Before Friday’s stock market rout, which pales in comparison to Monday’s biggest point-decline ever, everything was coming up roses for the U.S. economy. Synchronized global growth, low inflation, solid job creation, a strong sense of optimism among businesses and consumers, robust corporate earnings, aided and abetted by the recently enacted tax cut: What’s not to like?
All that changed Friday with a single statistic in a single economic report that fanned “inflation concerns” and triggered a synchronous stock and bond market selloff, at least according to press reports.
Monday’s 1,175-point, 4.6% dive in the Dow Jones Industrial Average DJIA, -4.60% was accompanied by a huge rally in Treasuries, more than erasing Friday’s losses. “Inflation concerns” clearly took a back seat to — let me guess — flight-to-quality buying?
The price action in markets drives perceptions about the economy. But reality doesn’t change nearly as quickly, which is why simplistic explanations often vanish with the next day’s price action. Let’s take a look at a case in point.
The front page of Friday’s Wall Street Journal featured a story, “Tech Giants Power to New Heights,” detailing “record quarterly financial results” reported by Apple Inc. AAPL, -2.50% , Alphabet Inc. GOOG, -5.05% and Amazon.com Inc. AMZN, -2.79% on Thursday.
By Friday evening, following the Dow’s devilish 666-point decline, those stellar results were now “mixed,” according to the Journal story, which provided readers a link to the earlier, seemingly contradictory story on the tech giants’ record quarter.
What changed? Perceptions, as viewed through the filter of the stock market: that’s what.
While it is true that the U.S. stock market has been overvalued for some time, based on metrics such as price/earnings ratios, all it took was a two-day selloff to cast a shroud over weeks of optimism and price appreciation.
To be sure, warnings about a bubble in equities, and even bonds, have been a standard feature of TV commercials (buy gold!) and analysts’ reports for years.
What set things in motion Friday, according to press reports, was news that average hourly earnings had increased 2.9% in January from the prior year, just one of the data points in the monthly employment report. The increase represented the strongest wage growth since 2009.
For years we have heard chronic complaints about stagnant wage growth from politicians and the public. And for years, the Fed has been fretting over its failure to hit its 2% inflation target, finding some reason, transitory or idiosyncratic, to explain the chronic undershoot.
All of a sudden, when wages show some sign of life, suggesting the labor market is tight enough, and demand for goods and services strong enough, for employers to offer higher wages to attract workers, that’s a cause for alarm?
When pressed, Fed policy makers have made it clear that a 2% annual increase in the personal consumption expenditures price index is not a ceiling. The Fed is even considering “potential alternate frameworks for the conduct of monetary policy,” including price-level targeting, which would entail tolerating inflation in excess of 2% to offset the persistent undershoot, according to minutes from the December meeting.
It sounds nice in theory, but I’m not sure how it would play out in practice, given the “inflation concerns” fanned by Friday’s report of rising wages.
Just to put things in perspective, 10-year yields are about 50 basis points higher than they were when the Fed’s federal funds target rate was 125 basis points lower in December 2015. An increase in real rates, not inflation expectations, has been the main driver of rising yields since the start of the year. If yields are rising because of stronger growth, that’s a good sign, not a bad sign.
So what about the rise in inflation expectations, the other key component of nominal bond yields? The Fed has been worrying that inflation expectations are too low, depressing actual inflation. Again, the Fed’s goals are realized, and that’s a reason to rewrite the script?
Stocks have gone up so far so fast that a two-day, 8.5% decline in the Dow was enough to put fear in the hearts of investors and alter the backdrop of strong economic growth? Remember Black Monday, Oct. 19, 1987, when the Dow fell 508 points, a loss of 23%? That was a big deal.
Besides, if you are looking for early signs of a pick-up in inflation, don’t let wages guide you. Prices lead wages, not the other way around. Milton Friedman tried to deflate the notion of cost-push inflation decades ago, but the idea that costs push prices up keeps coming back.
Besides, Monday’s bond market rally cries out for a new story. Inflation concerns are so, well, last week. My money is on investors fleeing stocks for the safety and security of U.S. Treasuries. That should work for a few days, at least until the need to fund the government and raise the debt ceiling reminds investors of the Treasury’s massive borrowing needs this year.