Christmas isn’t coming this year for the stock market. That’s mostly because Federal Reserve Chairman Jerome Powell decided to play the role of Grinch this year. He stole Christmas on December 19 by hiking rates, still projecting two rate hikes in 2019, sounding a hawkish tone and reaffirming the Fed’s plan to keep shrinking its balance sheet.
Ouch. Markets didn’t like that quadruple whammy. Stocks went from looking like they were ready to stage a rally, to plunging to new lows for the year. The S&P 500 has dropped 5% since the Fed announcement, and it has only been 24 hours.
But, the market seems to be overreacting here. To be sure, the broad market fears are reasonable. Both the equity and bond markets are signalling that the Fed is making a policy mistake by tightening when the economy is slowing. More than just tightening, the Fed is double tightening by hiking rates and shrinking its balance sheet at the same time. Markets are concerned that the Fed is overdoing it. This is a reasonable fear. Overdoing quantitative tightening could kill the economy and cause the next recession.
While these fears are reasonable, they also seem overstated in a 5% selloff in just 24 hours. The Fed is something to worry about long term, but not just yet. The medium- to long-term trend in stocks is ultimately dictated by earnings, and right now, earnings are pretty good. The Fed hiking rates by a quarter point from all-time lows against the backdrop of a fully employed and growing economy isn’t going to kill those earnings. Instead, it’ll create a bump in the road, and nothing more.
As such, market fears related to the Fed overdoing quantitative tightening are reasonable but overstated. The Fed is overdoing it. But, right now, this “overdoing it” isn’t going to kill the economy or the market.
With that in mind, let’s take a look at seven reasons why investors shouldn’t be too worried about the Fed yet.
It’s Only a Quarter-Point Hike
Lost in the negative headlines is that the Fed simply hiked its target rate by just a quarter point from 2.25% to 2.5%. Also lost in the shuffle is the fact that the Fed has been doing these quarter-point hikes fairly consistently for the past two years. Yet, during that stretch, the economy has remained healthy and stocks have gone up.
It’s somewhat hyperbolic to say that this marginal quarter-point hike in December will kill the economy. I say “somewhat” because this could be the straw that breaks the camel’s back. That is what markets are worried about. But, the camel is pretty strong right now, as the U.S. economy is still at full employment with falling jobless claims, rising wages, strong confidence, checked debt-levels and healthy corporate earnings.
As such, it looks unlikely that a quarter point hike will be the straw that kills the U.S. economy. If this is the only hike we get for the foreseeable future, earnings growth should remain healthy and stocks should head higher.
If Not Now, Then When?
Perhaps one of the biggest reasons not to be too worried about the Fed hiking rates yet is that the economy today is healthy, and should be able to withstand a tiny quarter point hike.
The U.S. economy is growing at a 4%-plus clip. That is near the highest mark over the past twenty years. Also, GDP growth has been consistently trending higher ever since mid-2015. That is a three-year stretch of accelerating growth, the largest such streak in recent memory. Moreover, the job market is healthy, consumers are healthy and corporations are healthy.
If the U.S. economy can’t handle a quarter-point rate hike when it’s firing on all cylinders, then when can it? In the big picture, this rate hike seems appropriate given by the underlying health of the economy. Future rate hikes? Not so much. But, that’s why the Fed isn’t a big concern just yet. If the economy cools and the Fed backs off, earnings growth should still remain healthy, and stocks should likewise head higher.
Rates Are Still Near All-Time Lows
In the big picture, the Fed is lifting rates off of zero. The Fed Funds target rate is now at 2.5%. Historically speaking, that is still an all-time low, and rates at these levels shouldn’t kill the economy.
Prior to every major recession since 1960, the effective Fed Funds rate was north of 4%, and often north of 5%. We still have a long ways to go before we are at those levels.
As such, in the big picture, this is a low interest rate economy that shouldn’t be overly stifled by a quarter-point hike. So long as the Fed remains data-dependent going forward, earnings growth won’t be killed by rates moving higher from all-time low levels, and stocks should go higher.
There’s No Guarantee Of Any Further Hikes
Markets are concerned that the Fed is even thinking about raising rates next year in a slowing economy, and that the language from the Fed was perhaps inappropriately hawkish, all things considered.
But, if you compare the Fed dot plot from December with the one from September, there’s reason to believe that the Fed may not hike next year. Clearly, the the voting members of the Fed increasingly think we are rapidly closing in on the neutral rate, meaning that they are well aware of the incoming data, which doesn’t point to continued robust economic growth in 2019.
It took them just three months of mixed data to reduce next year’s rate hike forecast from three hikes to two hikes, while reducing the long-term target rate from 3% to 2.8%. In another three months, if the data goes from mixed to negative, you will see more drastic reductions. Thus, at this point in time, further rate hikes are anything but a sure thing.
Consumers Have Jobs
Circling back on the “if not now, then when” argument, the job market is as healthy today as it has been since before the Recession, and is more than braced for a rate hike.
Jobless claims are still dropping, including very low initial claims numbers in the past two weeks. Overall, we aren’t seeing a bump up in initial claims that we usually see when the economy is starting to weaken. Also, the unemployment rate remains near all-time lows, and consumer confidence and sentiment are near all-time highs.
If you put all that together, you have a really strong consumer today. That strong consumer will only marginally feel the impact of a quarter-point hike. Thus, the consumer projects to remain healthy for the foreseeable future. So long as that’s true, earnings should grow and stocks should rise.
Inflation Isn’t A Problem
The Fed’s job is to do two things: promote full employment and contain inflation. We’ve already discussed the full employment segment. We are there. Jobless claims are falling and the unemployment rate is near historic lows.
Meanwhile, we also already there on the containing inflation front. The core PCE inflation rate has been hovering around 2% for several months now, and has actually shown signs of falling off recently due to plunging oil prices.
Broadly speaking, inflation is contained. The Fed doesn’t need to hike much more. Considering that they’ve already grown increasingly dovish over the past three months, it seems increasingly likely that they wont hike as much as expected in 2019. If so, earnings growth should still be good, and stocks should rally.
Current Debt Levels Can Sustain Higher Rates
One of the market’s biggest concerns regarding the Fed hiking rates is that current debt levels are stretched, and higher rates will cause the current debt bubble to pop. Supporting this fear is the fact that corporate debt to GDP levels are currently as high as ever.
But, what really matters is debt to GDP levels after you strip away liquid assets that can be used to offset that debt, or net debt to GDP. When you look at net debt to GDP, those levels are below where they were during previous recessions. Plus, as shown earlier, rates are also well below where they were during previous recessions.
Thus, you have lower than average net debt levels and lower than average rates. That combination won’t cause a debt bubble pop too soon. Instead, it creates a trickier yet still manageable corporate debt situation. So long as that’s manageable, earnings growth should be healthy and stocks should go up.
As of this writing, Luke Lango did not hold a position in any of the aforementioned securities.