January 10, 2018

Stocks set another record high yesterday, but finished well off their highs for the session after yields on long bonds moved up yesterday afternoon. That decline in bond prices and rally in yields has carried over this morning sending futures lower.

As we note often, the two primary determinants of stock prices are earnings and longer term interest rates. Since the tax bill began to evolve and the prospects for passage started to rise, investors have gradually built in the benefits of a large corporate tax rate cut into earnings prices. That process, while largely complete, will probably be ongoing through earnings season that starts in earnest Friday as several major banks report results. Earnings season will wind down in early February, but after a few dozen key companies report, most of the necessary upward adjustments to estimates will be factored in.

It has been presumed that the effect of the tax cuts and other pro business steps taken in Washington could begin to ratchet up inflationary pressures. Just this past week, the spread between 10-year Treasury bond yields and 10-year TIPS rose to over 2%, a key message that markets were finally pricing in an inflation rate consistent with Federal Reserve targets. Wages are also starting to rise. While last Friday’s employment report saw year-over-year increases stay at a muted 2.5%, the month-over-month increase was 0.3% or about 3.5% on an annualized basis. Oil prices yesterday hit a multi-year high. Other primary metal prices are also at multi-month highs. With that said, it was only in the past couple of sessions that bond prices themselves began to reflect these changes. In the imperfect world we live in, everything doesn’t get discounted at exactly the same moment. Thus, while the benefits of lower taxes were being priced into stocks between November and early January, the impact of higher inflation may be just starting to take hold.

These impacts pull stock prices in opposite directions. Upward earnings estimates clearly push stocks higher, while higher interest rates move them lower. If we all had perfect crystal balls, we would know ahead of time precisely the magnitude of upward earnings adjustments and how increased economic activity would push inflation expectations and therefore interest rates higher. But we don’t. Moreover, should inflationary pressures increase persistently, the Federal Reserve, whose primary task is to maintain a stable pricing environment, would likely take a more aggressive tightening stance toward monetary policy. If it were effective, the net impact would be that short term rates would rise more than expected, but inflation expectations would moderate as would the pace of increase in long term rates.

Right now, the 10-year Treasury yield sits at about 2.6%, virtually identical to the February high when everyone was so excited about the prospects of Trump’s economic agenda. If rates hold near here, the negative impact on stock prices would be muted. The impact of higher earnings would more than offset the modest rise in interest rates. If, however, rates shoot up toward 3%, that could easily slow down, or even halt temporarily, the honeymoon equity investors have had over the first days of 2018. But the real fear for both stock and bond owners would be a rise closer to 4%.

In a normalized world without central bank intervention, the current rate of growth and inflation expectations would suggest a 10-year Treasury rate of 4% or a little higher. But we live in a global world and with 10-year German bunds trading at about a 0.5% yield and similarly Japanese bonds returning hardly anything at all, the upward pressure on bond prices caused by so many foreign buyers active in the U.S. market has kept rates subdued for a long time. Even though the Fed has stopped buying bonds in the marketplace, the EU, Japan and China continue as buyers. Japanese institutions that have long been buyers of Japanese bonds can’t do that any longer because the yields they receive are inadequate to meet pension requirements. They are forced to go outside, and American bonds offer the best combination of yield and safety, even acknowledging that buying American bonds takes on some currency related risk.

Thus, even though a combination of 3% growth and 2% inflation might suggest a 10-year Treasury yield of 4% or a little more, I doubt yields will get there quickly. But, at some point, as world economies improve, central banks will no longer be active buyers of bonds. As they pull away, the gap between actual market rates and a more logical but theoretical normalized rate will close. If 10-year Treasuries today returned 4%, there is little doubt that they would become increasingly appealing to investors to the point that some would sell stocks to buy these bonds even with the prospect of very strong earnings ahead.

I would also like to add two exclamation points. First, the impact of the tax cuts is one time in nature. In 2018, companies will be reporting earnings with a U.S. corporate rate of 21% versus 2017 historical numbers based on a tax rate of 35%. Next year (2019), the comparison will once again be apples-to-apples. That leads to my second point. Stocks look 6-9 months ahead. The outlook for mid-late 2018 is excellent. But as we move forward to later in 2018 and look 6-9 months further out, we see periods of slower year-over-year earnings growth, and perhaps, higher inflation and higher interest rates. Thus, while it is nice that most companies will benefit this year from the tax cuts, the real focus for equity investors should still be on companies with real organic growth. Strong persistent growth will carry through 2018 and 2019 even with moderate increases in inflation expectations. Clearly, if inflation gets out of control, we face a big problem, but that is putting the cart way in front of the horse. Right now, we are only talking about modest, albeit persistent increases in inflation expectations. Markets can absorb that without much pain. If markets correct for a day or two in sort of a hangover reaction to the exuberant celebration of the past week, that is probably a healthy reaction. There is no reason, for now, to be anything but optimistic. But one needs to be sober as well.

Today, Pat Benatar is 65. George Foreman is 69. Rod Stewart turns 73.

James M. Meyer, CFA 610-260-2220

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