Nicholas Colas is chief market strategist at brokerage ConvergEx Group. Previously he worked in equity research at Rochdale Securities and investment bank Credit Suisse First Boston.
Harlan Levy: What's behind the apparent disconnect between the extremely sluggish, slowing U.S. economy and the booming stock market?
Nick Colas: The stock market continues to remain quite high while the U.S. economy seems to be in slow-growth mode.
The connection is interest rates, because, as expectations of global growth have come down, global interest rates have come down. That has pulled the U.S. yield curve down with that move, and with low interest rates comes support for high stock valuations. That's just math. The lower the global interest rate picture, the more valuable future cash flows are, and that's how you value equities. That's the connection point.
Q: What do you think of stocks and where they're headed?
A: It's a real tug of war. On the one hand you've got very low interest rates, and that's supportive of stock valuations. People tend to forget that when they look at P/E ratios that interest rates are a primary input into stock valuations, and the lower interest rates go, the more supportive they are of high valuations, uncomfortably high valuations given history. But we've not had this term structure of interest rates in history, either, so we're going to see very high valuations simply because rates are so low.
On the other side of the rope, you have fundamentals that are good but not growing. You're not seeing revenue growth. You're not seeing margin growth, and the best use that many companies can think of for their cash is to buy back their stock rather than grow their businesses.
So on the one hand you have stagnant earnings and on the other hand continuing low rates that are supportive of stock valuations. It doesn't make for great returns, and it does make the system fairly fragile and vulnerable to shocks, because you don't have any earnings growth to point to. But it doesn't in the near term indicate there's anything wrong with valuations.
Q: Do you expect a serious correction up ahead?
A: There are a lot of catalysts over the next two weeks. We have the Brexit vote on Thursday. On the same day we have the Federal Reserve's stress tests of the 33 banks that they review this year. Invariably, one or two banks could be put in the penalty box as a result.
We also have the Russell index rebalance on Friday, which is typically the heaviest trading volume (insert day) of the year.
And then we have the Fed's annual capital review on large banks, which blesses or questions their plans for stock repurchases, dividends, and potential acquisitions. That's the second leg of the Fed's stress tests, and both happen before the end of the month.
We also have chair Yellen's testimony before Congress, and the markets are clearly looking for more information about how she thinks about rates short- and long-term.
So we have a lot of points of volatility coming before the end of the second quarter, none of which individually are unexpected. But when you have that many events, the markets' reactions can be a bit volatile.
For the rest of the year I see stocks basically plodding along, but with more volatility than we've seen over the past number of years, simply because valuations are so dependent on interest rates and continued reasonable economic growth.
If you get shocks to interest rates or any exogenous shocks they'll create more volatility than we've seen recently.
Q: But are stocks going to avoid any serious correction or collapse?
A: Big corrections are caused by unforeseen events. Excluding that, because there's a whole range of issues, like the presidential election and global geopolitics that can always create a one-off event that tanks stocks, which is always a risk, fundamentally, the direction of interest rates still seems to be lower, and with that as a backdrop, stocks are still a relatively asset class, simply because rates are still declining.
Q: What sectors do you like and which ones don't you like?
A: Utilities have been a very strong sector for the first half of the year as rates decline, and they should still be fine in the second half, because rates will still be lower.
The other areas we include energy, because there clearly has been a rebound in oil prices, and the energy sector was so beaten up that it still has some room to run.
Big-cap technology, technology generally has been at best a market performer this year and will continue to be so. Technology, the biggest single sector in the S&P 500, tends to be a slightly riskier and slightly higher-return sector over time and trades with a little more volatility and a little more return than the market as a whole, and since we're only modestly positive on U.S. equities, it's hard to see tech as a real outperformer.
Financials, even after all these years of underperformance are still in the penalty box.
Q: Where do you think the Fed is going to go, since it apparently does not know what to do?
A: There were two things that came out of the Fed last week and chair Yellen's press conference afterward.
The first was near-term, which is that the Fed doesn't seem inclined to raise interest rates any time soon. The low May jobs number spooked them, and they're in a wait-and-see mode. We'll hear more this week, because Yellen is speaking in front of Congress in her annual testimony, so we'll have another bite of that apple to hear what she and the Fed are thinking.
The longer-term issue is that the Fed seems to have reduced its expectations of structural Fed funds rates and is taking them down, because they're worried about secular stagnation. "New normal" job growth is slower, and inflation is slower, and therefore rates have to be lower for much, much longer.
The market already understood the first issue and is now grappling with the second.
Q: When do you expect a rate hike?
A: I take my lead from the Fed fund futures markets, which have had a better call on the rate cycle this year than any Fed speaker and any Wall Street economist. The Fed funds futures markets say no rate increase this year.
Q: Is the central banks' experiment with very low interest rates starting to have negative, unintended consequences?
A: Yes. The most important one in the global experiment with negative rates in Europe and Japan and low rates in the U.S. is that it does seem to fray market confidence, because the effects of those low rates are not getting very visible real results in the real economy in the developed world. This feeds the narrative that central banks are losing their influence, their power, and their credibility with global markets.
