Reaction to Market Meltup – Higher Interest Rates
The sharp drop in the market today reflects, in our view, the normal market reaction likely after what some labelled a market meltup. The recent rise in long-term interest rates, reflecting both the Fed’s less accommodative monetary policies and increased treasury borrowings, in part, can lead to such reactions as this. In our view, if such a reaction helps to reduce investor complacency it will result in a more sustainable market uptrend.
Surprising Strong Wage Increase – Inflation Fear and Impact on Long Rates
Today’s surprisingly strong wage increase of 2.9% YoY helped to focus investors on the potential for further increases in interest rates — particularly long rates. Increasing wages generally play the most important influence on the need for businesses to raise prices. The unexpected strength in wage increases puts a greater focus on the bond/note market as long-term interest rates reflect the long-term outlook for inflation. Because of this wage report, one of the more dovish Federal Reserve Bank presidents and a member of the Federal Open Market Committee tilted somewhat away from that view. Another reason for investor nervousness.
House Classified Memo Release— Creating Even Further Increased Congressional Warfare
At mid-day, the House Intelligence Committee released the formerly classified memo that alleges abuse of government surveillance powers by the Department of Justice. We suspect that also played a role in the market rout. That release likely added to investor concerns over the likelihood Congress can approve both Federal government-spending levels and raise the debt ceiling limit — all in the next 30 days or less.
Short-Term Market Technical Reaction — the Economy Remains Strong
Today and any near-term market decline reflect, in our view, a technical reaction to the market meltup. Importantly, the economy remains strong as corporate America uses tax reform to increase its domestic investment spending. And as today’s wage increase announcement shows, consumers should show the spending power necessary to continue the economic growth through the first half of this year. Therefore, once this correction runs its course, investors will likely return to the underlying strength of the economy and company earnings. Both should underpin further improvement in the market.
With the likelihood of a continued steepening of the yield curve, financials such as banks should respond positively. The maturing phase of the domestic economy should benefit industrials and commodity companies. As we move into the second half of the year, if the less accommodative monetary policy begins to bite, then stock valuations could be capped. At that time, earnings growth will likely prove more important to stock performance than expanding valuations. At that point, stocks with strong long-term earnings performance will benefit more than cyclicals. Prudently, investors should also consider alternative investments to substitute for some long-term fixed income investments.
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