S&P 500: growth and interest rates

by George Hatjoullis

The S&P 500 has gone sideways now for almost four months. Some other equity markets have fared worse. The market is struggling to come up with a coherent narrative that enables it to move in some direction. Strong economy data suggest good news on the earnings front but raise the spectre of accelerated tapering and rate rises. Weak economy data have the reverse effect. Equity markets are starting to look like a hare caught in the headlamps. This is not necessarily a bad thing. It allows ‘bottom up’ investors to sort the wheat from the chaff without market noise. It allows sector strategists to review and adjust their portfolios. The idea that it is not possible to make money in equities unless market indices are trending is a nonsense perpetrated by macro strategists that are usually ex macro economists.

The relationship between growth and interest rates is not necessarily very complicated. It comes down to whether the central bank is preëmptive or reactive. In the former case the central bank takes the steam out of the economy. In the latter case it allows the steam to build up. Equity markets typically turn down initially when they perceive a preëmptive central bank. The Federal Reserve is not obviously preëmptive. Equity markets are also apt to act negative when (negatively) surprised by policy. Given the nature of forward guidance it would be hard to be surprised. The failure of the S&P 500 to correct more is thus perhaps unsurprising. The sideways move may well prove to be the correction before the rally resumes in the summer.

The equity market may also eventually react negatively if it comes to believe the central has been reactive or ‘behind the curve’. It responds negatively because it then anticipates an aggressive catch up action by the central bank to stop inflation getting out of control. There is no evidence that inflation is getting out of control (indeed the evidence suggests ‘lowflation’ is becoming a problem). There is no fear of a negative policy shock arising from the Federal Reserve having been ‘behind the curve’. What should the discriminating market watcher be looking for to see if a negative scenario could emerge? The simple answer is bottlenecks.

Severe recessions typically impact different sectors unevenly. When the recovery gets a head of steam this can lead to bottlenecks. This can be for a specific commodity, manufacturing part, transport facility, type of labour and so on. It is bottlenecks that create localised overheating but can also slow the whole GDP creation process. In some cases bottlenecks are easily unblocked but in others they may need time. In the days of strong unions and relative pay bargaining, labour shortages could very quickly be translated into general wage increases and strong rises in inflation. This appears not to be the case at the moment. Of course, if GDP starts to grow faster than forecast then the central bank may anticipate bottlenecks and preëmpt through a faster than signalled pace of interest rate increases.

There is no evidence of bottlenecks or of accelerating growth. There is no evidence of preëmptive interest rate increases becoming an issue. Steady growth and forward rate guidance are providing a benign background for equities, at least in the USA market. The main concern for investors is the elevated earnings multiple shown by some sectors and stocks. There is a legitimate concern about whether some stocks are priced too high relative to future earnings. However, this is a stock and sector selection issue. It is one that, at the moment, can be made without overall market trends confusing the issue.

The main risk to markets at present is geo-political. The market reaction to Ukraine has been benign because it is deemed to be a local event with few widespread consequences. This may change if the event escalates and sucks in more players or more aggressive economic sanctions begin to impact global economic activity. There is no way of predicting how the Ukraine situation will unfold.