Perpsective: Getting Back to...Normal?

by Liz Ann Sonders, Brad Sorensen, Jeffrey Kleintop, Charles Schwab and Company

Key Points

• A wild ride would be an understatement to describe stock market action recently. A more aggressive Fed and a tariff announcement have played key parts, but we don’t see these as threats to the bull market; just consistent with the heightened volatility we have been expecting.
• Economic growth has risen and inflation expectations have ticked higher; but we are just now getting back to the Fed’s target of 2% core inflation.
• Many have wondered—including the Fed—whether the link between a tighter labor market and wage growth/inflation had been permanently broken, but it appears the secular forces restraining wages and inflation may be dissipating.

A bumpy ride to “normalization”

U.S. stocks have been on a wild ride recently—a stark contrast to the relative calm that dominated most of the last year. Stock indexes touched correction territory (+10% loss) in early February before staging a sharp rebound, with intraday several hundred point Dow moves more common than not. Last week the rebound began a retracement as investors expressed concerns about the potential for a more aggressive Federal Reserve and the initiation of more direct protectionist trade policies by the Trump Administration, including a 25% tariff on steel and a 10% one on aluminum. Stomach churning at times but should we be surprised? After a decade of abnormally loose financial conditions and global central banks massively boosting their balance sheets and taking rates to zero or below, we have begun the normalization process. Even in less unprecedented times, tighter monetary policy has led to higher volatility and weaker markets; so fundamentally, this is not a surprise. Interestingly, the timing seems about right according to famed economists Kenneth Rogoff and Carmen Reinhart, who in their 2008 book This Time is Different: Eight Centuries of Financial Folly revealed that the average recovery time from a severe financial downturn and debt bust for countries is about 10 years.

Positively, despite the sharpness of the correction, investor confidence in the financial system appears intact with the rebound seen in the immediate aftermath of the February correction. There was some concern that the carnage among the inverse volatility-related exchange-traded notes could spread to create more systemic issues; but that does not appear to be the case. But the stock market has been less forgiving about the announcement by President Trump of new tariffs on steel and aluminum, which lacked any details. The concern that this could lead to trade wars and retaliatory measures by other countries, and ultimately hurt economic growth and foster higher inflation, was enough to send shivers down the stock market’s spine. The upcoming details on these tariffs, as well as the foreign response, will be important to watch, as will any further actions undertaken by the Trump administration.

In the meantime, the strong earnings picture is intact for now, which should help to underpin stocks. According to FactSet data, the “beat rate” for profits was 74% for the fourth quarter of 2017—above the 69% average over the past five years; while the revenue beat rate was 78%—a record high since FactSet began tracking the data in 2008.

A longer-term perspective

We believe increased volatility will persist, with alternating bouts of spikes, followed by periods of easing conditions. Concerns over economic growth moving to a higher trajectory and inflation heating up will likely continue to be a factor, with worries that the Fed may be forced to tighten more quickly an ongoing volatility-driver. However, we refer back to a speech that former Fed Chair Janet Yellen gave in 2016 where she said that it’s useful to consider the benefits of a “high-pressure economy with robust aggregate demand and a tight labor market.” While she is no longer the chair, it is reasonable to conclude that she was expressing the general views of much of the Federal Open Market Committee (FOMC)—of which current Fed Chair Jerome Powell was a member. He had the “pleasure” of talking to (listening to?) Congress for two days; and despite his clear intention to say little that would immediately move markets, investors took his first day of testimony as slightly hawkish, resulting in some selling of stocks. But Powell adeptly came across as slightly more dovish in day two and stocks were rallying…until the Trump tariff announcement.

Interest rates have risen, both on the short- and long-end, but they remain low in the longer context of history. Although the yield curve has flattened, until an actual inversion (were it to occur), and even though past performance does not indicate future results, stocks have shown a tendency historically to perform well during the flattening phase—with volatility hiccups.

Interest rates have risen…but remain historically low

In the meantime, although growth has picked up and inflation is on the rise, neither suggest we are entering an aggressive over-heating phase.

Growth remains below historical expansion levels

Inflation also is below levels seen in previous years

Of course, as longtime readers of this publication will note, we often say that it’s often the case that the absolute levels of economic fundamentals matter less than the trend—whether things are getting better or worse: “Better or worse often matters more than good or bad.”

