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One of media’s chief pastimes in recent years—and particularly in recent weeks, given the hyper-focus on inflation—seems to be speculating about what central banks will do in light of economic data releases. So it was with joy that we relished the massive confusion in the press as it attempted to discern exactly what Britain’s latest unemployment report meant for future BoE actions. Would the slight unemployment rate uptick delay hikes? Or would the higher-than-anticipated wage growth speed them? At times like this, it is worth remembering central banks’ actions cannot be forecast—they are people’s decisions, often biased and opinionated. Bankers decide which data to emphasize and which to downplay; which theories to operate on and which to ignore. Ultimately, the media fixation on what data mean for rate hikes is a sideshow for equity investors—one we hope you tune out.
First, the data. Britain’s unemployment rate ticked up 0.1 percentage point to 4.4% in Q4 2017—an unexpected increase, as economists forecast no change. This is still a very low unemployment rate by historical standards, close to the early 1970s’ record lows. Nevertheless, some economists said this uptick should delay BoE rate hikes, noting it moves Britain’s economy away from the 4.25% unemployment rate the BoE says will spur wage-driven inflation. (More on that concept to come.)
Yet here is the thing: The unemployment rate isn’t simply the percentage of the population out of work. Like America’s, Britain’s unemployment rate is the percentage of unemployed people who sought a job in the previous four weeks. If they didn’t seek work, they aren’t included—these discouraged people fall out of the labor force. In Q4, the unemployment rise wasn’t driven by increasing slack in the labor market. It wasn’t due to firings, layoffs or anything of the sort. Actually, 88,000 more people finished Q4 2017 employed than at its outset.[i] But 109,000 people rejoined the labor force. How, then, will the BoE see this uptick?
Earlier this month, in the wee hours of a Friday morning, President Trump signed into law a bill funding government through September 2019, to the collective relief of many who (oddly, to us) fear government shutdowns. But the bill brought its own worries! Along with funding government, the bill suspended the debt ceiling and boosted spending on defense and non-defense areas. Add this spending to the recent tax cut, and many pros are bemoaning big potential deficits ahead. Some say the Federal deficit will hit $1 trillion by 2019 and comprise 5% of GDP, triggering a cornucopia of related fears. Is this spending package appropriate for an economy close to full employment? Isn’t adding to the national debt unsustainable? Could it inflame inflation and cause the economy to overheat? Will a high deficit late in the economic cycle hinder the government’s ability to combat the next recession? In our view, these worries are misguided—a higher deficit shouldn’t imperil the US economy or derail stocks.
First, history shows high deficits don’t cause recessions or bear markets. Exhibit 1 shows federal surpluses and deficits since fiscal year 1990 with recessions highlighted.
Exhibit 1: US Federal Surpluses and Deficits Since Fiscal Year 1990
When volatility strikes, it can seem like bad news is everywhere. Media hype seemingly big numbers, usually with minus signs attached. At times like this, one of an investor’s most important tools is scaling—putting big numbers in context to see whether they are really so meaningful.
Case in point: When volatility escalated recently, headlines bemoaned the Dow’s “biggest one-day point drop ever.” They blamed volatility products for the swings—calling them the “major driver” of market mayhem. Still others fixated on rising wages’ role in sparking inflation fears behind the swoon. These stories feed into folks’ understandable desire to know what is causing market-moving events, more so if they are “record breaking.” But big numbers without context don’t tell you much.
On That Dow Drop
In the lead-up to today’s US inflation report, headlines declared it a “big test” for markets—if too high, rate hike fears would spike again, potentially “pouring fuel on the fire of last week’s market sell-off.” Sure enough, when the data showed CPI rising 0.5% m/m—more than expected—and bringing the year-over-year inflation rate to 2.1%, S&P 500 futures reversed a 0.5% gain in premarket trading to fall 1.2%. When stocks opened, the S&P 500 initially fell 0.3%. But by mid-morning it was up, and the index finished the day up 1.3%.[i] Seems the report wasn’t so make-or-break after all. This holds an important lesson for investors: Beware of claims any event or report will have a preset market impact—especially in the very short term. Moreover, always remember the longer term is what counts most.
Saying why stocks behaved the way they did on any day is a foolish endeavor, but in this case, it wouldn’t surprise us if bots were programmed to react to the seeming spike, while the humans digested all of the available information, including the many economists who argued the headline spike stemmed mostly from fuel prices and seasonality—not meaningful signs of broadly accelerating prices across the entire economy.
