Anxiety is rising on Wall Street. The incoming data are beginning to paint a clearer picture. Inflation is on the rise, and the implications of rising inflation for an economy heavily dependent on (artificially) low interest rates could be profound. One man who must be particularly nervous (if not wondering why he accepted the job in the first place!) is recently appointed Fed Chair Jerome Powell. The Fed is widely expected to pass on a rate hike at tomorrow’s meeting, but there will undoubtedly be voices among the Board arguing, not without merit, for a quicker return to “normalcy.” It’s never an enviable position to be the guy charged with taking away the punch bowl. This is especially true when the sitting president has demonstrated his unwillingness to allow “independent” government agencies to remain independent. Another government official who should be a little nervous (but seems woefully oblivious) is Treasury Secretary Steve Mnuchin. Mnuchin is the man who gets to figure out how to fund trillion-dollar deficits into a rising-rate environment without breaking the bank. I don’t envy either man.
Last week I was asked to appear on Nightly Business Report (NBR) hosted by my friends Sue Herera and Bill Griffeth. The topic was the multitude of economic data to be released over the coming week as well as the data’s impact on deliberations as the Fed. The incoming data consists of a broad array of metrics covering such areas as consumer incomes and spending, confidence, manufacturing, housing, construction, vehicle sales, services, employment, productivity and more. All that data, it was argued, should provide a comprehensive look at the health of the economy. No arguments here. But when asked which of the data points would receive the most attention from investors, I knew the answer immediately. Average Hourly Earnings, which will be reported on Friday, has been rising in importance as wages have drifted higher. If the figure for April comes in hot (greater than the consensus expectation of +2.7% growth on a year-over-year basis), stock investors will likely sell on the fear of faster interest-rate hikes by the Fed. If it comes in lower than expected, investors might perceive a continuation of the Goldilocks investment environment (steady growth with low inflation) that has reigned for the better part of the past nine years. At current valuation levels, the stakes are pretty high.
We’ve said for years that (artificially) low interest rates have been the lifeblood of our economy and stock market. For years, unfavorable economic news was greeted positively by stock investors because the most important issue (if not the only issue) was whether or not the Fed was going to keep interest rates super low or begin the process of unwinding its accommodation. Remember the “taper tantrum”? Stocks sold off dramatically simply because the Fed wanted to reduce the amount of bonds it was buying as part of its efforts to suppress interest rates. Well, we got through that, and several increases in the Fed Funds rate, but the reality is that the Fed has never really taken off the training wheels. Until and unless investors perceive that the Fed is “behind the curve” and therefore forced to raise interest rates, the markets are likely to be somewhat comforted and emboldened by the perceived backstop of the Fed. But the day may be inching closer. This is why the wage data on Friday is so important.
To be sure, there are ancillary issues bothering investors as well. There are concerns that President Trump’s hardline approach to trade negotiations will blow up in his face and result in full-scale trade wars. There are also worries that similar hardline tactics with North Korea and Iran will land us in a bigger hole with very few attractive options. There are a plethora of other things to worry about. But when you stake your destiny on low interest rates for so long, it makes sense that investors are hyper-sensitive about inflation and higher interest rates.
Rising inflation and interest rates tend to suppress the stock valuations. When you keep in mind that when we buy a stock, we are buying a share in the future earnings of the company, it is easy enough to understand why: the future dollars a company earns will be worth less due to inflation than the dollars we are paying now for our stake. For much of the year, the markets have been adjusting to the emerging inflation risk. As long-term investors, we keep faith that market returns are tied to the health of the underlying economy, and a healthy economy will see periods of moderately rising inflation. In fact, rising inflation can be a good thing when it reflects strong underlying demand. So, without the benefit of a reliable crystal ball, we maintain our course of owning stocks in high-quality and defensive companies