May I Introduce Volatility?

Well, we finally got our elusive correction – at least, almost.  Breaking a two-year run of relative calm and complacency, stock investors started running for the hills last Friday.  The S&P 500 was down 2.1% that day, followed by another plunge of 4.1% on Monday.  From its all-time high reached on January 26, the index dropped very nearly 10% to its low at the opening on February 6.  All said, though, the sell-off of 9.7% fell just short of the technical definition of a correction (10%+).  The drop in the Dow Jones Industrial Average, at 10.7%, did qualify. The Nasdaq fared best, with a drop of just 9.1%.

Perversely, the impetus for the selling was more positive economic data.  To be sure, much of the economic data over the past several months have suggested that nine years after the Fed introduced aggressive money stimulus, the economy may finally be breaking out of its ~2% growth trend.  The unemployment rate is low, and job growth continues at a robust pace; consumer and business confidence is very high; manufacturing has rebounded; growth outside the US has improved dramatically; housing is booming again; consumer credit is expanding; the banking system is very well capitalized; burdensome banking regulation is being softened; and corporate tax rates have been reduced.  But the one elusive piece of the puzzle had always been inflation, and more specifically, wage inflation.  The relative lack of middle-class income growth that has characterized this economic recovery has become the albatross around the Fed’s neck.  It has also provided the justification for maintaining highly accommodative monetary policy.  So when we received two data points last week that suggested wage growth is accelerating, investors became fearful that the goldilocks investment environment – characterized by low inflation, low interest rates, rapidly rising corporate earnings, and most important, a highly accommodative Fed – could be coming to an end.

Following incessant warnings of an overdue correction (including by us), investors shot first and saved their questions.  It had been about two years since the last 10% correction in stocks, well above the average of about one year between such events.  This time, though, both bonds and stocks were sold aggressively.  The CBOE Volatility Index (the “VIX”), which uses index-option prices to measure the markets’ expectations of near-term volatility, spiked to its highest level since August, 2015.  The selling was exacerbated by algorithmic trading programs, many of which hadn’t been tested prior in any meaningful way.  The yield on the 10-year treasury spiked to 2.85% – up nearly 1.5 percentage points from the low of 1.36% in July 2016.  There were very few place to hide.

We have been concerned about the economy’s (as well as the stock market’s) dependence on artificially low interest rates for several years.  We think the Fed should have begun the process of unwinding its unprecedented monetary experiment 3-5 years ago.  Now, though, a hasty move by the Fed to counteract the threat of inflation could have much more dramatic implications.   Why?  Well, the first reason is that the long period of artificially low rates has caused economy-wide debt to surge to very high levels.  The Fed’s decision to suppress interest rates for so long effectively amounted to a policy of addressing the problem of too much debt by encouraging more debt.  Now, as interest rates reset higher, the need to service high levels of debt will act as a tax on our economic growth potential.  The second reason is that the Fed’s accommodative monetary policy has effectively resulted in the borrowing of demand (and prosperity) from the future.  The best example of this is the auto sector.  Would auto sales be as robust if the cost to borrow was meaningfully higher?  And the third problem manifested itself over the past week: Fed policy has pushed asset valuations to frothy valuations, leaving them and the economy vulnerable to nasty corrections.

Better wage growth is not the only factor causing interest rates to rise.  Below we provide our list of the factors driving rates higher:

1) There are fears that following several years of below-target inflation, price increases may finally be materializing.  The most recent evidence were the 2.9% YOY increase in Average Hourly Earnings in January and the 2.8% YOY increase in 4Q Wages & Salaries (component of the Labor Department’s Employment Cost Index), both reported last week.  The fear is that wage inflation will cause more widespread inflationary pressures throughout the economy. And most economists believe that if we continue to create 200,000 jobs per month against the backdrop of 4.1% unemployment, wages are likely to rise at an accelerating pace.

2) As part of its policy normalization process, the Fed is now buying less Treasury bonds even as its current holdings mature.  The resultant decrease in the size of the Fed’s balance sheet reduces a source of demand for Treasury bonds that had been very consistent for several years.  The reduced demand could be causing interest rates to rise faster than they otherwise would.

3) The recently passed tax legislation is expected to increase our budget deficits by $1.3-$1.5 trillion over the next ten years.  While some economists believe that better economic growth will make up for those deficits, most think that won’t be possible.  Therefore, the US Treasury will be issuing more bonds to fund $1 trillion deficits again.   The increase in supply should cause interest rates to rise.

4) Most economists believe that the tax cuts will be stimulative for the economy and lead to more inflation.  Higher inflation equals higher interest rates.  In addition, higher rates of economic growth can cause upward pressure on real (inflation-adjusted) interest rates because the demand for loans increases in better economic times.  And remember, these tax cuts are coming at a time in which the economy had already been showing strength.  In fact, some of the incoming economic data suggest 1Q18 economic growth may rise to 4% or higher after hitting 3%+ in 2 of the last 3 quarters.  Again, higher economic growth generally leads to higher inflation and interest rates.

So, the big fear is that the Fed may be falling behind the curve in its quest to stave off an overheating economy (and the associated higher rates of inflation).  Some believe that the urgency to normalize rates is even greater now that tax reform has been passed.  And if the Fed does indeed begin to fear that it is falling behind the curve, it may start hiking rates too fast. This could cause a lot more volatility in asset prices, including real estate.  In a worst case scenario, rapidly falling asset prices could affect confidence and thrust us into the next recession.

For my part, I don’t think we’re at risk for materially higher inflation (as measured by the standard metrics) over the near term.  The main reason is that there is still a lot of slack in the labor market.  By my estimate, another 6.7 million workers could re-enter the labor force in the event that the Labor Participation Rate were to simply rise to the long-term average of 65.3% (since 1980) from the current level of 62.7%.  The Labor Participation Rate measures the ratio of people who are either working or actively looking for work to the population of eligible workers (must be over 16 years old and not living in an institution, like prison or a nursing home, and not active duty military).  If the Labor Participation Rate were to rise back to its high of 67.3% (January, 2000), which is unlikely due to demographic factors like baby boomers retiring, there would be another 11.6 million workers re-entering the work force.  But there are also other factors that are keeping a lid on inflation.  Among these factors are globalization, the price discovery made possible by the internet, and weak growth in labor productivity.

I am more concerned with asset price inflation, which I think should have been given much more consideration by the Fed years ago.  For the third time in 25 years, the Fed has stood idly by as asset prices climbed steadily into the stratosphere.  Its failure to incorporate asset prices in its assessment of overall inflation leaves it in a very precarious position.  And as it stands now, I think there is a high chance of a policy “mistake” by the Fed (raising rates too fast for the markets to handle) following what I view as poorly structured tax cuts and other policy mistakes that are in the works (protectionist trade policies, more restrictions on immigration, and the failure to make long-term investments in productivity-enhancing projects).  The unfortunate reality is that stocks and other financial assets are no longer cheap after a bull market that has lasted nearly 9 years.  Therefore, the investment backdrop will be much more difficult in years to come.

We have been warning for months now that the market looked frothy and that the level of volatility was abnormally low and could not continue.  Volatility appears to be back.  We can’t predict where things go from here, but we are quite comfortable owning solid, blue-chip companies, and we will look to pick up great companies at better prices if the volatility continues in the coming weeks.  Remember, it is futile to try and time market corrections like the one we’ve endured over the past week. And it may not be over yet.  The best policy is to know what you own and play the long game.