Weighing Positives and Negatives in Today’s Markets

Headwinds and tailwinds continue to tussle against each other, confusing the outlook for investment markets and the economy.

For several years, synchronized global monetary expansion provided floors under stocks and the economy. But the Federal Reserve is now tightening monetary policy, and other central banks, with the exception of Japan’s, are preparing to follow suit.

The U.S. economy continues its solid growth. Stock prices moved higher as earnings growth consistently exceeded already-high expectations. The stock market’s technical factors also look good. Far more stocks are hitting new highs than new lows, and more stocks are increasing in price than declining in price.

The issue for investors is how much longer earnings and stock prices can continue to rise.

The S&P 500 and Dow Jones Industrial Average still haven’t exceeded January’s record highs, though they’ve been close. It’s looking like most of this year’s earnings growth already was priced into the markets in 2017’s surge.

The Fed’s tighter policy is steadily reducing the monetary base. That typically leads to slower growth and higher interest rates. Short-term interest rates are substantially higher than they were in late 2017, making safe, short-term treasury bonds a much more attractive alternative to stocks and other risky investments than they were less than a year ago.

Tighter monetary policy has been offset by fiscal stimulus, including tax cuts and deregulation. The power of the fiscal stimulus should fade late in 2018 or in 2019. Then, tighter monetary policy is likely to be the dominant factor. The markets usually are affected first by tighter money, and the economy follows.

Businesses have to overcome more than the effects of the Fed’s policies. Wage growth is up substantially, and that will continue because the labor market is so strong. That will pinch profits, especially since productivity growth is weak.

Trade conflicts and tariffs also are obstacles to higher earnings.

Stock buybacks and other financial engineering techniques helped push stock prices higher in recent years. The tax cuts stimulated a lot of buybacks in 2018 and that might continue into 2019. But buybacks are likely to fade with the tax cut stimulus.

Problems in Europe and China also create potential risks for stocks globally and in the United States. Each economy has significant imbalances and reported slower growth recently.

Investors need to remember that their key to success isn’t so much what happens in the future but what happens compared to what’s already priced in the markets.

The markets reflect expectations that the next couple of years will be very similar to the last few. Investors don’t believe the Fed will increase interest rates much more or that inflation will move significantly higher. Market prices also reflect expectations that earnings growth will continue at recent rates.

We’re in the late phase of the economic cycle, so investors have to beware of faltering growth and rising inflation. The biggest risk remains that central banks might tighten too much, but this year’s trade conflicts add a new risk.

There’s a lower margin of safety in most investments today than there was a year ago. The potential rewards from most stocks and bonds are fairly low since central banks are biased toward higher interest rates and the fiscal stimulus will fade.

In early 2016 and into 2017, the potential surprises were more positive than markets were expecting. I expected inflation and interest rates to be lower than were priced into the markets. Global growth also appeared more likely to surprise to the upside than the downside.

Now, the potential positive outcomes are largely priced into the markets. Any major surprises are likely to be negative and would reduce investor enthusiasm. Disappointments in earnings or the economic data could roil markets quickly.