). Earlier this month, Morgan Stanley pointed out that, in the upcoming October Employment report on November 2nd, a 0.1% gain in wages will put that lagging indicator at the magic 3.0% YoY gain. As long as that indicator has a “3” handle, the Fed will have little choice but to continue to hike.
We have had wage gains of 0.2% or more in each of the last five months. Given the Amazon $15/hour minimum wage announcement, the recent steel worker contract settlement parameters, and the fact that there are hundreds of thousands more unfilled jobs than there are people looking for work, it appears that the 0.1% is a lock, and that we will see accelerating wage growth at least through the end of 2019.
It is this prospective monetary policy that has put a scare into Wall Street. Besides interest rate hikes, the Fed will also be reducing its balance sheet by $50 billion/month, which, in addition to the huge federal budget deficits, must be financed by the private sector and/or foreign purchases. We have already seen a reduced appetite for Treasury debt from both China and Japan, and recent bond auctions have been sloppy. This implies that markets will require higher rates to clear.
The deceleration we have already seen in the hard data is likely due to the Fed’s rate hikes of the past couple of years. For sure, this is true in the housing arena. The inevitability of rate increases over the next year with implications for the cost of government, corporate debt, and housing is what is eating at the equity markets. And I haven’t even touched on the implications for consumers. The biggest Wall Street worry is that the Fed will overdo the rate hikes and cause a recession, like they have done in 10 of the last 13 business cycles. If they do (and history says they will), the current volatility could look like a walk in the park!
Robert Barone, Ph.D.
Robert Barone, Ph.D. is a Georgetown educated economist. He is a financial advisor at Fieldstone Financial. www.FieldstoneFinancial.com .
He is nationally known for his writings and Robert’s storied career includes his having served as a Professor of Finance, a community bank CEO and a Director and Chairman of the Federal Home Loan Bank of San Francisco. Robert is currently a Director of CSAA Insurance Company (a AAA company) where he chairs the Finance and Investment Committee. Robert leads the investment governance program at Fieldstone Financial, is the head of Fieldstone Research www.FieldstoneResearch.com, and is co-portfolio manager of the Fieldstone Financial Unconstrained Medium-Term Fixed Income ETF (FFIU).
Statistics and other information have been compiled from various sources. The facts and information are believed to be accurate and credible, but there is no guarantee as to the complete accuracy of this information.