Over the last year or so, the stock market has often displayed a tendency to react to news somewhat illogically. That has created opportunities in many cases, but the most widely felt effect has been confusion. Stocks, because the focus of traders and investors has been firmly on how news might impact interest rates, have frequently risen on so-so economic data, and fallen when the data are strong.
In a way that happened again yesterday when the Fed’s decision not to hike rates was met by a wave of selling. That would seem to be another confusing reaction to news, but the details of that decision along with some disappointing data this morning give us a clearer picture of economic circumstances and future rate decisions.
Unfortunately, that all makes this drop seem warranted, and that’s not good news for stocks.
On the surface, the fact that the Federal Open Market Committee (FOMC) felt able to say in the statement that accompanied their decision that “...the labor market has continued to strengthen, and that economic activity has been rising at a moderate rate. Job gains have been strong, on average, in recent months, and the unemployment rate has stayed low...” was extremely positive.
Also, given the panic the market has recently shown on the subject, no rate hike, even in an “off” month such as this, is a surely a good thing. Yet stocks still took a dive once the decision and statement were released.
That reaction was because while talking positively about jobs, the Fed made a subtle but very important change to their language when talking about prices. Last month, the committee said that inflation, or at least in the way they measure it, had “continued to run” below the 2% mark that is their stated target. This month, that “continued to run below” was replaced with “have moved close to.”
The implications there are obvious. After an extended period of ultra-low interest rates the Fed has been looking to “normalize” rates for a few years now, but even as the job market has continued to improve the lack of inflation has continued to indicate that there was more slack to be taken up. That has led to a more gradual path of hikes than many people envisaged, but if prices are now showing signs of life, hikes will now come faster than before.
What rate hikes there have been so far have not really interrupted the upward path of stocks for one main reason. Each has been accompanied by a statement from the Fed, backed up with all the available data, that the U.S. economy was strong enough to absorb them without breaking stride. That has proven to be the case so far.
Until quite recently, even after twenty-five basis point increases, interest rates have remained at levels that encourage borrowing and investment and make stocks attractive relative to bonds. The market seems to indicate that this changes when the 10-Year T-Note yields above 3%, and any hike from here makes that a virtual certainty.
Still, if growth continues to accelerate, the economy can still handle higher rates. Until very recently, market pricing was on the assumption that this would happen, but a little-publicized data point released this morning made that less likely.
Productivity data doesn’t receive the level of attention given to the GDP growth estimates, but in many ways it is the most important factor that drives those numbers. That is particularly true in the current political environment, where the presidential administration is trying to reduce immigration, legal as well as illegal.
Economic growth comes in one of two ways, either a) more people producing things (population growth), or b) the same number of people producing more things (productivity growth). With no a, b becomes very important and this morning’s data suggest that things are not as rosy as expected.
The 0.7% increase in productivity revealed this morning would normally be a good number, even if it did miss the 0.9% expected. But, without the prospect of immigration to prompt growth and with a labor market that is starting to look stretched, a lot is now invested in expectations of productivity improvement. Any miss therefore becomes a problem.
The stock market has already reacted negatively to this combination. Rising rates without a corresponding rise in growth could easily damage the still fragile U.S. economy, and that is what has been indicated over the last 24 hours. Underlying corporate growth is still good, and ultimately that must be a factor, but for now traders are running scared again and we are back to where discretion is the better part of valor for investors.