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A look at the current market
Never-ending reports have been pointing out that economic growth has slowed from its robust rate of the second quarter, and there are clear decelerations in housing and vehicle sales.
Growth in manufacturing is also slowing down as businesses reduce their investments in new capital and equipment. Exports were also lower in the latest Gross National Product (GDP) report, as a result of a combination of tariffs and slower growth outside the United States.
We are experiencing investment markets showing classic signs of tighter money and higher volatility at the late stage of the business cycle. Bond prices are lower, and the dollar is rising, working toward its high of late 2016.
Commodities are falling, especially oil. Oil prices took a downfall due to an increase in supply and are now more than 20 percent below their recent highs and show no signs of approaching the elevated 2014 prices. With the decline that began in late September, U.S. stocks joined the global equity downturn that included all but a few markets.
Unlike the February 2018 correction, troublesome indicators of market momentum and investor sentiment accompanied the October tumble.
Going forward, investors should be concerned about earnings growth. A foundation of the bull market has been increasing earnings faster than GDP. Now, rapid earnings growth is at risk, wages are rising and tariffs are increasing the costs of commodities and other inputs, while making it more difficult to sell overseas.
Higher interest rates raise business costs and so productivity remains low leading to businesses not being able to offset higher costs by operating more efficiently. Also, financial engineering, such as stock buybacks and dividend increases, supported stock prices. Buybacks declined through 2018 but surged in early November.
One dominant factor that has been impacting the overall market is China. China has a range of economic issues to navigate, and problems in China are felt in the rest of the world. Problems include high debt, over-investment in real estate and a transition to a domestic-oriented instead of an export-oriented economy.
Its lingering trade conflicts with the United States adversely affected China's currency and foreign exchange reserves. China's growth has slowed, and its central bank already is stimulating its economy.
There are three likely scenarios for Fed policy, the markets and the economy in the next year or two.
Since 2009, whenever the economy and markets faded, the Fed stepped in to reverse the declines but that is less likely to happen this time.
Fed officials made it clear that they believe the economy is self-sustaining and there is no concern about stock prices. It would take a sustained downturn for the Fed to reverse policy.
Another possibility is that the Fed realises a tighter policy already is affecting the economy and markets. Then, it would resist any dramatic change in policies for a while to see how much of recent growth is sustainable at the higher interest rates. If the Fed stands pat, the likely result would be a sustained period of slower, but solid growth.
The third possibility is the biggest risk. The Fed might continue to raise interest rates as long as the labour market is strong. The end result being a recession which the Fed would have difficulty reversing.
Like the growth stage and bull market, this late stage of the cycle could last a long time if the Fed does not tighten too much. While most investors worry about the next crash, it is better to prepare for a long period when both economic growth and asset price increases are flat or sluggish.
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