In that sense it’s a mixed picture as earnings are getting better at a rapid clip. According to Thompson-Reuters consensus estimate data, expectations for 2018’s year-over-year growth for the S&P 500 have jumped from 11% last fall to nearly 20% today. The trend in, and forecasts for, gross domestic product (GDP) have been less robust, with fourth quarter GDP being revised down slightly last week. Looking ahead the Atlanta Fed’s GDPNow model estimates 3.5% annualized growth for this year’s first quarter. Inflation has ticked up, with the overall Consumer Price Index posting a 2.1% annualized growth rate in January—1.8% at the core (excluding food and energy) level. More recently, we saw a further uptick in the core personal consumption expenditures (PCE) price index to 1.5%, up from 1.3%. Core PCE is considered the Fed’s “preferred” measure of inflation, and it remains below their 2% target. However, noticed by markets was that the index is up at a 2.0% annual rate over the past six months.

So what’s the result? We believe that there are still supports to an ongoing bull market, but with the Fed continuing to remove monetary accommodation by more quickly raising interest rates and letting assets roll off their balance sheet, increased volatility seems likely to continue. For now, the core of the American economy looks good—with consumers remaining confident and the labor market healthy—and corporate earnings growth has surged. But the ongoing implications for the economy and earnings of higher inflation, tighter monetary policy and more overt protectionism from the Trump Administration have not yet fully played out. Burgeoning deficits and debt are also concerns for the growth rate trajectory of the economy, household debt levels are less cumbersome courtesy of the deleveraging undertaken in the aftermath of the financial crisis.

Confidence remains high

Unemployment is historically low

But a modest increase in household debt…

…is not leading to higher delinquencies

Unbroken link between employment and inflation?

As seen above, unemployment in the United States is quite low—a story that is similar in a few other areas of the globe. In theory, the relationship between unemployment and inflation is very simple: when unemployment is low, the competition for workers pushes up wages; and higher wages mean higher costs for firms, which pass them onto consumers by raising prices. The opposite is true when unemployment is high. But, it looks as if this relationship between unemployment and wages hasn’t been working. Labor markets have been increasingly tight in the United Kingdom, Japan, and the United States, yet there has been little movement in wages.

• In the U.K., the unemployment rate is the lowest since the 1970s, but it’s accompanied by little wage growth (about 2.5% annualized according to the Office of National Statistics).
• In Japan, the unemployment rate is the lowest since 1993, with the ratio of job openings to applicants the highest since 1974. Yet, wages in Japan are rising at less than a 1% annualized rate, (Ministry of Health, Labor and Welfare).
• In the United States, the unemployment rate is the lowest since 2001 and the labor force participation rate for the primary workforce (those ages 25-54) has started to rebound from the low set in 2015; yet wages are growing at less than 3% (Department of Labor).

The single country perspectives above have one thing in common—these nations are outliers, not to mention that U.S. wage growth looks to be finally accelerating. The average unemployment rate among 36 major countries tracked by the Organization for Economic Cooperation and Development (OECD) has only recently fallen below its 30-year average. For example, Europe’s labor market, which is larger than in the United States, has not been tight at all, with the unemployment rate remaining above its 20-year average, until last year. This is very important, since wages are increasingly determined by the global labor supply.

Europe’s unemployment rate has been well above that of the United States and Japan

Source: Charles Schwab, Bloomberg data as of 2/28/2018.

The global labor market is rapidly changing. The global unemployment rate across 36 major countries tracked by the OECD has been dropping rapidly in the past year or so and is now in line with 30-year lows. There is typically a lag in the relationship between unemployment and wage growth, and global labor markets may now be at an inflection point where wages may start to rise more rapidly, like we may be seeing in the United States. The relationship between wages and unemployment still works when we look at individual Eurozone countries. In general, wages in countries with lower rates of unemployment are rising faster than those with higher rates of unemployment, as you can see in the chart below.

Wages in Eurozone countries with lower unemployment are rising

Shaded area encompasses countries and therefore illustrates the current relationship between wages and unemployment.
Source: Charles Schwab, Latest Eurostat data as of 2/27/2018.

Now that the labor market in Europe is finally beginning to tighten, the global labor market may respond with higher wages. The result may be a faster pace of inflation, justifying the moves signaled by the world’s major central banks. All this matters to investors since central banks are behaving as if wages and inflation will revive this year. But it is a fine line: if they don’t revive and central banks don’t alter their policy path, or if wages suddenly begin to surge and central banks act more aggressively to rein in financial conditions, global stock markets could be in for a rough 2018.

So what?

Monetary policy “normalization” could continue to be a bumpy one for U.S. and global equity markets, even if it’s in the context of an ongoing secular bull markets. Earnings and economic growth remain healthy globally, but the expectations bar has also been set higher; and we have yet to witness the implications on the global economy, earnings and/or investor sentiment of the heightened level of protectionism.

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