“LADIES AND GENTLEMEN – PLEASE FASTEN YOUR SEATBELTS”
If you have every flown with a commercial airline, you have undoubtedly heard these words. This message is broadcast whenever the plane has encountered turbulence and there is resulting concern about the safety of the passengers and crew.
After last week’s performance of the stock market, investors should heed the same message. The Dow Jones Industrial Average dropped 666 points (a rather ominous number), or 2.5%. The Dow was down 4.1% for the week. The other major indices, the S&P 500 and the Nasdaq Composite, were down by similar amounts last week.
Why the sudden turbulence? The economy has been performing very well. Interest rates remain at historically low levels. Corporate profits are strong. Unemployment is low. Congress just passed tax legislation which is already beginning to stimulate the economy. The administration is working on an infrastructure spending package which is expected to pump billions into the economy.
The problem is that all of this growth is beginning to create inflationary pressure. The Labor Department jobs report that came out Friday showed that non-farm payrolls increased by 200,000 in January. This was higher than expected. Unemployment now stands at 4.1%, a 17-year low. The economy is now at full employment, meaning that just about everyone who wants a job has one.
With so little slack in the labor pool, wage pressure is inevitable. Wages were up 0.3% in January from the prior month and they were up 2.9% year-over-year from January 2017. This was the biggest increase in pay since 2009.
The global demand for raw materials is causing prices to rise. Commodity prices are up, which you probably noticed when you last filled up your vehicle at the gas station.
The rate on the 10-year Treasury note, a key benchmark interest rate, hit 2.85% on Friday, the highest level in four years.
The Federal Reserve has indicated that it intends to raise rates three times in 2018. There is now discussion, in light of the very strong economic conditions, that the Fed may add a fourth increase.
Why are higher interest rates bad for the stock market? If other, less risky investments yield more because of rising interest rates, they become more attractive. Similarly, stocks become less attractive. Investors bought stocks instead of low-yielding alternative investments (e.g. CDs and bonds) in the aftermath of the Great Recession. Now they will be able to shift out of stocks and back to less risky fixed income investments. The result will likely be money moving out of stocks and into bonds, CDs and even savings accounts.
Higher interest rates also increase borrowing costs for consumers and businesses. This has a dampening effect on investment and consumption. This will put pressure on corporate profits.
The message is that investors are approaching market turbulence. There is no way to know how severe it will be. However, it would be wise to remain seated and buckle up.
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