“The market is way ahead of itself.”
“Company earnings don’t justify stock prices.”
“Rampant inflation and higher interest rates will torpedo the markets.”
I could list a half dozen more reasons why the bears believe that the markets should not be at these levels. Yet, in my opinion they are going higher.
The first quarter has ended and once again investors “bought the dip” and profited from doing so. The macroeconomic numbers, while fluctuating week to week, show a definite uptrend whether you are looking at retail sales, housing, manufacturing, exports or global growth. Even the nemesis of this recovery, the unemployment rate, appears to be stalling out, although at a high number.
Twenty two states have officially entered recovery and more are on their way. Americans are spending money on things they need, and sometimes, on things they don’t need, if the price is right. When the recession hit, manufacturers were quick to slash inventories as consumers went on a buying strike; but now I expect companies will begin re-stocking those shelves. Manufacturing inventories have risen four out of the last five months and I’m betting that trend will continue.
All of this positive economic news, however, brings the inevitable day of reckoning closer. Unfortunately, you can’t have recovery without rising interest rates. It’s one of those fundamental tenets of the markets and that’s what has many investors worried, especially in the bond market. Despite the assurances from Federal Reserve Chairman Ben Bernanke that interest rates will remain low for the foreseeable future, pressure to raise rates increases as the recovery strengthens. The Fed knows it. Investors know it and now you know it.
But not all interest rates are equal. For example, The Fed stopped buying mortgage-backed securities this week. As a result, mortgage rates are beginning to creep higher. Last week’s auction of several issues of U.S. Treasury bonds saw a distinct decline in interest from buyers. This led some bond vigilantes to begin selling bonds and, as a result, interest rates of most Treasuries rose substantially.
Clearly, if economic growth explodes then the Fed will be forced to raise rates sooner than later in order to head off inflation. I don’t see that kind of growth. Instead, I expect measured growth, somewhat slower than the usual recovery cycle. Our official forecast here at Berkshire Money Management is 2% growth in the first half of this year and 2.5% in the second half. That will keep the rate of unemployment “sticky” and, in my opinion, the Fed will do everything in their power to keep the monetary environment friendly to job growth while heading off the threat of incipient inflation in other ways.
For example, the Fed can, at the very least, stop buying bonds (like mortgage-backed securities this week), which will nudge up the rates sellers of this kind of debt will have to pay in order to get loans from investors. The Fed can also sell Treasury debt to investors for cash and literally burn the proceeds, thereby taking money out of circulation. Remember, the simple definition of inflation is too much money chasing too few goods.
“But all that money the government dumped into the markets has to cause inflation down the road,” argues a Stockbridge client just recently returned from his winter retreat in Florida.
“Not necessarily,” I argued.
We forget that by the first quarter of last year an estimated $20 trillion of American household wealth had disappeared in the market crash and housing debacle. Since then the financial markets have regained some of that lost wealth for investors but not so in the housing markets. In contrast, the government’s money pumping operations amounted to nowhere near $20 trillion. So we are still facing deflationary forces rather than inflationary pressure.
If the Fed does nothing in the years to come and the economy rebounds strongly then inflation will become a problem. Given the almost daily discussions policy makers and the Federal Reserve are having over interest rates, I think the greater danger is that we err on the side of tightening too soon.
In the meantime, enjoy the Easter weekend, and stay invested.