The Week in Review
- Correction Territory
- Where's the Inflation?
- Service Sector Steaming Ahead
- Consumers Demonstrate Confidence
- Looking Ahead
Yesterday's 1,033-point decline for the Dow Jones Industrial Average (a 4.2% dip) and the 101-point drop for the S&P 500 brought both stock indices into "correction" territory, down 10.4% and 10.2%, respectively, from their January 26 highs.
It's been a rapid turnabout from record highs to 10% declines, to say the least, but we've seen nothing to shake our confidence in the economy and hence we see no legitimate reason for the markets to have fallen other than investor behavior and fear.
In fact, recent reports on the service sector, corporate earnings, the job market and consumers' borrowing and spending habits have only reinforced our view that the economy and earnings continue to expand. This ultimately bodes well for stock prices.
We aren't ignorant of the sometimes fear-mongering headlines that flash across our screens or march boldly across the tops of daily newspapers and we understand that they can, at times, be scary. In fact we believe they've already scared some investors out of the markets, which is a good thing. That doesn't mean that you should follow suit. Your long-term objectives and goals this week are likely the same as they were last week, and our strategies are designed to meet challenges just like this.
After the recent shakeup, most of the major stock market benchmarks have gone from black to red for the year to date, although not as dramatically as you might think. For the year through Thursday, the Dow Jones Industrial Average and the broader S&P 500 have both returned -3.3%. The MSCI EAFE index, a measure of developed international stock markets, has seen a shallower decline of 1.3%. The 3.08% yield on the Bloomberg Barclays U.S. Aggregate Bond index on Thursday has risen significantly from 2.71% at year-end. On a total return basis, the U.S. bond market has declined 1.9% for the year. Bonds are making headlines of their own, but still add value and balance to investor portfolios over time.
Where's the Inflation?
The catalyst for the recent market decline was last Friday's labor report, which showed incomes rising in January. This suggested to some investors that higher inflation (and thus a more aggressive Federal Reserve policy of raising interest rates) is right around the corner. Fearing that higher inflation and an active Fed would hurt consumers and corporate bottom lines, those investors sold. As the markets tumbled, it's possible that some computer-driven stock strategies also kicked into high gear and sold as well.
But there are some flaws with the better-wages-mean-inflation narrative. It's quite possible that January's rapid wage growth was an outlier for two primary reasons. First, lower-income temporary workers hired for the holidays were let go during the month. Second, as we mentioned last week, 18 states implemented new, higher minimum-wage standards. So, if you take out the lowest paid workers and add in higher minimum wages for a slew of people, you get a big jump in incomes for one month. A single month does not make a trend and it's possible that next month's labor report will vindicate those who say January's data was an anomaly.
Further, the idea that rapid wage growth somehow will spur inflation higher is suspect. According to Moody's Analytics "...the boost to core inflation is fairly small and takes several quarters to come to fruition. Therefore, even if wage growth suddenly accelerates, the Fed should not feel any urgency to raise interest rates more often than the three to four [times] expected this year."
Minneapolis Fed President Neel Kashkari gave a speech Thursday morning where he made the same argument, noting that higher wages don't necessarily translate into inflation at all. Our in-house research team also ran the numbers and came to a similar conclusion, finding that there is almost no correlation between wage growth and inflation.
We believe that the Jerome Powell-led Federal Reserve will take a page from the Bernanke/Yellen playbook and will lead Fed policy in accordance with the facts on the ground, rather than speculating over a single month's wage-growth data.
At the moment, there's little inflation to fear. PCE (personal consumption expenditures) inflation, the Fed's favored metric, was up just 1.7% year over year in December compared to 1.8% in November—in other words, below the Fed's 2% target and nothing to get worked up about. We'll get a couple of reads on inflation for January next week, which will either give the alarmists more fuel for their fires or put that concern to rest (at least temporarily).
Service Sector Steaming Ahead
Lost in the coverage of the market's gyrations this week was the news that the service sector, tracked by the ISM Non-Manufacturing index, showed some of the strongest activity in its 20-year history. In particular, the new orders component matched 2017's peak, and the employment piece was at its highest level since the financial crisis, which dovetails with last week's better-than-expected employment report.
The service sector represents more than two-thirds of GDP and is a driver of our consumer-led economy. As we noted above, economic growth remains strong, with GDP up at a 2.6% annualized rate in the fourth quarter according to the first estimate. With over 60% of the S&P 500 companies reporting, earning growth is estimated to be over 15% for the last three months of 2017 and signs are good that first quarter earnings will also show a jump.
Consumers Demonstrate Confidence
We received two insights into consumer behavior this week through the consumer credit report and the job openings and labor turnover survey (JOLTS).
Consumers were spending heavily in the last two months of 2017. Revolving credit, which is mostly attributable to credit cards, rose 13% month-to-month in November and a further 6% in December—at over $1 trillion outstanding, revolving credit is at its highest level on record. Non-revolving credit (think car and student loans) was also up for the month. Together, they add up to consumers who are increasingly comfortable taking on debt to finance their lifestyles.
The JOLTS report gives us insight into worker confidence by looking at both hiring and job-hopping in the labor market. In December, the number of job openings declined slightly, which may be a side effect of an economy at full employment. Hiring activity remained steady for the month, and the "quits" number, which tracks the number of people leaving a job to search for a new one, rose a bit, which reflects conviction that new, better and usually higher-paying jobs are available.
Speaking of inflation, next week will see the release of consumer (CPI) and producer price index data for January, along with reports on retail sales, industrial production, housing and consumer sentiment. While the CPI data will make headlines no matter how it comes in, remember that the more comprehensive PCE report, which we won't see until next month, is what most influences Federal Reserve policymakers.
If you'd like to learn more about our tactical or fundamental strategies, please contact Steve Johnson at 844-587-7393 or firstname.lastname@example.org.
Please note: This update was prepared on Friday, February 9, 2018, prior to the market's close.
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