Last year, 2018, the Federal Reserve changed course and, as a consequence, the stock market changed course.
For much of the period, beginning with the turnaround from the Great Recession, up until late 2017, the Federal Reserve was intent upon underwriting the economic recovery by creating a wealth effect to buoy consumer spending. The Fed also positioned itself to err on the side of too much monetary ease so as to avoid any unfortunate disruptions to the financial sector.
The Federal Reserve pretty much achieved its objective. The economic recovery will reach its tenth anniversary this summer and the financial sector recovered without any disconnections.
At the end of 2017 and into the early months of 2018, there was an adjustment in the Fed’s focus. Some of this came as a natural outcome of the lengthy expansion, some of it came from the changing of the guard at the Fed with Jerome Powell taking over from Janet Yellen as the Fed’s chair, and some of it came from an effort on the part of the President and the US Congress to produce a more active fiscal on the part of the federal government.
The mood change from these differences resulted in a much more volatile stock market and a feeling that the steady hand of the Federal Reserve was focused somewhere other than the US consumer. Emphasis switched to watching business capital investment due to the tax reform act passed in December 2017.
Thus, you had the S&P 500 stock index rise from around 720 in March 2009, just a few months before the bottom of the Great Recession, to around 2,870 in January 2018. From January 2018, the growth trend ceased.
The March 2009 period though January 2018 was a “boom time” for passive investment vehicles as more and more money was transferred to these offerings to “ride out” the overall upward movement of the market. It was a time that Jack Bogle, the inventor of the passive investment vehicle and who just passed away, basked in the knowledge of how popular the passive funds had become.
But, 2018 was different. The environment changed. The Federal Reserve was working through its efforts to raise short-term interest rates and to reduce the size of its securities portfolio.
The market had to deal with what these changes meant and how it might impact the future.
Furthermore, expectations about future growth rates seemed to be dominated by supply-side factors, both in the United States and elsewhere. This scenario is captured in the forecasts that have been produced by the Federal Reserve System.
After a 3.0 percent rate of growth for 2018, the Fed sees the growth rate dropping off to 2.3 percent in 2019 and 2.0 percent in 2020. The Fed sees even slower rates of growth after this.
Now, however, we have to be concerned about what the government shutdown is going to do to these future growth rates. Most analysts are agreeing that the 2019 figure could be substantially less than 2.3 percent, but, right now, there is little spillover beyond this.
The underlying point is that economic growth in the near future is not expected to be anywhere near the 3.0 percent attained in 2018, and in a real sense could be quite a bit slower. No recession in this forecast, but the prospects for the economy are not robust.
Unemployment is expected to stay below 4.0 percent, remaining near a 50-year low, but the growth of labor productivity is not expected to rebound to any extent. This environment, however, does not bode well for a rebound in business physical capital investment. It is also highly unlikely at this stage in the election cycle and with the political impasse that exists that much in the way of an infrastructure spending program could be passed. The federal deficit situation also argues that the money will not be found to actually fund an infrastructure program.
But, what about the state of the banking system and the position of the Federal Reserve going forward?
It is my feeling that the economic recovery can continue even into its eleventh year, if not longer, given the place the Federal Reserve and the banking system are in. I tried to describe my thoughts on this in my last post.
Chairman Powell and the Federal Reserve do not want to see economic growth come to an end. Fed officials do not see a recovery to any degree of price inflation and they are very content to see the unemployment rate continue where it is now.
Mr. Powell and other Federal Reserve officials have “backed off” from a mechanical approach to the raising of the Fed’s policy rate of interest and have emphasized, over and again, that the next move, if there is one, will be very dependent upon current and expected market conditions and will not be done just to continue raising rates. It sounds to me like Fed officials are going back to a more incremental approach to rate changes, based upon the “feel” of the marketplace. I am all in favor of this approach.
Furthermore, as I explained in my last post, there is still plenty of liquidity around in the banking system and, consequently, in financial markets. As of the last Federal Reserve statement, the banking system has more than $1.6 trillion is “excess reserves.” And, the Fed is still willing to err on the side of not creating any financial disruptions in the banking system by getting “too tight.”
So, even though the Fed may want to raise short-term interest rates a little more and to reduce its securities portfolio further, I believe that the signals that they are sending are ones indicating that they will act with caution.
I interpret this to mean that the Fed will work to sustain the economic expansion, but not move to push things further.
As far as the banking system is concerned, in my last post, I argued that the largest six financial institutions in the country are in pretty good shape. And, they have all produced, for the full year of 2018, significant returns on shareholder’s equity. The general tone one gets from their year-end earnings reports is that they are prepared to lend in 2019, but they are going to be careful and conservative about the loans that they give out.
The basic argument I took from the bank presentations is that there is so much uncertainty in the economy for the year 2019 that they need to filter this into all that they do. Thus, bank lending for this year will be modest, but not aggressive.
Putting this into the whole picture, it seems as if business capital expenditures will not be booming this year.
But, this is all consistent with the growth figures presented above. Economic growth for the United States will be modest, but will continue to be on the upside. Inflation will be below the Fed’s target of 2.0 percent and unemployment will remain below 4.0 percent. Profits should be up, but not by as much as have been reported over the past year or two.
The stock market? Up but modestly with continued volatility due to all the uncertainty around. But, the Fed will not be underwriting another robust year of stock gains.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.