Investors have rediscovered market volatility. After a relatively placid three months, when stocks did not move more than one percent in either direction, the October sell off has reminded everyone why investing remains a dangerous activity. The catalyst of the seesawing action boils down to a battle between bulls, who believe U.S. growth will be strong enough to withstand higher interest rates and bears, who worry that a slowdown combined with rising wage costs and higher rates, will eat into corporate profitability.
So far in 2018, the economy has expanded by an annualized 2.2 percent in Q1, 4.2 percent in Q2 and by 3.5 percent in Q3. For the full year, most economists have been predicting a 3 percent pace, which would be the strongest annual growth reading since 2005. This year’s growth spurt can be attributed to the big tax cuts, mostly on the corporate side and an increase in government and consumer spending.
But these numbers are history. The recent stock market gyrations are the investment community’s attempt to answer an important question: How will the economy fare after the sugar high of the tax cuts wears off in 2019 and will the Fed recognize the downshift soon enough to halt their rate increases?
The pessimistic case is this: After keeping interest rates low and pumping money into the economy during the financial crisis, recession and the early part of the recovery, the Fed will be unable to perfectly time when to stop, which will ultimately cause the economy to cool off too much, triggering a recession. History may bear this out, because rate hike cycles have often resulted in an economic contraction.
Adding a layer of worry is the escalating trade war with China. So far, tariffs have not pushed up prices, as producers seem to be absorbing the increases. Consumer inflation has increased at a 2.3 percent annual pace in September and the Fed’s favorite measure, the price index for personal-consumption expenditures (PCE), increased at just a 1.6 percent pace both overall and at the core level in Q3.
The data are not exactly causing anyone to resurrect their 1974 “Whip Inflation Now” buttons -- inflation at the end of that year was a scorching 11 percent! That said, some companies, like P&G, Kimberly-Clark and Nestle are starting to increase prices, a nod to rising costs and a strengthening U.S. dollar.
Investors also worry that growth in China could be slowing. The world’s second largest economy expanded at a 6.5 percent annualized pace in the third quarter, the slowest reading since Q1 2009. Whether or not the Chinese government’s figures are accurate, it is fair to say that activity there is cooling.
Where does this leave us? Many believe that growth will downshift next year to the post-recession average of 2 to 2.5 percent. If that occurs, corporate profitability would likely take a hit; the Fed may not time its rate strategy perfectly; and the bull market may not make it to its 10th anniversary in March.