A Compelling Case For The Fed To Defer Rate Hikes — Good For Stocks

October, 2016
S&P 500: 2168

OUTLOOK MEMORANDUM
A Compelling Case For The Fed To Defer Rate Hikes – Good For Stocks

The Fed seems intent on raising its benchmark Fed Funds rate based on our economy’s having approached its non-inflationary potential, the unemployment rate having dropped to an historically low 4.9% level, and upturns in both wage and core CPI inflation. But, throughout this year, it has found reasons to defer the next rate hike reflecting a heated debate among economists and investors. Those favoring a hike emphasize the shrinking economic slack and the upturn in inflation. Those who think rates are at an appropriate level and should not be raised point to the low 4% level of nominal GDP growth, the historical relationship that normally would have interest rates several percentage points below this depressed GDP growth rate, and their expectation that nominal GDP growth is likely to continue at 3.5-4.0%. They also see evidence of more slack in the economy than do the proponents of rate hikes. Thus, they think lifting rates is unnecessary and risky. While our traditional slack-based tools indicate that the Fed should raise rates, we currently find the arguments of those opposed to rate hikes more compelling. If the Fed continues to proceed cautiously, we think it might be 2019-2020 before liquidity becomes sufficiently tight to cause a recession. This would keep the fundamental environment for stocks positive for another few years, especially with the earnings headwinds of the 2014-2015 oil price crash and dollar strength diminishing over the coming quarters. With bond yields likely to rise, long-term bonds appear risky, especially since foreign central banks have begun selling their US Treasury bonds.

While the current economic and market environments differ in some important ways from those that have characterized most of the post-World War II period, the development of this long recovery from the 2007-2009 financial crisis has followed the normal liquidity-cycle script. As the Fed pumped huge amounts of liquidity (i.e., money and credit) into the economy in 2009 and financial markets resumed functioning, first the stock market, and then the economy, began to recover. This massive inflow of liquidity continued for about two years, and since then, liquidity has been eroding gradually as the Fed ceased its massive bond purchases and the demand for credit has accelerated. It is important to recall that economic cycles do not die of “old age”; recessions result when the Fed, or a financial crisis, denies sufficient liquidity to the economy. As we will explain shortly, with the Fed having begun to raise short-term interest rates last December after more than seven years of monetary ease, we have entered a later stage of this liquidity cycle. Yet, we think that if the Fed continues to proceed cautiously, there still are likely to be several years left in this cycle, with meaningful upside remaining in the current bull market for stocks. In baseball terms, we think we are in the seventh inning of this game. Our focus in this Outlook is to explain why we think the Fed needs to be very careful in raising interest rates in the current unusual environment.

Where do we stand in the current liquidity cycle? The chart below shows our Alexandria Capital Liquidity Index that measures the availability of money and credit in the US economy going back to 1965. It indicates that liquidity always has been extremely high following recessions (the shaded periods) as the Fed tried to boost economic activity and the demand for credit was low. Then, about a year or two into each cycle, liquidity begins to decline. In recent cycles, our index has fallen to 100 shortly after the Fed has begun to raise interest rates, indicated in the chart by the black arrows. It is important to note that the deterioration in liquidity historically has not been sufficient to cause a recession until after our index has fallen below 98 (horizontal red line). In addition, it has taken about 18 months of liquidity below 98 to cause recessions in the past.

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Currently, nine months after the Fed began to raise its benchmark fed funds rate, our index is just above 100. If the Fed continues to proceed carefully, it could take more than two years before the index declines below 98. If so, and with normal lags, the next recession may not occur for another 3-4 years. Since bull markets historically have peaked about 6-12 months before recessions, the bull market may last for another 2-3 years. Certainly, the recent new high for this cycle in the Index of Leading Economic Indicators (next chart) signals that the economic expansion is likely to continue over the coming year. With a growing economy and with the recent earnings headwinds of declining oil prices and the strong dollar diminishing, S&P500 earnings growth is forecast to increase to about 13% over the coming year. Such an environment should be supportive of further gains in stock prices.

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A debate has been raging about whether the Fed should be raising interest rates. At the start of this year, following the Fed’s much- delayed initial rate hike in December, many expected 3-4 more hikes to occur in 2016. They thought such hikes were necessary to keep inflation under control, but others viewed them as representing a major potential policy error for the Fed. At each of its meetings this year, the Fed’s Open Market Committee has found reasons to defer, but now is strongly suggesting that it will raise rates again in December.

Those in favor of Fed rate hikes generally do so based on “gap” measures of economic slack. This is an approach we have employed for many years in anticipating Fed policy changes. This concept is that, at any time, our economy has a given potential to produce goods and services without overheating and setting off inflation. This non-inflation potential is a function of the size of our labor force, the average number of hours each employee works each week, and the productivity (hourly output) of each worker. When the economy is operating at a rate below its potential, then inflationary pressures are muted. But, when it gets close to its potential, or rises above it, inflation generally begins to accelerate.

Historically, the Fed has begun to tighten monetary policy as the economy approaches its potential in an effort to keep it from overheating and inflation from worsening.

