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By most measures, there is great strength in the economy at the moment, due in part to government stimulus measures, of tax cuts and increased government spending. The U.S. GDP grew at 3.2% in the first half of 2018. U.S. corporates earned record high profits in the first two quarters of 2018. For the third quarter, total earnings of S&P 500 companies are likely to be up by 17.8% on 7.1% higher revenues.

The unemployment rate has dropped to 3.7 percent, the lowest rate since December 1969, and it is likely to fall even further. For close to two-thirds of the US population, this is the lowest unemployment rate in their lifetime.
Leading indicators, manufacturing indices, CEO confidence, and consumer confidence are all indicating that the U.S. economy is robust.

So why has there just been a brutal week-long pullback in stocks?

The number one fear among investors is that the Federal Reserve will tighten interest rates too much or too quickly. The second greatest fear is that a trade war with China will hurt American GDP.

The first point is exacerbated by the fact that short term and long term interest rates are both rising.
The market worries about higher interest rates because they are perceived to drive up costs for corporations and consumers. Higher rates also create investment opportunities in the bond market that might siphon investments away from stocks. And higher rates can impact stock prices because of the way that stocks are valued (discounting future dividend flows with a higher interest rate gives a lower present value of an investment).
In the case of short term interest rates, this is nothing new. The Fed pre-announces where it sees interest rates going on its “dot-plot”, giving the market a range of where it sees rates in the future, and nothing has changed in this regard. The last Fed interest rate hike, on September 26th, was completely expected.
Long term interest rates, as measured by the 10 year US government bond, have also risen, which is perhaps a more interesting story. At the end of last year, ten year bond yields were at 2.40%, now, they are 3.15%, a seven year high.
This past week 30 year mortgages hit 5%, vs. the 3-4% range they have traded in for the past eight years.
With these rates a full percentage point higher than they were a year ago, that adds $200 per month to a monthly mortgage payment on a $300,000 loan.
The housing market and housing industry is one clear loser from higher rates. Another is automobiles, where zero percent financing is now a thing of the past. Ford announced an 11% drop in its monthly sales for September.
Another worry is the absolute amount of debt in the economy, and the strain that higher rates put on servicing that debt. Compared to the last three decades, corporate credit quality is much weaker than at previous credit cycle peaks such as 2000 and 2007. Fifty-six percent of all corporate bond issuers are speculative grade (junk), compared with 49% in 2009.

Rising rates are coming from several factors apart from the Federal Reserve raising short term rates:

1) The Fed is also draining liquidity from the economy by letting $50 billion of its bond holdings mature every month. That takes money out of the economic system, but it also means that the U.S. Treasury must find new buyers for its bonds, particularly because the government tax cuts added $2 trillion to the budget deficit which must now be financed. Without the Federal Reserve keeping long term bond prices artificially low, rates are rising and long bond prices are falling.

2) Inflation is bad for bond prices, and perceptions over inflation have changed. Inflation is composed of wages and prices. With unemployment so low, wage growth acceleration is now a certainty, which will force businesses to raise prices. Wages are currently growing at 3%. Furthermore, tariffs cause prices to rise due to higher input costs. Tariffs can be considered a tax paid by American consumers in the form of higher prices. Also, if tariffs cause production of goods to relocate back to the U.S., it puts even more upward pressure on wages.

3) The Federal deficit is exploding, and with higher interest rates, the government will be obliged to spend far more servicing the U.S. debt. A few years ago, the U.S. budget deficit was $600 billion. For this year, it will be $900 billion. To some though, that number is more like $1.5 trillion if we include loans made to the US Social Security system, federal pension benefits, and veteran benefits. Deficits are financed with an equivalent amount of new bond issuance, making bond prices go lower and bond yields go upqqq. This is when the economy is doing well, and there should be surpluses to stow away for any bad times ahead. The debt-to-GDP ratio in the United States is now at 105.4%. Meanwhile, over $10 trillion of corporate debt will be maturing over the next five years. Political antagonism directed toward other nations that have traditionally bought our debt does not help to absorb this.

To prevent inflation, the Fed has to raise interest rates pre-emptively, before inflation becomes a problem. Right now, the Fed indicates on its “dot-plot” map that we will have one more rate hike this year, three more next year, and one more in 2020.

However, the market does not believe that. The futures market is looking for one more rate hike before the end of the year, two more next year, and then is predicting that rates will stay unchanged, at around 3.25%, for the following six years after.

The background of monetary policy worldwide is becoming less accommodative, which provides a headwind for risk assets, like stocks. Higher rates, along with the Fed draining liquidity out of the economy, is not perceived as good. Nonetheless, all of this is known, and built into bond prices.

Generally, bear markets do not begin until an economic cycle ends. At present, real interest rates, (i.e. interest rates minus inflation) are still close to zero, which is too low to put an end to the current economic cycle…..yet.

But there are storm clouds forming on the near horizon. Stocks have gone up because the Fed bought some $4 trillion in securities over the past ten years. Now the Fed has begun selling those securities, as interest rates rise, as earnings have peaked, as oil continues climbing in price, and as inflationary pressures begin appearing.

Growth outside the U.S. is decelerating, corroborated with global freight volumes declining since early 2017. Emerging markets have huge debts as well, many denominated in dollars, and the strong dollar makes it difficult to pay them back. To give an idea of how emerging market debt has grown, emerging market debt, including China, has grown from $9 trillion in 2002 to $63 trillion in 2017, according to the International Institute of Finance. Some $21 trillion was added to the global debt mountain in 2017, bringing it now to an all-time high of $237 trillion worldwide.
This summer, emerging markets were roiled by Turkey and Argentina, whose currencies lost 40% and 50% respectively of their value. The MSCI Emerging markets index is down some 15% in 2018.

The midterm elections are not likely to have a major market impact unless the democrats take both the House and the Senate, which is unlikely. However, the Mohammed Bin Saud affair is worth watching because it represents a crossroads of an outraged international public vs. a corrupt regime that wields great power over oil prices. The U.S. government has, so far, successfully ignored the situation. But the American Congress is increasingly likely to act on this horrific event, with or without the President of the U.S.
They might impose sanctions on Saudi Arabia, deny any further arms sales to them, and allow U.S. victims to sue Saudi Arabia for any collusion in the September 11, 2001 attacks.
Saudi Arabia, retaliating against any US sanctions, may “weaponize” its oil production. It has already issued such a threat, emphasizing its “vital role in the global economy” and warning that “any action would be met with 'greater action”.

The “action” in question would mean a severely reduced oil supply, causing oil prices to spike significantly, which isn’t good for risky assets like stocks.

In Europe there are great worries over the Italian populist coalition’s budget, which puts Italy on a collision course with Brussels. Italy wants to increase its deficit from 1.8 percent to 2.4 percent of GDP, while Brussels insists that this violates EU fiscal rules designed to protect the Eurozone. The great fear over Italy is that it is looking increasingly like Greece, and serving as a platform of anti-Euro and anti-Europe sentiment. Italy’s €2.3 trillion public debt, one of the world’s largest, makes the country vulnerable as selling programs dump Italian bonds and investors worry over contagion for a potential Eurozone financial crash. This risk should not be under-estimated.

There are fears Italy’s €2.3 trillion public debt, one of the world’s largest, makes the country vulnerable to and risks acting as a contagion for a potential Eurozone financial crash.

The Dow rose 7% through the end of the third quarter, while the S&P 500 was up 8.9%.

Grant Rogers

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