Trying to anticipate markets’ immediate reaction to a scheduled, widely anticipated event (e.g., an election result or data release) is folly. Markets often do what the crowd doesn’t expect. Stocks discount all widely known information, including widely held expectations. Remember when President Trump’s election was supposed to roil markets? S&P 500 futures plummeted overnight and foreign markets tumbled while Americans slept, but when US markets opened, the S&P 500 rose 1.1%.[ii] We’ve also had several instances where stocks defied warnings that Fed rate hikes could bring immediate turmoil. Sometimes it can be almost comical how investors can seemingly shrug at the monster they are told is under the bed and get on with life.
Last Thursday, more than 24 hours of talks between the leaders of Germany’s center-right Christian Democratic Union (CDU) and the center-left Social Democrat Party (SPD) finally yielded a coalition deal, pending SPD party members’ final approval. While coverage focuses on who got which ministries, party leadership drama and what all this means for further European integration, we believe the main takeaway is markets’ continuing to gain clarity about the German political scene. Although it seems Germany will soon have a government again, it likely remains gridlocked—a positive, in our view. As investors move past election-season jitters and appreciate strong eurozone economic fundamentals, we think the region’s stocks should benefit.
In September’s general election, incumbent Chancellor Angela Merkel’s CDU and Bavarian sister party Christian Social Union (CSU) took 35% of seats in the Bundestag (Germany’s parliament). Success! But there was a hitch: No party had a majority, and the SPD said it wouldn’t re-up its “grand coalition” with the CDU. And no wonder—the SPD endured a shellacking in the 2009 election after four years as the CDU’s junior coalition partner. After sitting in opposition during Merkel’s second term (2009 – 2013), the SPD again allied with the CDU in 2013—and then posted its lowest tally since WWII (22%) in 2017’s elections. Presenting yourself as a viable alternative to the dominant party is hard when you helped govern.
Understandably then, it took lots of wrangling and apparent concessions to convince SPD leaders to try it again—Merkel’s Plan B after her attempts to form a coalition with the Free Democrats and Greens failed. In the meantime, Germany broke a postwar record for length of time without a government. But at last the CDU and SPD have a deal. Under it, the SPD would get 6 of 14 cabinet positions—more than expected—among them the coveted Finance Minister spot. As one wag put it, “This is the first SPD government led by a CDU chancellor.” This probably overstates it, but a relatively evenly split coalition between two parties on the cusp of parting ways just months ago is a recipe for gridlock.
Over these last couple weeks, we have seen a couple of telling themes in the media’s reaction to stocks’ sharp pullback. In a sign of how much sentiment has improved in recent years, many agree it is just a flesh wound, as the boys in Monty Python might say—a temporary blip, not the start of a full-blown bear market. Compare that reaction to mid-2013, when everyone thought a “taper tantrum” that began when Ben Bernanke first alluded to winding down quantitative easing would spiral into another financial crisis—even though stocks didn’t even reach correction territory. So that’s nice. Less nice, however, is why many outlets argue stocks should keep doing well. The common refrain? “The economy is still growing! Unemployment is low! Wages are growing! We aren’t in recession!” These are all true statements. But they ignore a key point: Markets look forward, not backward. To assess whether a drop is a correction or a bear market, you can’t rely on backward-looking data.
While it is true that bear markets usually pair with recessions, they generally don’t start simultaneously. Stocks are a leading economic indicator. Bear markets usually begin months before recessions do. See Exhibit 1, which compares bear market and recession start dates since 1926.
Exhibit 1: Bear Markets Usually Begin Well Before Recessions Do
With all the talk of program trading and other computerized forces contributing to last week’s S&P 500 crashes, there is one question we have heard a lot: How can we normal investors even hope to do well in a machine-dominated market? The answer is simple but counterintuitive: by being human, having independent thought and not being forced by programming to overreact to volatility in the blink of an eye.
Those who are paid to overthink volatility on a daily basis universally agree trading algorithms bear at least some blame for big down days on Monday and Thursday. Specifically, they fingered program trading—algorithms forcing big blocks of trades once indexes hit certain levels. As Zachary Karabell explained it at The Washington Post last week:
JPMorgan recently estimated that only 10 percent of stocks are now traded daily by individuals making active choices about what to buy or sell. That figure may be low, but we do know that a large portion of all stocks are owned in relatively new investment vehicles called Exchange-Traded Funds (ETFs) that represent a passive basket of stocks, and that a number of hedge funds are comprised of tens of billions of dollars investing not just in those ETFs, but in derivatives (instruments such as options or futures) that are structured to generate double or triple the returns of those ETFs, or the inverse. Most days, all those baskets and derivatives cancel each other out. But they sit there waiting for days when activity accelerates, pegged to programs that buy and sell based on how quickly prices are moving. The result is a market that is often placid but can take a slight wind and turn it into a selling vortex and then reverse direction and become a buying hurricane.
