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Will the Fed Pause Too Late to Help the Economy?

Last update on: Nov 24 2019

The Fed will continue to tighten monetary policy, the economy will continue to slow and earnings growth will continue to decline. The real question is, “By how much?”

I warned last spring that we were in the late stage of the economic cycle, and for  several months have said we’re past peak growth. Investors began to recognize this in the last quarter of 2018, and that’s why stock prices fell.

Futures markets indicate stock investors believe the Fed and other central banks won’t raise interest rates any higher (despite the Fed announcing plans to raise rates at least twice in 2019) and that inflation will remain below 2%. Investors seem to believe this action will keep the economy and earnings growing at their recent rates.

But I expect the tightening the Fed already has implemented will continue to work its way through the economy, reducing growth. Most stock analysts, however, still haven’t reduced their earnings forecasts much, even as companies face increasing obstacles to maintain recent growth rates.

For example, stock buybacks are likely to decline as the one-time cash surge from the 2017 tax cuts fades and cash growth from operations slows. Stock buybacks have been a major support of stock prices through the bull market.

Slower economic growth is likely to be a drag on earnings growth. Global companies were the first to report disappointing earnings growth, because Fed tightening first affects overseas economies. Soon, more U.S. companies will report earnings disappointments.

The tight labor market in the United States has led to steadily rising wage growth, and that’s likely to continue for a while. The labor market is a lagging component of the economy. Wage growth often remains strong even after the economy is past the peak. Wage growth will crimp profits, because productivity growth is low.

Data and surveys indicate some sectors of the economy have reached capacity constraints, and that’s increasing the cost of doing business. Other trends limiting growth and earnings are strength in the dollar, global competition and trade conflicts.

Company managements have been warning slower growth is coming, but analysts generally don’t seem to believe them. The good news is that none of my reliable indicators that a recession is imminent are giving warning signs yet.

In 2019, there’s likely to be a growing debate over how much the Fed’s shrinking balance sheet matters. The Fed stopped buying securities to increase its balance sheet in 2015. The U.S. central bank last year began allowing some of the securities to mature without replacing them. You can see from the chart that the Fed’s assets have been declining. The debt issuers, especially the federal government, need to find new investors to buy new bond issues. That’s a major reason interest rates increased rapidly from the lows of July 2016.

Even if the Fed stops raising interest rates soon, it likely will continue to reduce its balance sheet. The Fed says that’s not likely to have much of an effect on the economy or interest rates, and most investors seem to agree. But balance sheet expansion was a powerful source of stimulus, and I expect shrinking the balance sheet will have a powerful effect in the other direction.

The European Central Bank also plans to stop buying securities, which is likely to raise interest rates and have a negative impact on growth and stock prices. I expect Europe will attract more headlines in 2019. Growth and stock prices are down, and the Italian debt problem is likely to resurface in a big way.

Add the economic problems in China to this mix, and it’s a safe bet that the rest of 2019 will be interesting. Your portfolio should be prepared for a lot of volatility and surprises.

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