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Reality bites: U.S. markets are playing catch-up
Stocks radically outpaced the economy this cycle as a result of low interest rates and quantitative easing

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Friday, October 12, 2018 – Page B8

Chief economist with Gluskin Sheff + Associates Inc. and author of the daily economic newsletter Breakfast with Dave

Now is not the time to panic or hyperventilate (as in, don't behave like the President and lose your cool).

Go back to earlier this year when the S&P 500 dropped 10 per cent from late January to early April - again, fuelled by bond yields and some inflation pressure. The world didn't exactly come to an end, although it ushered in a more selective and discerning market condition. This doesn't mean I've turned bullish just yet - only that some perspective is needed. As we saw earlier this year, corrective phases can last a few months and require hefty doses of capitulation before they end.

Here's the reality. The stock market played some catch-up to the Treasury market and the selloff was in part a reappraisal of U.S. Federal Reserve policy. But the technical picture had already been eroding for some time.

The lagging performance of S&P 500 Financials was a canary in the coal mine, especially since this is one group that should have been benefiting from rising rates. Credit growth has been slowing. Households have never before been so exposed to equities, and have done the reasonable thing, which is to take some chips off the table.

Indeed, net flows into U.S. mutual and exchange-traded funds are down 46 per cent from a year ago through the first three quarters of the year. Earnings estimates have stopped going up dramatically, and we are seeing a subtle change in corporate guidance to the downside. This is a brand spanking new development that has nothing to do with the Fed. And insider selling has really been picking up sharply.

I have to say that U.S. President Donald Trump is doing more harm than good with his finger-pointing at the Fed and his inflammatory language. "I really disagree with what the Fed is doing," he said, adding "I think the Fed has gone crazy." The problem is that Mr. Trump is not an expert on monetary policy, but Fed chairman Jerome Powell and his team are; the President would be well advised to bite his lip for a change.

Go back to the January confirmation hearing, and Mr. Powell made it very clear that he was going to "normalize" interest rates.

No doubt, his recent comments that the Fed is a long way from "neutral" - where the Fed funds rate is neither stimulative nor restrictive - was only stating the obvious. We already know that the Fed's estimate of neutral is 3 per cent and the funds rate is in a range of 2 per cent to 2.25 per cent. So we are three to four interest rate hikes away. And while the term "accommodative" was removed from the most recent Fed press statement, Mr. Powell made it abundantly clear that policy was in fact exactly that - accommodative.

The ensuing comment that Mr.

Powell made that the Fed may have to exceed neutral is a complete no-brainer. The neutral funds rate is the rate that exists when the economy is cruising along at full employment and price stability. Well, the unemployment rate has actually been below the Fed's 4.5-per-cent fullemployment estimate for 18 months and every inflation measure is at 2 per cent or higher. So the macro climate is definitely consistent with the Fed funds rate moving above neutral. Only the uneducated and uninitiated don't see this.

Now this view that inflation is not a problem is actually a bit of a joke and belies the data. Talk about a fake narrative. This time last year, U.S. CPI inflation was 1.9 per cent. Today, it is 2.3 per cent.

This time last year, core CPI inflation was 1.7 per cent. Today, it is 2.2 per cent.

For all the bellyaching, all Mr.

Powell has done is maintain the funds rate at, or below, zero in real terms. And yes, the Fed is gradually shrinking the balance sheet, but it is still hugely bloated.

Here is why the U.S. stock market is going down: It is playing catch-up to the rest of the world.

The problem with starting a trade war with China is that when the Chinese economy cools off, it is big enough to reverberate across the planet. In 2008, it was the rest of the world that caught the U.S. flu, and now it is the other way around.

Now if the complaint from the White House is about this last leg of the bond yield run-up, think of how the administration's own actions are responsible for this. The fiscal deficit is spiralling. The Treasury has increased the size of the auctions to such an extent that borrowing needs have ballooned about 70 per cent from a year ago. And China is fighting back in this trade war by reducing their exposure to Treasuries - and so is Japan. These are the United States' two largest creditors (each with holdings in excess of US$1-trillion).

So U.S. fiscal policy-makers decided to run the economy hot as it heads into the 10th year of the expansion with a lack of any spare capacity in the economy.

This has helped produce an environment where real GDP growth on a year-over-year basis is 2.9 per cent and the real funds rate is at or below zero per cent. And where the year-over-year trend in nominal GDP is 5.4 per cent compared with a nominal funds rate of 2 per cent to 2.25 per cent. If you believe the President, the recent gyrations are all about the Fed. I have a name for this: "Fake blame!"

The reality is that the stock market radically outpaced what the economy did this cycle - completely unprecedented. And this was because of the Fed's policies of maintaining unnaturally low interest rates and the market incursions via relentless quantitative easings. We estimate that about 1,000 rally points in the S&P 500 was due directly, and indirectly, to the Fed's benevolence - so what is happening, and it is actually a good thing, is that the central bank is gradually moving us away from a liquidity cycle to a more fundamentally based cycle.

And maybe some investors are seeing that the fundamentals aren't quite as bullish as they thought.

Associated Graphic

Screens display tumbling market numbers at the New York Stock Exchange on Wednesday.


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