US stocks officially entered correction territory Thursday, after a late-day selloff drove the S&P 500 down 3.8% on the day.[i] In a mere 9 trading days, the index is down -10.1%.[ii] This is classic correction plunge-from-a-high market movement and, in our view, a time for your brain to set emotion aside and employ cold, logical thinking. Always remember: If you need equity-like returns for some or all of your assets, you need to be in equities the vast majority of the time. Absent a great reason to sell, owning stocks is probably the wisest choice you can make. And, right now, in our view, the things media and talking heads want you to believe are logical sell signals seem like nonsense. Common fears today are almost the inverse of what media and pundits claimed was missing from this bull market not three months ago.
The dominant narrative, as our Elisabeth Dellinger discussed recently, argues inflation is to blame. Wage gains exceeded expectations in January’s report, which some believe will trigger a wage-price spiral. That, to believers, implies much higher than anticipated interest rates ahead—which, media argues, are sure to knock stocks.
Please forgive us if we find this somewhat ironic. Last November, media was jam-packed with arguments that falling interest rates were the problem. Given short-term rate hikes and falling long-term yields, the yield curve was flattening! One bond market bigwig was quoted as claiming this was a recession “red flag.” While we agreed with the focus on the yield curve then, as we wrote, we thought they were overdoing it. Now we’re supposed to fear rising interest rates, even though these reverse that flattening. We know logical consistency is a lot to ask, but this seems ridiculous to us. Either way, it seems to us media and those extrapolating a slight rise in rates much further are likely once again overdoing it.
If sharp pullbacks weren’t so scary, it would be almost funny how investors managed to freak out collectively solely because they all bought into a flawed economic theory that a Nobel Prizewinner debunked 50 years ago. While it probably doesn’t seem like it right now, of all the crazy stories to hit sentiment in recent years, from Chinese stock market circuit breakers (2016) to teeny tiny Greece, the Great Inflation Scare of 2018 is in the running for craziest. Allow me to explain.
Tying price movement over a day or two to any one thing is almost always a foolish endeavor. But nearly everyone was scared of inflation on Friday and Monday. It started with the release of the January jobs report on Friday morning, which showed wages rising 2.9% y/y in the month—one of the fastest in eons. Considering how sluggish wage growth has preoccupied people over the last several years, you would think this would be good news. But apparently it wasn’t, because people believe wage growth drives inflation. If wages could soar before the tax cuts kicked in and really goosed investment and wages, people claimed, then it is only a matter of time before the economy overheats, wages and inflation go through the roof, and the Fed is forced to jack up short rates and end the party.
The problem with this logic is something we’ve explained here many times before: Wages don’t drive inflation. To paraphrase the late, great Milton Friedman, inflation is always and everywhere a monetary phenomenon—too much money chasing too few goods. Your three variables there are the money, the chasing and the goods. Money doesn’t refer to our paychecks. Rather, it refers to the total amount of money sloshing around the system—including anything that reasonably functions as money, like commercial paper, loans and Treasury notes. Unless economic output soars, a higher quantity of money changing hands more quickly will drive prices higher. It is simple supply and demand.
The stock market selloff worsened Monday, when the S&P 500 tumbled 4.1%, its worst day since August 2011.[i] The index is now down -7.8% in price terms since its last all-time high on January 26, just seven trading days ago.[ii] Scary stuff, until you remember bull markets usually die with a whimper, not a bang. While this move hasn’t reached the threshold magnitude yet to earn the moniker, this drop is classic correction stuff, in our view, and likely not the start of a bear market. We think the wisest move now is to sit tight, lest you sell after a drop and get whipsawed by the recovery.
As a refresher, corrections are sharp, quick, sentiment-driven declines of -10% to -20% or so. They start suddenly and usually end equally quickly, with further gains on the other side. Bear markets, by contrast, are deeper (-20% or worse), longer and have identifiable fundamental causes. Corrections are fleeting and a normal part of any bull market. They help keep sentiment in check, preventing stocks from overheating and helping extend the bull’s lifespan. They aren’t possible to predict or time repeatedly, so enduring them is the toll we all pay for bull markets’ stellar longer-term returns. It is possible to navigate bear markets and cut out a chunk of the downside if you can spot one early enough.
Big down days like Monday do happen during bear markets, but usually not at the beginning. Bear markets usually roll over gradually, lulling investors into complacency with a gentle decline. The average monthly decline of a bear market is around -2% to -3%, with declines escalating at the end due to negative compounding. Those tame early declines suck people in, throwing more and more money at what they see as buying opportunities—they focus only on price movement, without looking at forward-looking fundamental indicators. They don’t announce themselves with steep early drops—if they did, they wouldn’t lure people back. Yet big down days during bull markets aren’t uncommon, either. Monday’s drop was the 10th of -3.5% or worse during this bull market alone.[iii] It wasn’t as extraordinary as you might think.