J.P. Szafranski, BridgeTower Media Newswires
It’s complicated. Markets and economies are complex systems with competing variables that wax and wane in importance at unpredictable intervals. Investors often myopically apply their focus to a specific metric or factor conceivably because it’s simple to understand or its trend appears easily predictable or perhaps there is some particularly attractive or exciting attribute. The tendency to seek simplicity is innately human. We have limited time, so it’s useful to apply one factor or narrative to explain the recent past and to predict what’s to come.
Here are some examples for stock market participants. Easily predictable trend: Amazon revenue growth. Investors have used Amazon’s ascent to retail world domination to not only understand Amazon’s stock price appreciation but also to predict the decline and fall of scores of other retailers. Simple to understand: Trump trade. As President Trump took office, his agenda of tax cuts, deregulation and infrastructure spending appeared to drive massive stock price gains for industrial, financial and large U.S. taxpaying corporations. Despite the abject failure of Trump’s legislative agenda to date, these stocks remain buoyant. Maybe it’s not so simple after all and perhaps a good portion of the price gains came from apolitical optimism about economic expansion. Attractive and exciting attribute: Elon Musk mania. Despite Tesla’s established track record of financial losses, cash burn and missed production milestones, CEO Elon Musk has proven exceptional at raising new funds at remarkably lofty valuation levels. The simple unwavering focus from supportive analysts and investors willing to fund Tesla is that since Musk creates beautiful products and employs groundbreaking technology, large profits will inevitably materialize in the future. Hopefully this works out for all involved.
The same simplicity-seeking tendency can be applied to economic data and interest rates. Recent economic data is curiously contradictory. On the optimistic front, unemployment continues to drop to multi-year lows, with the Bureau of Labor Statistics reporting a rate of 4.2 percent in September. Economic survey data is approaching ebullient levels, with the ISM Manufacturing Purchasing Managers’ Index elevating to 60.8 in September, a multi-year high. The ISM’s “soft data” is validated by actual “hard data” from the Federal Reserve with industrial production growing year-over-year every month since January this year, after multiple years in negative territory. The Conference Board’s Leading Economic Index is up 4.4 percent year over year through August, which argues for continued economic strength.
With such positive data, it is vexing to observe long-term interest rates entrenched at historically low levels. The 10-year U.S. Treasury Note yield finished the third quarter 11 basis points lower than its year-end 2016 level of 2.445 percent. Meanwhile, core inflation is decelerating, with the BLS reporting that consumer prices excluding food and energy are up 1.7 percent year-over-year in August, the fifth such month of sub-2.0-percent readings after a previous run of 17 months above 2.0 percent.
The Federal Reserve has increased its short-term target rate three times in the past year and seems poised to do it again before the end of the year. As a result of rising short-term rates and stagnant long-term rates, the yield curve has noticeably flattened this year, which is not typically a harbinger of future economic growth. Furthermore, the Fed has just begun what it expects will be a multi-year process of unwinding its historically large bond portfolio. This has never been done before and its effect on markets and economic growth is a very significant known unknown.
This current data dichotomy is unlikely to persist. We don’t have a strong viewpoint on which way things will break, but these macroeconomic factors are likely to converge. Over-emphasizing one of these groups of data over the other in the meantime is an invitation for looking silly in hindsight. It is, however, somewhat easy to imagine stock market downside risks in both a scenario where economic growth decelerates to justify low rates and inflation as well as in the case that interest rates rise in recognition of stronger growth and inflation.
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J.P. Szafranski is CEO of Meliora Capital in Tulsa (www.melcapital.com).
