January 11, 2019 Market Report - 2018: A Tug-of-War Between Economic Indicators

The markets are struggling with mixed interpretations of our current economic indicators.  The Federal Reserve has eight major categories of economic indicators. They are: Gross Domestic Product (GDP), Households, Investment, Trade, Manufacturing, Labor, Inflation and Monetary Policy & Financial Markets.  Each indicator has subsets of data  which the stock and bond markets view with varying importance.

2018 was a perfect storm of economic indicators telling us that the U.S. economy is as strong as it has ever been.  After years of sluggishness, this economic strength led the markets forward in 2017.  Last year, the concern was that the economy was growing too fast and thus creating an inflationary environment that makes everyday products more expensive.  To combat inflation, the Federal Reserve, (The Fed), may raise the Federal Funds Rate. This is an overnight interest rate that banks use to lend each other money in order to maintain a certain level of cash reserves.  The Federal Funds Rate does not have a direct and immediate impact on the markets and interest rates, but it does have significant influence.

So why worry about inflation?  As with any economy, the answer always lies within supply and demand.  Let’s simplistically look at wages and inflation.  When the economy is very strong, we have more people working which may create a shortage of workers.  If the supply of workers is low than employers must raise wages to keep or attract employees.  When wages are higher, employees will buy more products which increases their demand.  Since the employer must pay higher wages, they must raise their prices, hence inflation.  The fear is that this cycle of higher wages and higher prices starts to spiral out of control.  A core mission of The Fed is to maintain stable prices.

After keeping rates at near zero since 2008, The Fed raised rates three times in 2017 and four times in 2018.  The last rate hike in December triggered the worst December market sell-off since the Great Depression.  The fear is that The Fed may be stopping the economy rather than slowing it and creating the opposite problem of a Recession or a shrinking economy.  

An example of the is that while mortgage rates currently remain historically low, should they begin to rise, many consumers who were considering purchasing a home may find the added burden of a higher interest rate too much.  They may buy a smaller home or not purchase a home at all.  A new home builder, re-modelers, building suppliers, home improvement stores, flooring, windows, furniture and all associated with the purchase of a home will see a slowdown in business which would slow hiring or causes layoffs.

Our economic data is at a crossroads and policy decisions carry more weight.  The stock and bond markets are “leading” economic indicators that tend to anticipate future trends.  Our high level of economic growth, which has been a rarity since the Tech Boom of the late 1990’s, coupled with an increasingly active Federal Reserve is creating conflicting messages about where to allocate assets.

Ultimately, this is the unknown facing the markets – Inflation or Recession.  Ideally, the economy finds the right balance and continues to grow in a consistent manner.  It is key to remember that over the long-term, volatility is an essential part of the markets and our portfolios, however it can be unsettling in the short-term.