Don't Fight City Hall

In our last missive we opined that the stock market was overdue for a correction that could prove to be the pause that refreshes. The Dow promptly jumped over 10% as it posted gains in 13 of the first 18 trading sessions of the year. The closing high of 26616.21 on January 26, however, proved to be the high watermark for the quarter as the venerable index gave back all of the gain and then some over the ensuing nine trading sessions.

Since then, the market has resembled the old arcade game, “Whack A Mole.” Just when it looked like it might be down for the count, it would pop back up again. One thing is for certain – the complacency that characterized stock investors for the past two years or so has disappeared as volatility returned with a vengeance. There were 23 days during the quarter in which the market gained or lost 1% or more as investors weighed the potential positive consequences of lower corporate taxes (and commensurately higher profits) against the potentially negative fallout from a possible trade war.

For the quarter as a whole, the Dow incurred a price decline (dividend reinvestment not included) of 2.5% and the selloff did much to alleviate the previous overbought condition. The jury, however, is still out on whether the correction is merely the desired pause that refreshes or the start of something more ominous.

Commodity prices rose slightly during the period as the Commodity Price Bureau’s Index gained 0.8%. The results, however, were decidedly mixed. Crude oil was the star component as it rose 7.5% while gold provided a more modest 1.3% gain. Some of the more mundane components, such as copper, suffered declines. It should be noted that, while copper price moves rarely make the headlines, they have historically been a good leading indicator for the economy.

Interest rates rose across the maturity spectrum as note and bond prices experienced price declines due to incipient fears in some quarters of rising inflation pressures. The Federal Reserve continued to pursue its policy of gradual upward pressure on short-term interest rates by making its sixth increase in the federal funds rate in the current cycle. More on the central bank anon.

Fourth quarter GDP was reported to have risen at a 2.9% annual rate – still below long-term trend growth but better than the average performance over the sub-par recovery. The labor market is tight and “Now Hiring” signs are ubiquitous. Initial claims for state unemployment insurance benefits remain near record lows and the unemployment rate has fallen to 4.1%. Thus far, however, there is scant evidence that the strength in the labor market is translating into significant wage gains. Hence, the inflation fears noted heretofore appear to be somewhat premature.

Personal income gains were healthy in January and February even though personal spending was not quite as strong. Industrial production fell in January but rebounded sharply in February. The housing market experienced the reverse trend as starts were quite strong in January but fell back somewhat the next month. All in all, while perhaps not hitting on all cylinders, the domestic economy appears to be healthy.

Let’s now return our attention to the question of whether stocks have been merely taking a breather in an ongoing bull market or if what we have been witnessing is the onset of bigger problems. A roundup of the usual suspects in terms of leading indicators of bear markets and recessions suggests that there is little to fret about at present.

Commodity prices, historically one of the best leading indicators of trouble for risk asset prices and/or the economy, have been mixed but relatively stable overall. They typically fall for months in advance of trouble in the stock market or the economy.

The relative strength of the financial stocks likewise tends to move lower well in advance of steep corrections in the general market. The chart of this indicator looks much like the chart of commodity prices. Hence, one would assume that the risk of a bear market and/or recession is relatively low at this point.

Nonetheless, there is an old adage on Wall Street that advises, “Don’t fight City Hall.” In this case, “City Hall” is the Federal Reserve. Despite all of the chatter about moderate tightening, the Fed has been fairly aggressive in applying the brakes to money supply growth (see charts below). The monetary aggregates are still growing. But, on the margin, growth has slowed considerably. At some point that is going to put a drag on risk asset prices and economic activity.

Furthermore, while the Fed’s upward pressure on short-term interest rates has been measured to this point, such is not the case in all of the global credit markets. The London Interbank Borrowing Rate (LIBOR) has moved to its highest level in nine years. This key rate is linked to an enormous amount of derivatives and loans worldwide.

We noted awhile back in these pages that even modest interest rate increases can represent substantial increases in debt service costs when said interest rate gains are coming off a low base. Such increases in debt service costs heighten the possibility of a so-called “Black Swan Event” (e.g. a surprise default that sends shock waves through the credit markets).

In short, the odds favor a continuation of the recovery and the resumption of the bull market but the end game will draw inexorably closer as long as the Fed continues to drain the punch bowl.

Weaver C. Barksdale, CFA


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