In Search of the Goldilocks Economy

by: Richard A. Anderson

In closing 2018, the S&P 500 posted its worst December since 1931, during the Great Depression, and its worst quarter since 2008, during the Great Recession. The good news is we didn’t have to wait long for the bounce back. To start 2019, the S&P 500 posted its best January since 1987. As of Friday’s market close, the S&P 500 is 5.0% below its high on September 21, 2018, but is 19.0% above its low on December 26, 2018.

Do you remember what contributed to the S&P 500 declining 20.2% from September 21st to December 26th?

Fear and negative sentiment surrounding interest rates and trade negotiations between U.S. and China were charged with the lion’s share of the blame for the downturn in stock prices.

As it pertains to interest rates, comments made by Fed Chair Jerome Powell in a question-and-answer session with Judy Woodruff of PBS on October 3rd incited a sell-off in bonds and stocks. Powell’s comments that stirred up investors’ emotions were, “The really accommodative low interest rates that we needed when the economy was quite weak, we don’t need those anymore.” He added, “Interest rates are still accommodative, but we’re gradually moving to a place where they will be neutral. We may go past neutral, but we’re a long way from neutral at this point, probably.”

Translation: Neither the economy nor the stock market needs the Fed for continued support. They are both in a good position to withstand future interest rate hikes and those rate hikes are going to happen sooner rather than later. The Federal Reserve cannot let investors dictate interest rate policy.

The neutral rate Powell referenced is the point where interest rates are neither accommodative nor restrictive to the economy.

These comments by Fed Chair Powell were supportive of the U.S. economy, reinforcing the notion that the economy doesn’t need the Fed to provide stimulus anymore. In essence, the Fed can take the training wheels off of the economy. However, investors were spooked because the comments served as a warning that the Fed could raise rates faster than expected, which could put pressure on bond yields and stock prices.

Fast forward to today. What has contributed to the S&P 500 rising 18.3% from its December 26th low?

Optimism and positive sentiment surrounding interest rates and trade negotiations between U.S. and China. Does this sound familiar? The feelings of fear and negativity in late 2018 towards the issues of interest rates and trade negotiations have reversed to feelings of optimism and greed.

As it pertains to interest rates, comments made by Fed Chair Powell at the American Association and Allied Social Science Association Annual Meeting on January 3, 2019 sparked a market rally. Powell said, “If we came to the view that the balance sheet normalization or any other aspect of the normalization was part of the problem, we wouldn’t hesitate to make a change.”

Translation: Disregard everything said during that October question-and-answer session. The economy can support higher interest rates, but stock markets cannot at this time. Investors have spoken and interest rates will remain low.

This comment was music to investors’ ears, as it signaled the Fed would exercise caution and patience in raising interest rates going forward. Powell essentially walked back the comments he made in October.

I bring up these comments made by Fed Chair Powell and the reaction to these comments by investors to highlight that news does not always receive the reaction we would expect. Powell’s comments in October praised the strength of the U.S. economy. Yet investors reacted negatively because it could signal an end to the equity bull market. Contrastingly, Powell’s comments in January were less supportive of the U.S. economy. Yet investors responded positively because it could mean lower interest rates that breathe life back into an aging bull market.

There is an old expression that bull markets don’t die of old age, they are killed by the Fed. This expression is evidence that sometimes good news can be bad news and bad news can be good news when the market is hoping the Fed doesn’t get too aggressive raising interest rates.

Investors are like goldilocks. They are looking for economic data that is not too hot, not too cold, but just the right temperature. Too hot and the Fed could raise rates too quickly. Too cold and we could be headed for a recession. If the data is just right, we have economic growth that wards off fears of a recession while not forcing the Fed into action. This juxtaposition make interpreting data releases all the more tricky.