Dovish Talk, Markets Rise, but Dangers Abound

Federal Reserve Chair Jerome Powell took to Capitol Hill this week for the bi-annual Humphrey-Hawkins testimony. Powell’s opening remarks were seen as dovish – the markets hoped-for rate cut now appears to be a near-certainty in three weeks when the Federal Reserve Open Market Committee next meets. The markets responded immediately: when Powell’s written opening remarks were released, futures soared, and by the time Chair Powell began speaking to Congress, the S&P500 broke the 3000 level. As the second day of testimony began, the Dow Jones Industrials broke into record territory and above the 27,000 mark. The markets clearly believe a rate cut regime is just around the corner, but is that, in the long-run, the best for the economy?

The US economy has become increasingly bifurcated. With decades-low unemployment and rising wages, the consumer is holding up well. Even lower-income workers are finally beginning to more fully benefit from the labor market’s strength. Business investment, on the other hand, has generally been subdued and choppy. Rather than invest in future growth, many companies opted to use the 2017 tax-cut windfall to buy back their own stock. The stock repurchases were successful in reducing share counts and goosing earnings on a per-share basis, but they did little to move the economy forward.

Another glaring bifurcation in the economy is that the manufacturing sector, which makes up about 12% of the US economy, appears to have slowed dramatically even as the services economy, where so much of the consumer’s disposable income is spent these days, is alive and kicking. We expect that the net effect of these offsetting trends will be a reduction in economic growth from 2.9% in 2018 to closer to the 2% trend that has prevailed for most of the recovery from the Great Recession.

There is no reason to anticipate that lowering rates will meaningfully address the slowdown in the broader economy. Companies have had access to cash, and yet investment has not surged. The Fed has a big hammer to swing with monetary policy, but not every problem is a nail. Simply put, lack of investment is not due to lack of availability of inexpensive credit.
In the short-term, the lowering of rates is good news for the stock markets. With yields falling on bonds, more investors turn to equities for returns, and as we all know, the more demand exists for stocks, the higher the prices become.

So why am I concerned when unemployment is low, economic growth, though slowing, is moving forward, inflation is under target, but not deflationary, and the stock market is soaring?

Stock prices are moving upwards, but corporate earnings are not. The increase in prices is not being driven by fundamentals, but by macro-economic financial engineering. The danger is that prices totally decouple from fundamentals. In technical terms, the price to earnings multiples expand to a speculative point that leads to instability. In more conversational terms, these are conditions where bubbles can form – and bubbles invariably burst. As a long-term investor, I would much rather see slow and steady growth driven by earnings and balance sheet strength than a sharp rise driven by headlines, followed by a crash and burn.

My concern (not prediction, but concern) is that a July rate cut in the face of a still healthy economy will create the exuberance and bubbles from which crashes, and crises, arise. Rather than expecting monetary stimulus to generate more business investment, it’s more realistic to think that interest-rate cuts will cause higher asset prices and more debt. Recessions are caused by financial imbalances and a rate cut could be the trigger for a recession rather than insurance against it.

To be sure, we remain fully invested. As we work with our clients, we are ever more vigilant to emerging risks and potential imbalances in the system. We look for companies that are well positioned to continue growing in the face of an uncertain future, and companies with strong management teams that have demonstrated the ability to navigate the unexpected. Though the overall market appears expensive, our research team continues to find blue chip companies trading at reasonable valuations for client portfolios.