This is shown in the top line of the chart below. The blue line, read off of the left axis, is the percent that reported GDP represented of our estimate of the economy’s potential each quarter since 1973. The chart shows that the Fed historically has begun to raise interest rates (the black arrows) when the economy has reached about 99% of our estimate of its potential (the red dotted line). This pattern has been repeated again in the current cycle as shown at the right side of the chart. The green line in the chart is the 12-month increase in the Core Consumer Price Index (right scale). Advocates of Fed tightening note that with our economy having recovered close to its potential and with core inflation having risen to 2.3% from 1.8% a year ago, additional Fed rate hikes now are appropriate.

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In addition, they point to labor markets having tightened, with the unemployment rate having fallen over the past year to 4.9% from 5.3% a year ago, and wage inflation having accelerated to 2.8% this year from 2.3% a year ago.

Those who support Fed tightening also argue that interest rates near 0% are distorting the economy. They see “cheap” money as creating “bubbles” of speculation in the real estate and bond markets, as well as damaging savers and those who are retired. Finally, they argue that the Fed needs to raise rates back toward more normal levels so that it has “ammunition” to counter the next recession by lowering rates.

Those opposed to significant Fed rate hikes say very low rates are appropriate in the current low-growth environment. Historically, there has been a fairly close relationship in our economy between nominal GDP growth rates (i.e. real growth plus inflation) and the level of interest rates. This means that if our economy is growing at a 5% rate, interest rates will be near 5%. The chart below shows this for the period since 1952, smoothing out short-term variations by using 5-year moving averages for each of the three series. Nominal GDP growth is shown in red, the Fed Funds rate in green, and the long-term US Government bond yield in blue. Clearly, they have moved together over this long period.

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Note, however, that interest rates frequently have been about two percentage points below the nominal GDP growth rate, except during the period of the late-1980s and early-1990s when 5-year GDP growth rates were unusually high. At its right side, the chart also shows that nominal GDP growth has been historically low and below 4% for the past nine years (red line), and that the Fed Funds rate has been close to 0%.

Opponents of significant increases in the Fed Funds rate argue that nominal GDP growth is likely to remain below 4% during the years ahead, and that continued low Fed Funds and bond yields thus are appropriate. They feel that attempts by the Fed to raise rates will significantly damage the economy.

Nominal GDP growth is expected to remain low reflecting ongoing sub-par labor force and worker productivity growth. Historically, the US has enjoyed labor force growth averaging about 1.5% per year and productivity growth of about 2% that combined with 2-3% inflation to give us 5-6% nominal GDP growth. But, with the baby-boomers retiring, annual labor force growth has slowed and is forecast to average only about 0.5% per year over the next ten years. Productivity growth also has averaged only 0.5% over the past six years. While the sharp decline in productivity growth is not well understood, experts think we will be lucky to average 1% annually over the years ahead instead of the more normal 2%. Combining these labor force and productivity forecasts gives us an annual real growth forecast of 1.5% for the years ahead (0.5% + 1.0% = 1.5%). If inflation averages 2.0-2.5%, then nominal GDP growth would average 3.5-4.0% (1.5% + 2.0% = 3.5%). Given past relationships, and if interest rates continue to be below the GDP nominal growth rate, opponents of Fed rate hikes argue that in such a low nominal growth environment, the Fed Funds rate should continue to be close to 0% and US Treasury bond yields should remain in a 2-4% range.

They also say that the unemployment rate is overstating the degree of tightness in labor markets due to retiring boomers, pointing to the historically low percentage of 25-54 year olds that currently are employed. While they acknowledge that wage inflation accelerated last year, they note that both wage inflation and core inflation rates have stabilized this year. “So, what’s the rush to raise rates?” they ask.

We think the Fed will raise rates over the next year, but they will do so very gradually. Our traditional tools point to the need for a series of Fed rate hikes over the coming year. But, with both labor force and productivity gains likely to remain below historical levels over the next few years, it is difficult to see nominal GDP growth exceeding 4%. Thus, while the odds are high that the Fed will raise the Fed Funds rate by 0.25% before yearend, we conclude that the Fed Funds rate should remain below 2% over the next two years, and US Treasury bond yields will likely stay below 4%. The main risk to the bond portion of this outlook is that major foreign central banks (e.g. China and Japan) have begun selling some of their US Treasury bonds this year, and may continue to do so. If the annual US deficit increases as forecast, and if the US public slows its flow of money into bond funds, long-term bond yields could increase faster than this analysis suggests.

A cautious Fed is bullish for stocks. At the start of this discussion we noted that our Liquidity Index, though down from its peak levels in 2009-2010, still is at 100, significantly above the 98 level that always has preceded recessions by more than a year. If the Fed is likely to proceed very slowly in raising its Fed Funds rate, then it may take two years or more for Liquidity to deteriorate to a troublesome level below 98 on our index. If it again takes about 18 months of depressed liquidity to trigger the next recession, the current economic recovery may last for another 3-4 years and the bull market for stocks could last for another 2-3 years. On the other hand, this analysis also suggests that if the Fed chooses to raise the Fed Funds rate aggressively to more than 2% over the next 1-2 years, this could drop our Liquidity Index below 98 by late 2018 and bring the economic recovery and the bull market for stocks to an end by early 2019. Consequently, investors are likely to continue watching the Fed closely. There are Fed policy meetings every six weeks, and with the Fed seemingly intent on raising rates, we can expect the markets to continue nervously anticipating the decisions resulting from each of these meetings.