You see this in all kinds of ways. For instance, while the Fed said last week that the most likely path of interest rates is at least one, more likely two rate hikes this year, the Fed funds futures market is not factoring in a rate increase until 2017 at the earliest.
Q: The situation seems fragile, and I'm wondering about Japan-style deflation hitting the U.S. What do you think?
A: It is absolutely fragile. Deflation in the U.S. doesn't seem to be a problem, mainly because housing prices are a primary input into the Consumer Price Index, and rents are definitely increasing. For the U.S. deflation is not a near-term threat. It is still a worry in Europe and Japan, which is why you see central banks there going to quantitative easing and trying to spark some level of inflation, because they are worried about deflation.
It does have a spillover effect in terms of global interest rates, including ours, which is why the U.S, 10-year is currently yielding 1.6 percent, an extraordinary rate, given that U.S. inflation is probably trending closer to 2 percent. A negative real rate on the 10-year is surprising.
Q: Do you the 10-year rate will ever get beyond 2.5 to 3 percent?
A: Getting to that level is at best a very long-term trend. It's extraordinary to think where rates were before the 2008 financial crisis and where they are now and how the psychology has shifted. When you think about long-term issues you have to think about demographics, growth rates of populations, which are poor in Europe and outright bad in Japan and only OK in the U.S. So it seems unlikely that we'll see Fed funds rates at 3 percent over the next five to 10 years.
Growth rates of populations are an underappreciated factor in long-term economic growth, because the faster your population grows, if everything else is equal, the more your economy is going to grow. Gross Domestic Product growth is basically population growth plus productivity plus inflation.
Q: What's your prediction for growth this year and beyond?
A: It looks like after a very slow first quarter we're getting a bit of a bounce in the second quarter, and 2 to 2.5 percent is a realistic expectation for second-quarter GDP growth.
The balance of the year could be a little weaker, because job growth has slowed. So something on the low end of that range, 2 percent growth for the third and fourth quarter. It seems like the Fed's conversation last week pointed to something along the same lines for 2017.
Q: What do you think of manufacturing, with the recent poor reports and inventories growing?
A: The recent weaker trends in the industrial economy feeds the narrative that many investors worry about: that we're nearer to a peak than a trough. Business cycles being what they are, investors are very aware that we're many years into a recovery, and it's rash not to expect a drop-off at this point. Those numbers need to rebound in order to re-instill some confidence that we're not at the end of the cycle.
Q: What do you think about jobs?
A: Were going to continue to see weakness in the jobs market for the second half of the year, not job losses, just very slow job gains. The critical factor here is that it's a tale of two labor markets. One market is highly skilled workers in demand. That market is basically at full employment. If you have a college degree or a technical degree. If you're a computer programmer. If you are a college-educated worker, your employment picture is excellent. You see wage gains, and you're in high demand,
The other half of the market with less education, particularly those with only a high school education, that market is not really growing. Those workers don't have the skills that many employers demand, so there's a heavy dose of stagnation in that market.
Q: What do you think of what former Fed member Richard calls "fiscal fecklessness," the inability of Congress to do anything?
A: For the near term, it's the status quo, the same as we've had for the past eight years. The market already understands that and has factored it in, so from the capital markets' standpoint it's not really relevant.
The issue is that it puts the entire load for economic stimulus on the Fed. The same thing holds true for Europe, where central bankers are carrying the full load of trying to spark growth, and demand for austerity is retarding that growth on the fiscal side. So as long as central banks are as accommodating as they are, you're not going to see the pressure for fiscal stimulus. It's going to be entirely monetary, so to some extent central bankers are enablers of bad fiscal policy.
Q: What kinds of serious structural reforms are needed?
A: In this nation the two most important are, first, corporate tax reform, because U.S. corporations' nominal rates are quite high relative to the rest of the world. Reducing those and simplifying the corporate tax structure would be beneficial to U.S. economic growth.
The second one would be much more attentive regulation on global tax evasion. If the Panama Papers taught us anything, it's that there's a whole strata of global wealth that is at best case actively legally avoiding a lot of taxes, and we should close those loopholes.
Or they're illegally evading taxes, in which case they should be prosecuted.
The missing piece of the discussion about the global 1 percent of wealth holders is that if you simply collected the appropriate amount of tax that as current regulations would demand you would begin to free up some capital for the fiscal stimulus everyone wants to see happen.
Q: What are the chances of that?
A: It's a number that asymptotically approaches zero.
Q: Finally, with all the shocks the world has suffered are you optimistic at all?
A: What makes that hard to analyze is when you look at where we are in history, now coming up on 10 years from the global financial crisis, that crisis and recession and the global impact has had very long-lasting effects on voter psychology and consumer psychology and makes the system more brittle than what we saw in the 1980s or 1990s, which in retrospect feel like a much happier and simpler time.
There's nothing on the horizon that I can say is a very negative development. But we have to be aware that things that don't seem like a big deal can turn into a big deal much more quickly simply because the system is not structurally as strong as it was 15 years ago.
There's a very strong and lingering sense of unease about all the basic structures that underpin society. You see it in government and politics. That Donald Trump is the Republican nominee is a symbol of that brittleness. There's also a concern about how much central banks can really affect outcomes.