The U.S. economy remains very strong, and the U.S. stock market remains weak and in the midst of a correction. The big questions on investors’ minds Re: “Will this correction lead directly to a stock market collapse connected with a recession in the U.S.? Or will this correction lead to a rally in U.S. stocks for a few months or longer before an oncoming recession creates a bigger correction?”
As readers know, our view has always been that stocks rise when corporate profits rise, and corporate profits rise when real U.S. GDP (the after-inflation GDP) rises. Real U.S. GDP will probably rise by 3% or more in 2018, and will probably rise by about 2.5% in 2019. These numbers are stronger than they have been for quite awhile.
The real risks to the U.S. are not current trends, but future trends caused by two possible forces.
- A slowdown in growth from the rest of the world, of which China is a major part. Many fear that China will be destabilized by the current trade friction with the U.S. and some other trading partners.
- A rapid rise in U.S. interest rates, which would cause a collapse in the availability of money at a reasonable price. This would set off a decrease in corporate expansion and a decrease in profits, and create higher returns on competing bond investments — all of which could lead to lower stock prices.
Thus, much attention has been placed on economic growth outside the U.S. and interest rates within the U.S. The Fed has been gradually raising interest rates from a very low level since December 2015. The Fed Funds rate to banks is currently 2.25%, which is still at a very low level historically. Some are fearful that raising these rates to 3% rapidly will slow economic activity. In our view, this correction has been driven by these two fears of future events.
The good news is that recently a stronger U.S. dollar and lower commodity prices have removed some inflationary pressure from the economy, and more Federal Reserve members have started to believe that lower inflation is ahead. Lower inflation would decrease the need for many more interest rate hikes. For example, oil prices, copper prices, and the prices of many industrial raw materials have fallen, while wages and employment have increased.
Clearly this stock market correction has been somewhat bigger than we had anticipated. It has been particularly brutal to some market sectors. The fast-growing tech sector, the industrial sector that exports goods to the world have been hurt by a strong dollar, and sectors dependent upon oil for their raw materials (shipping and airlines), have been harder hit than the economy as a whole. Now that oil prices have been falling, this sector is set to benefit, but only for as long as oil continues to fall in price.
We have exercised our traditional loss cutting mechanism for clients to protect capital and many have large cash balances. This cash is invested in short-term income-yielding securities. We have found that having cash is a strategy which can be useful because it protects capital in declining markets, and cash is then available to invest should the above fears dissipate. Until then, we are waiting and watching.
Cryptos: Competition Coming From Governments
A period of relative crypto calm has been disrupted by a sharp drop; Bitcoin dropped to its lowest levels of the year, opening bearish technical prospects for a fall into the mid-$4000 range. What caused the kerfuffle? It’s always uncertain in the world of cryptos, but a new study from the International Monetary Fund proposes the creation of what it calls “Central Bank Digital Currencies” (CBDCs). IMF head Christine Lagarde made the following remarks at a Singapore fintech conference on Wednesday:
“Even cryptocurrencies such as Bitcoin, Ethereum, and Ripple are vying for a spot in the cashless world, constantly reinventing themselves in the hope of offering more stable value, and quicker, cheaper settlement… should central banks issue a new digital form of money? A state-backed token, or perhaps an account held directly at the central bank, available to people and firms for retail payments? True, your deposits in commercial banks are already digital. But a digital currency would be a liability of the state, like cash today, not of a private firm. This is not science fiction. Various central banks around the world are seriously considering these ideas, including Canada, China, Sweden, and Uruguay. They are embracing change and new thinking—as indeed is the IMF. Today, we are releasing a new paper on the pros and cons of central bank digital currency—or “digital currency” for short. It focuses on domestic, not cross-border effects of digital currency. The paper is available on the IMF website. I believe we should consider the possibility to issue digital currency. There may be a role for the state to supply money to the digital economy.”
Interested readers can download the IMF’s paper here.