From the July 2017 issue of the Investor Advisory Service newsletter, here are some thoughts on the economy and interest rates and their impact on the stock market for investors.
Unemployment fell to 4.3% in the most recent Bureau of Labor Statistics release. A tightening labor market ought to push wages higher, but average hourly wage growth remains subdued at around 2.5%. This keeps a lid on consumer spending and, in turn, also keeps inflation in check.
Low inflation allows the Federal Reserve to maintain its dovish posture. The Fed is being quite slow-footed in its campaigns to raise rates and reduce its balance sheet. The $4.5 trillion balance sheet has been a thumb on the scale favoring borrowers over savers for some time. While the Fed wants to reduce this swollen balance sheet, it is not clear how this can be accomplished without roiling the debt markets which have been supported through various forms of quantitative easing.
As expected, the Fed raised its target for short-term interest rates by 0.25% in June. This was the second hike of 2017 and brings the target range to 1.00%-1.25%. Long-term rates have declined fairly steadily in 2017. This downward trajectory appears contrary to the Fed’s tightening activity, but short-term and long-term rates need not always move in the same direction. The bond market has returned to the “lower-for-longer” stance that predominated from the beginning of 2014 until the 2016 elections, where investors almost universally expect rates to increase, yet these expectations get steadily more modest over time.
Low long-term interest rates are good for the housing market. The latest reading for the S&P Case-Shiller index measured national home prices up 5.8% on a 12-month basis. Lower rates have also hurt the U.S. dollar, which has declined steadily throughout 2017 compared to a basket of foreign currencies.
This is good news for the stock market. A combination of dollar weakness, low interest rates, and robust corporate earnings growth has pushed the S&P 500 to new all-time highs. The market’s rally has been broad, with every sector outside of basic materials enjoying gains during the last month. Investors need to be similarly distraction-averse. However, it is always important to balance optimism against caution, to make portfolio decisions based on long-term considerations, and to stake one’s financial well-being on a diversified portfolio that benefits from the continued success of growing, profitable companies.