Economic Insights - February 5 - 9, 2018
- A normal correction in context: The U.S. stock market entered a correction last week. It was likely a return to more normal volatility, and was not in response to declining economic fundamentals. Long-term interest rates didn’t decline, surely a sign of upward pressure on 10-year U.S. Treasury yields.
- Economic quick-takes: Economic data releases were few but positive. The U.S. labor market was doing very well, PMI’s were strong, and wage growth is likely picking up in Germany.
A normal correction in context
It will be news to few that the U.S. stock market entered a “correction” last week. The S&P 500 was down 10.1% peak-to-trough from January 26 to February 8. The big move started after last Friday’s Employment Report. That morning, February 2, stocks opened lower and finished down more than 2%. The fall continued Monday, down 4.1%, and lasted through the week before rebounding somewhat on Friday, February 9.
Stock prices have been increasing relentlessly for more than a year. As bad as this correction seems, it still leaves the S&P 500 above where it was in November 2017. Volatility is normal in equity markets, and we had gone a long time without much volatility. In some sense, last week was more normal than the past year of stock prices continually and smoothly grinding higher.
What caused the fall?
No one knows for sure, but it’s likely that a small decline due to the employment report was exacerbated by technicals and market internals. The result can probably best be thought of as an extended “flash crash.”
Friday’s employment report from the Bureau of Labor Statistics (BLS) was very positive, and strong wage growth fueled concerns about broader inflation pressures. Nonfarm payrolls increased by 200,000 and average hourly earnings were up 2.9% year-over-year. It was a strange day when good news was bad news. That’s because investors thought a stronger economy might augur higher inflation, which would cause the Federal Reserve (Fed) to raise rates faster, ultimately slowing economic growth. Long-term interest rates would also rise, putting pressure on equities.
The big downdraft on Monday, however, seemed to be about technicals. The CBOE Volatility Index, commonly called the VIX, is a measure of stock market volatility. The VIX spiked above 50 for the first time in over two years. Many investment strategies become forced sellers when the VIX rises. The massive surge in the VIX surely brought many of them to market.
Common correction, uncommon interest rates
Apologies to Philip Fisher for a play on the title of his famous book. What we saw in the equity markets was a fairly standard correction, even if worsened by market internals. The reaction from interest rates, however, was very nonstandard. The 10-year U.S. Treasury rate failed to reach even a one week low at any point during the massive sell-off. From the time the S&P 500 fell 10.1%, the 10-year Treasury rose from 2.66% to 2.85%.
If the correction was sparked by inflation worries, rising 10-year yields would make sense. Rates would need to compensate investors for higher inflation. But at some point during the correction, one would think rates would signal risk-off and fall. That’s what rates did during all other recent corrections: from the U.S. election, to Brexit, to China’s surprise devaluation of the yuan in 2015. They didn’t, and for us that was a small confirmation that 10-year yields could work even higher in 2018.
Central bankers yawned
Or, at least they acted like they yawned during the recent market volatility. William Dudley, the chair of the Federal Reserve Bank of New York, said, "My outlook hasn’t changed because the stock market is a little bit lower than a few days ago." James Bullard of the Federal Reserve Bank of Saint Louis said, "This is the most predicted sell-off of all time." Robert Kaplan, Chair of the Federal Reserve Bank of Dallas said, "Corrections are healthy. What I look at is whether it has implications for financial conditions or the health of the underlying economy and I would say, ‘I don't think so.’"
It's possible that if the rout continues, it can do some of the Fed’s work. Tightening financial conditions can come from lower stock prices, higher corporate borrowing rates, or a higher federal funds rate. Our base case of three rate hikes in 2018 remains. However, a shift down to two hikes, or a misstep of four rate rises, are certainly possibilities.
Economic fundamentals remain more than sound. As mentioned above, strong data explain some of the market turmoil. There wasn’t a lot of economic data out last week, but what was released was positive. Solid growth should continue in the United States, Japan, and Eurozone well into 2018.
Market volatility can stay elevated as investors transition to a more normal inflation and interest rate environment. We expect 2018 to be a much bumpier ride than last year. There’s the new Fed chair, Jerome Powell. He’s seen as being in line with Janet Yellen’s views. However, Chair Powell might have a slightly different tone than Governor Powell. Likely higher inflation, tighter labor markets, and a growing U.S. federal budget deficit can all cause more volatility.
Weekly data round up
Good data on the U.S. labor market continued with the job opening and labor market turnover report from the BLS. It showed the level of quits are at the highest since early 2001. People only quit their job if they feel confident they can find another opportunity. The four-week moving average of jobless claims reached the lowest level since 1973, according to the Census Bureau. That becomes even more impressive when factoring in the rise in the labor force over the past 45 years. The weekly Bloomberg Consumer Comfort Index showed little reaction to the market turmoil. In fact, consumers’ views of the economy reached the highest level since 2001.
Purchasing manager indices (PMI) around the world point to a continuation of the synchronized global economic expansion. The U.S. ISM Nonmanufacturing PMI hit the best level since 2005. In the Eurozone, the composite PMI increased 0.7 to 58.8. China’s PMI increased to 53.7 from 53.0. Global trade numbers were also very robust: German exports were up 10% year-over-year, and Chinese exports grew around 11%.
There are signs that Germany’s labor market is getting hot. IG Metall, the largest labor union in Germany, won a 4.3% pay increase for their workers over the next 27 months. That’s up from a 2.6% pay increase in 2017. According to the European Commission, Germany had its biggest industrial labor shortage ever in 2017. That pairs well with the Eurozone unemployment rate at a cycle low 8.7%.
Remember, good economic news, i.e., the prior week’s payroll report, was one trigger of market volatility. Going forward, there will likely continue to be uncertainty about whether strong economic data are good for stock markets. Better data or higher inflation could mean faster rate hikes by the Fed, or a higher terminal rate. 2017 was relatively sanguine. Periods like that have happened before, and can continue for a while. The global economy should do well. However, it’s likely 2018 won’t see financial markets that are quite as tame.