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All it took was the return of stock market volatility to turn everything upside down.
Wages are rising! Inflation is back! Soaring bond yields are undercutting stock prices! A new Federal Reserve chairman is creating anxiety about monetary policy! Big tax cuts mean big deficits, and so on, and so forth.
It’s not clear to this observer which is the more significant development: the volatility in stock prices or the variability in explanations proffered for the correction, defined as a 10% decline, in the Dow Jones Industrial Average DJIA, +0.35% and S&P 500 Index SPX, +0.76% from their Jan. 26 all-time highs.
My advice to investors: Relax. Better yet, get out your yoga mat, assume the Lotus position, focus on breathing and say “om.”
Yes, stocks were, and still are, expensive by historical standards and due for a correction. But reality doesn’t change as quickly as the price action. The prevailing story line of strong U.S. and global economic growth, solid corporate earnings, stable inflation and historically low interest rates is still very much with us. The 1,175-point decline in the Dow on Feb. 5 may have been the biggest single-day point loss ever, but in percentage terms, the 4.6% decline doesn’t even make the top 50.
This isn’t to say that the U.S. economy is in a permanent state of Nirvana. To the contrary, the nation faces significant fiscal (i.e. budgetary) problems that lawmakers have skillfully kicked down the road, leaving the next generation to deal with the detritus.
The bottom line is, nothing has changed in the past two weeks to alter the idea that the U.S. economy is expanding at a healthy clip, inflation is still below the Federal Reserve’s 2% target for the personal consumption expenditures price index, business and consumer confidence are solid, and already strong corporate earnings will be boosted by the reduction in the corporate tax rate to 21% from 35%.
Watching the tape promotes anxiety and is bad for your health. But if you can’t tear yourself away the next time the Dow engages in a 1,500-point-intraday rollercoaster ride, here are five things to keep in mind to alleviate the sense of panic.
1. The Fed will raise interest rates and pare its balance sheet
Nothing new or different here, but the stock market sell-off and spike in 10-year Treasury yields to a four-year high of 2.85% set off alarm bells.
After seven years of near-zero interest rates, the Fed has raised its benchmark rate by 125 basis points in the past two years and, as of December, was planning on three more rate increases this year. The fed funds futures market is aligned with that forecast.
Until recently, long-term rates had refused to follow the lead of the Fed, producing a flatter yield curve and a disincentive for credit creation.
While higher interest rates reduce the present value of future cash flows, making stocks less attractive, that seems like a lesser concern than the potential for a near-term yield-curve inversion and ensuing recession.
2. Wages don’t cause inflation
The supposed catalyst for the stock market rout on Friday, Feb. 2, which spilled over into the following week, was a 2.9% year-over-year increase in average hourly earnings, a single data point in the January employment report.
Of course, that increase, the largest since 2009, was not shared equally by all workers. Earnings for production and non-supervisory workers rose 2.4% in the past year, in line with the trend over the past two years.
According to the Bureau of Labor Statistics’ Current Employment Statistics, about 82% of total private employees are classified as non-supervisory workers. So the vast majority of employees aren’t benefiting from the wage increase that sent Wall Street into a tizzy.
The late economist Milton Friedman debunked the notion of cost-push inflation almost a half-century ago. But like all bad economic ideas, this one keeps coming back to haunt us.
Wages, like prices, are a symptom of inflation. And in the grand scheme of things, prices lead wages, not the other way around.
On that score, Wednesday’s inflation report had something for everyone. The increase in both the consumer price index (+0.5%) and core CPI (+0.3%) exceeded the median forecast, while the year-over-year increases of 2.1% and 1.8%, respectively, were status quo.
The idea that inflation is about to soar is unsupported by the evidence. And as for any shift to more aggressive tightening, don’t forget that the Fed has said it is willing to tolerate an overshoot to offset the chronic undershoot on its inflation target.
3. Powell is Yellen with a necktie
One of the sillier excuses for the stock market sell-off was anxiety about the new Fed chairman. Jerome Powell is the first non-economist to head the Fed since William G. Miller (1979-1981), whose term is more notable for who succeeded him (Paul Volcker) than what he did.
Powell is a lawyer by training, an investment banker by profession and a Republican by political affiliation. He is no stranger to public service, having held various positions at the U.S. Treasury under President George H.W. Bush. He has been a Fed governor since 2012.
When Trump passed over the opportunity to reappoint Yellen and instead tapped Powell as his nominee, the press coverage depicted him as a “consensus builder” who would, like Fed chiefs before him, rely on the Fed’s large and highly trained staff of economists. According to The New York Times, when Powell joined the Fed, he wasn’t shy about drilling staff economists after meetings to improve his grasp of monetary policy.
Powell may prefer a lighter regulatory touch than Yellen, but when it comes to monetary policy, it is hard to see the Fed veering from its slow-but-steady approach to normalizing rates.
4. Long and variable lags?
President Donald Trump signed a $1.5 trillion tax cut into law on Dec. 22. Yet one of the reasons cited for the stock market sell-off that began on Feb. 2 was the fear of bigger deficits.
This is the same tax cut that goosed the Dow to a spectacular 8% increase in the first four weeks of the new year, according to press reports.
So which is it? Is the tax cut a reason to buy or sell? My advice is, beware ex-post reasons that are retooled to conform with the price action.
Congress did pass a two-year budget deal on Feb. 9 that increased budget caps on discretionary spending by about $300 billion over two years. That served to focus attention on trillion-dollar deficits, but by that time, the damage had been done.
5. Stocks for the long run
While past performance is no guarantee of future results, history suggests that owning stocks over the long run has paid off handsomely. Since 1982, the Dow has returned more than 2,000%.
The Dow rose 45% between Nov. 8, 2016, when Trump was elected president, and Jan. 26, 2018. Never has passive investing or a buy-and-hold strategy paid off so well.
It is unrealistic to think that asset prices only go in one direction. So rather than round up the usual suspects to explain the return of volatility, be grateful that some of the froth has been skimmed off the stock market.
Caroline Baum covers the economy and the Federal Reserve for MarketWatch.