Anatomy of a Recovery

The S&P 500 hit an all-time high on September 20, 2018 before falling 20% to the recent low on December 24, 2018.  The reason for the correction in stocks was fairly straightforward.  Investors had become concerned that the Federal Reserve was ignoring the many warnings signs and risk factors that had emerged with regard to the global economy.  At the same time, the Fed had failed to appreciate that a sub-4% unemployment rate had not automatically triggered an undesirable increase in inflation (as predicted by the increasingly infamous Phillips Curve).  Stocks swooned on the fear that these miscalculations by the Fed could cause a policy mistake and potentially put the economic expansion at risk.
Were investors right that the Fed was on the verge of a policy mistake?  It’s hard to prove a negative, but we have long believed that our economy has indeed become heavily dependent on low interest rates and therefore will not be able to withstand dramatic and/or abrupt increases in rates.  We think this assessment has been borne out yet again as economic growth is clearly slowing from the 2018 pace.  Indeed, each time we have seen rates begin to rise in earnest during the course of this recovery, economic growth has slowed.  One reason is the policy divergence between the Fed and the other central banks of the world.  As the Fed continued raising interest rates (partially in response to fiscal stimulus), the dollar surged against most other currencies.  The dollar’s strength had a dampening effect on the US economy through lower exports and pressure on corporate earnings.  But the other reason that a spike in rates might stifle growth is the sheer amount of debt that has accumulated in our economy.  Resources used to service debt cannot be used for more productive purposes.
But it seems as though we don’t have to worry about that for now as the ever-reliable Fed came through in the end.  Chairman Powell reversed course and said that the Fed would be patient in considering future rate hikes.  Powell also signaled a willingness to halt the shrinkage of the Fed’s balance sheet, which was a policy that had put some upward pressure on longer-term interest rates.  Is this a data dependent adjustment, or has the Fed buckled under market pressure for the umpteenth time over the past 25 years?  The S&P 500 has now recovered nearly two-thirds of the losses sustained during the fourth-quarter correction.   And while this outcome is obviously preferred over the alternative, the recent Fed actions don’t come without a cost.  The notion that stock-market losses will be limited by the Fed, commonly known as the “Fed put”, was reinforced yet again.  The tail (the markets) has yet again wagged the dog (Fed policy).  And this time, the Fed created the appearance, at least, of bowing to the political pressure from the White House to stop raising interest rates.
What is the longer-term cost of the moral hazard created by the “Fed put”?  That’s obviously extremely hard to calculate.  However, a quick glance at a 25-year chart of the S&P 500 shows that stocks have clearly followed a “boom-bust” pattern.  Are we doomed to repeat history?  Are we worried about an imminent bust?  Not right now.  The economy, though not growing at the break-neck pace of 2018, is on solid footing.  Corporate earnings, while growing at a much slower pace, should grow in 2019 despite margin headwinds.  And perhaps most importantly, stock valuations are reasonable with the S&P 500 trading at slightly over 16x the consensus estimate for 2019.  These factors, as well as a dormant Fed, should be supportive of stock prices as we enter the 11th year of this economic expansion.
The Fed has temporarily removed itself as the most obvious cause of a second straight negative year for stocks.  And while this feels good for now, we get the sense that Chairman Powell will be more vigilant against inflation and more responsive to the threat of asset bubbles than were his predecessors.  So just as the “Fed put” has been reinforced in recent weeks, we also think that something of a “Fed call” may be in place now as well.  In other words, we can see the Fed coming back into play if and when stocks get closer to all-time highs, inflationary indicators pick up, or economies outside the US gain strength.  With this Fed, the sky is not the limit.