- Heightened market anxiety in October was attributable to the same general macro factors affecting markets in recent months, as well as corporate earnings concerns
- The domestic data trend remained solid over the month, including a better than expected initial reading on Q3 GDP
- Inflation pressures appear to be rising, and the Fed is poised to continue with policy normalization for the foreseeable future
October was a tumultuous month for equity markets. Implied volatility for the S&P 500 surged to the highest level since the February market correction, and the index ended the month down 6.8%. The tech sector led the weakness on the month, down 8.0%. The skittishness in risk markets over the last several weeks has been largely attributed to the same macro factors that have dominated headlines for some time now: 1) trade tensions with China, 2) Italian fiscal concerns, 3) hawkish Fed policy, and 4) higher Treasury yields. However, the acceleration of the downturn over the last two weeks of the month was more likely attributable to micro headwinds, more specifically corporate earnings. Third quarter earnings reports, generally disappointing relative to expectations, fueled investor concerns that corporate earnings growth may have finally peaked. Profits were boosted in 2018 by tax reform and fiscal deficit spending, and these tailwinds have more than offset the macro headwinds thus far. However, investors have understood that eventually those tailwinds would subside, and as such, the markets have been hypersensitive to any signs of decelerated earnings growth, which surfaced in October.
Despite general market anxiety, domestic economic growth continues to look solid. The initial estimate of Q3 GDP suggested a 3.5% annualized growth rate over the quarter, 20 basis points (bps) above expectations. Growth was boosted by robust consumer and government spending, expanding at 4.0% and 3.3% rates, respectively. After reducing prior quarter growth by more than 1 percentage point, business inventories expanded in Q3 and added 2 percentage points to the top line growth rate. This would be the biggest contribution from inventories since 2015, and some are suggesting current trade worries contributed to the upside surprise because it coincided with strong growth in imports. In other words, companies perhaps front-loaded imports ahead of scheduled tariff increases and built inventories of various products. This is likely negative for current quarter growth as these inventories subside, but overall fundamentals remain sound.
The Leading Economic Indicators Index reached an 8-year high of 7% year-over-year growth in September. As Exhibit 1 illustrates, that reading is well above the long-term and economic expansion averages of 2.5% and 3.9%, respectively. Of course, this doesn’t imply that these measures can’t turn lower going forward, but we do know that LEI has never been positive during recessions.
The Great Recession officially ended in June 2009, but the shockwaves from the bursting of a credit bubble sparked global deflationary pressures that persisted for much of the last decade. Despite massive amounts of monetary and fiscal stimulus, consumer price growth remained stubbornly subdued below central bank targets for years. In the United States, strong job growth for more than 5 years has tightened the labor market to the point where the headline unemployment rate is now at a 49-year low, and upward wage pressures have finally surfaced in 2018 after many years of stagnation.
A common theme that emerged from Q3 corporate earnings seasons was higher prices. Companies across a broad spectrum of industries discussed the earnings impact of higher costs for the first time in several years. These cost increases included wages, transportation, input costs, tariffs, etc., and companies will be forced to increase pricing to customers in order to maintain profit margins. A Wall Street Journal article on October 31 discussed this topic in more detail. In an interview for the article, Kellogg Co. CEO Steve Cahillane said, “We think 2019 will be more inflationary than we have seen historically since the recession.” The article also highlights recent price increases on certain products from Clorox and Coca-Cola, as well announcements from airlines for planned price hikes. While tighter labor markets are contributing to wage pressures, a stronger dollar and tariffs are primary sources for higher materials cost.
The Path to Restrictive Monetary Policy
With the overall growth trend strong and inflation pressures rising, policymakers are likely to continue with rate hikes and balance sheet reduction for the foreseeable future. As noted in last month’s commentary, the median FOMC participant forecast from the September meeting showed one more rate hike in 2018 and three in 2019. This path would take the fed funds rate above participants’ long-run fed funds forecast, which implies that Fed leaders expect to take the policy rate beyond neutral and into restrictive territory. Generally speaking, central bankers would prefer to err on the side of caution with regards to price stability, even if that means tightening policy to the point at which economic growth is restricted. The trick, of course, is actually knowing the level at which the policy rate will transition among accommodative, neutral, and restrictive territory. This is easier to determine after the fact, and several Fed leaders have openly acknowledged this challenge during speeches following the September FOMC meeting.
Exhibit 2 provides a sampling of these comments, and a common theme is a willingness to move into restrictive territory, as well as uncertainty of the timing and level. It’s particularly worth noting the comment from Fed Chair Powell, who said: “But we’re a long way from neutral at this point, probably [emphasis added].” Regarding the neutral policy rate, Fed Governor John Williams confessed “we don’t really know where that is.” This is a healthy reminder (and refreshing honesty) to not consider Fed guidance to be a firm plan. So long as the economy grows anywhere close to the recent trend, policy tightening should continue even it becomes restrictive to growth (which they don’t know in real time)...
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