Over the past several months, I have talked a great deal about volatility. The fact is, volatility increases in direct proportion to market uncertainty. So, today’s volatility is just symptomatic of the confusion and uncertainty now prevalent at least in the near-term outlook.
The Trade Issue
The talking heads on bubblevision would have you believe that the bickering over trade and tariffs, especially between President Trump and China, is the only cause of market volatility. While it does have a temporal impact, market volatility began long before the trade issue became a major concern. But, now that trade is on the table, let’s examine it.
In past writings, I’ve discussed the trend in the private sector away from small business and toward large businesses. The main driver, I concluded, was continued government regulation and interference in the private sector business processes (including minimum wage laws, taxes like Social Security, Medicare, and Obamacare, business licenses, HR requirements…) which simply drive up the cost of small businesses. Such costs must be passed on to consumers for the businesses to survive. Most other places in the world, especially in the emerging markets, do not have such requirements, and, thus, can produce more cheaply. The Trump Administration’s drive to reduce the trade deficit and repatriate those jobs to the U.S. will, if successful, at the very least, cause inflation. It’s simple: it just costs more to produce here than in many other places in the world.
Finally, one shouldn’t forget that foreigners hold a significant level of U.S. Treasury debt. In fact, the trade deficit puts dollars into foreign hands, many of which come back home when foreign interests purchase Treasuries. Shrinking the deficit will reduce foreign dollar holdings which may come home to roost in the form of higher interest rates. Finally, China holds $1.2+ trillion of U.S. Treasuries. They might use this fact in the tit for tat “trade and tariff” negotiations.
Unemployment and Inflation
Besides the trade issue, the markets are concerned with the prospective rise in inflation due to the fact that businesses are scraping the bottom of the barrel when it comes to finding employees. February’s employment report appeared to be a blockbuster, but those data points were skewed by the move to the mainland of desperate Puerto Ricans in the wake of Hurricane Maria’s devastation and the painfully slow recovery from it. There were contradictions, too, in February’s two surveys, one showing positive employment in construction and retail, and the other showing the opposite.
March’s employment report (U3) was somewhat of a disappointment, showing only 103,000 net new jobs (vs. 185,000 expected). In addition, January and February were revised downward by 50,000. Looking at the U3 over three and 12 month periods, the average pretty much reverts to 200,000, about in line with an economy growing at 2%. Of course, there is always the possibility that the 103,000 number represents a significant slowdown (note that the March Household survey showed a net loss of 37,000 jobs). There are corroborating indicators of a non-accelerating economy, like retail sales and a significant rise in the lay-off rate. Wall Street will point to significantly rising corporate profits as the reason the economy is purring. But, these are one-time, non-organic profit increases mostly due to reduced corporate tax rates. It is really too early to tell if the economy will fall into recession, but it isn’t too early to recognize that the economy isn’t accelerating either. All of this is playing into the uncertainty narrative.
Sticking with employment, the most highly educated employment sectors (U1 and U2) show jobless rates of 1.4% and 1.9% respectively. The business community’s number one gripe is the lack of qualified applicants. And, we are now seeing a significant rise in the voluntary quit rate, to levels not seen since 2001. One would now expect wages to be rising. And, they are! They have risen 0.3% in four of the past five months (a 3.2% annual rate). All of a sudden, inflation is going to become an issue!
The Fed’s Inevitable Response
With a new Fed Chair and new Fed voting members who are not as sympathetic to equity market strains as were their predecessors, it is highly likely that short-term interest rates will continue to rise as the Fed moves rates up to contain the oncoming inflationary pressures. And the Fed has begun to significantly reduce the level of Treasury debt it holds on its balance sheet. This, too, puts upward pressure on interest rates.
Uncertainties surrounding the Fed also include the possibility of a policy mistake. In fact, such a mistake may have already occurred in the form of keeping rates too low for too long and allowing the economy to operate above its inflation free unemployment rate (4.5% according to the Fed) for several quarters. In order to control the oncoming inflation, the Fed may end up inverting the yield curve (short-term rates higher than long-term ones). Today, there are only 30 basis points (0.3 percentage points) between the two year and five year Treasury Note yields, and only 50 between the two year and the ten year. In reality, we are only two rate hikes away from yield curve inversion, and the Fed has promised us 5 or 6 more rate hikes between now and the end of 2019! According to the Fed’s own economists, yield curve inversion is the most predictable indicator of an oncoming recession. Talk about uncertainty!
Rising interest rates have a huge impact on consumer, business and government budgets (all levels). Home finance is significantly impacted by rising rates. Almost 20% of corporate debt turns over each year. Going forward, corporate debt costs are bound to rise significantly. Today, according to Morgan Stanley, more than 50% of all corporate investment grade debt is rated BBB; that is $2.5 trillion worth. Five years ago, total BBB rated paper amounted to about half of that ($1.3 trillion), and ten years ago, it was $686 billion or just over a quarter of today’s level. In a recession, a lot of this paper could be downgraded to junk status. More uncertainty and even scary!
At the federal level, Congress and the Trump Administration have chosen to load the public up with another $1 trillion budget deficit; this while the economy is still growing and doesn’t appear to need the stimulus, especially considering where the labor market stands. If a recession were to occur, can they really afford to increase this deficit? What would that do to interest rates? Uncertainty galore!
All the above issues are cause for market indigestion. And I haven’t even begun to discuss the weakness that has appeared in retail sales and consumption. The tax cuts appear to have been used to pay-off Q4’s credit card debt binge and reverse the significant decline in the savings rate.
The market paradigm has changed. Markets are adjusting. Economic growth is not accelerating; inflation, albeit mild, is reappearing. Interest rates are rising and are sure to have an impact on debt costs; easy money is now in the rear view mirror, and there is little room for fiscal stimulus if a recession should appear. It is for these reasons that financial market volatility is with us and is likely to remain for the foreseeable near-term future.
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 UVA 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.