“I think the Fed has gone crazy.” - President Trump
“Nobody wants a central banker who sleeps well, right?” - Fed Chairman Jerome Powell
Federal Reserve Chairman Jerome Powell said last Wednesday at The Atlantic Festival during an interview with Judy Woodruff, a respected journalist with PBS, that interest rates “are a long way from neutral at this point.” The “neutral rate,” whether we are talking about fed funds, the 2-year or the 10-year, is the rate for that particular maturity that neither stimulates or restrains the economy. Additionally, it is clear the Federal Reserve is concerned about the tight labor market. Chairman Powell says, “So the mystery really is, why, in a very tight labor market [companies] .. are not bidding up this scarce commodity of labor more.”
Concern that the Fed believes it has (potentially) much further to go with respect to interest rate increases worried the financial markets and drove interest rates higher last week. The 2-year US Treasury went from a yield of about 2.75% to 2.89% in a relatively short time frame, while the yield on the 10-year moved higher to 3.23% from 2.96%.
Some investors believe we are in a period of peak earnings, and that increasing interest rates, along with increasing costs like tariffs and wages, will result in lower profits for companies and therefore lower stock valuations. When interest rates move up rather sharply and unexpectedly, stocks tend to react poorly. Our longer-term view is that rates are moving higher precisely because the economy is doing very well. The time to worry about stock market corrections is when both stock prices and interest rates are falling. This is because the demand for borrowing is declining and it’s an indication that businesses are no longer interested in expanding. We think the stock market is recalibrating for a period of higher rates, not necessarily lower growth.
Our recent decision to rebalance our macroeconomic driven exchange traded fund (ETF) strategy away from small-cap companies and toward the largest (mega-cap) companies has paid off well in the last week as small- and mid-cap stocks have underperformed the S&P 500 and particularly the largest companies within the index. Our call to return to a more neutral weight in Emerging Market stocks has not yet been a good decision. Emerging equity markets continue to underperform the US stock market, especially in a time of “risk-off” driven trading.
The 2018 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel was awarded to William Nordhaus “for integrating climate change into long-run macroeconomic analysis” and to Paul Romer “for integrating technological innovations into long-run macroeconomic analysis.” As the pace of technological innovation has increased, at an increasing rate over the past century, Romer developed the theory that ideas and innovation are a separate category from goods and services production in an economy. Called “endogenous growth theory” it helps explain how policies and regulation affect the pace and development of technology and innovation in an economy. William Nordhaus began developing his theories about climate change and the economy in the mid-1970s. Some 20-years later, he developed an “integrated assessment model” that describes the interplay between the economy and the climate. It is widely used to examine the consequences of carbon taxes on projected economic growth. In other words, does the solution cost more than the problem it’s trying to solve?Make sure to read Don Molé's economic notes for 10-11-18.
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