April Investment Comments


Stock investors as a group seem like a bunch of manic depressives, present company excluded of course.  We worry when the economy doesn’t grow much because recessions accompany bear markets and we certainly don’t like those.  But we also fret when the economy does too well because that could result in higher inflation and higher interest rates.  If rates rise too much, it can slow down the economy.  Using this logic, success inevitably leads to failure, so why even try?

All this is an introduction to recent market anxiety about higher interest rates resulting from better economic growth.  Real Gross Domestic Product (GDP) grew 2.3% last year.  This is an improvement from 1.5% in 2016, but still within the range that prevailed since the recession.  However, growth has been feeling progressively stronger starting last spring.

Job growth in February was a remarkable 313,000.  Even more impressive was the resurgence of better-paying jobs in manufacturing and construction while lower-paying jobs in restaurants and nursing homes saw below-trend growth.  Better economic opportunities may be behind rising consumer confidence, which in February hit its highest level since the late 1990s.

This optimism has yet to translate into strong growth in consumer spending.  Personal income continues to grow moderately, but steadily.  Take-home pay is getting a boost from tax cuts, but many economists believe the benefits to consumer spending may be felt over a span of several months.  Retail sales have risen 4% over the past 12 months despite some weakness in early 2018 attributable largely to soft auto sales.  Auto sales have plateaued, and higher interest rates may have left some would-be buyers turned off by higher payments.

As measured by the Institute for Supply Management, the manufacturing sector picked up last month with growth in 15 of its 18 sectors.  It is a bit early to declare victory, but changes in business taxes brought about by December’s passage of the Tax Cuts and Jobs Act seem to have awakened the “animal spirits” of American business.  The evidence is anecdotal at this point, but we took note of surprisingly optimistic comments from companies during their fourth quarter investor conference calls in January and February.

And it isn’t just in the U.S.  The Eurozone saw 2.5% growth in 2017.  Japan, the third largest economy in the world, has experienced eight straight quarters of positive GDP growth.  Sadly, this is the longest growth streak in Japan in 28 years.  Emerging markets are even stronger, led by India at 7.2% and China at 6.8%.  Growth in India is stoking inflation, and weak controls in its banking sector are also causing concern.  But the point remains, economic growth is picking up almost everywhere.

In early February, investors seemed particularly spooked by the prospect of higher inflation and rising interest rates.  Bond yields had been picking up steadily, but the catalyst was the January jobs report which showed a spike in wages.  Investors have been watching the unemployment rate come down steadily for years.  Taken to its logical conclusion, eventually an economy can run out of people with sufficient skills.  This leads businesses to poach talent from each other, which means outbidding one’s competitors.  Inflation can become embedded in the economy.

However, it appears that January may have been an anomaly.  Even at the time of the January jobs report, it was speculated that some of the apparent wage spike may have been due to one-time bonuses promised by many companies following the new tax law.  It was comforting to watch February’s wage growth settle back to approximately the level existing before the January spike.

The energizing jobs report in February also showed that Americans were joining or re-joining the labor market, helping to ease some of the strain.  Econ 201 says that rising wages and the belief that jobs are plentiful will draw out discouraged workers who didn’t previously believe a job would be there for them.

New Federal Reserve Chairman Jerome Powell recently gave his inaugural, semi-annual testimony before Congress.  He noted that “My personal outlook for the economy has strengthened since December,” coinciding with the new tax law.  He added that he “doesn’t see evidence that the economy is currently overheating” or of wage inflation.

Investors desire a Fed chief with a steady hand at the tiller in order to steer a path of growth and moderate inflation.  There are at least three reasons stock investors panic over inflation and rising interest rates.  One is that rising rates, if taken to the extreme, can choke off economic growth and lead to a recession.  The second is that higher interest rates lead to lower stock valuations under some valuation methods.  The third reason is that interest rates can eventually rise to the level that bonds attract investment dollars away from stocks.

As with most things in life, moderation is the key.  Better economic growth is desirable, but not when it becomes so strong that labor and materials costs get out of hand.  There appear to be few signs of that at this point.  Stock valuations have become more reasonable due to improving economic growth and the benefits of corporate tax cuts.  Pulling in the other direction is the likelihood of somewhat higher interest rates and the unsettled geopolitical situation, including tit-for-tat reactions in foreign trade following the U.S. decision to impose tariffs on imported steel and aluminum.  However, even there, things are rarely exactly as they seem, as the administration seemed to walk back tariffs against our top trading partners.  Despite these risks, opportunities for investors remain intact, and it should be productive to stay invested in stocks most of the time.

Scott D. Horsburgh, CFA