Submitted by Lance Roberts of STA Wealth Management,
1. Nothing To Fear From Fed Rate Increase
There is an overwhelming consensus of opinion that the markets, and the majority of mainstream commentators, that when the Fed begins raising rates that it is a "good thing."
The primary premise behind that consensus is that the economy is now growing steady enough to absorb the impact of higher interest rates. This opinion was espoused yesterday by Kansas City Fed President Esther George who stated:
"I don't want us to be behind the curve in beginning to normalize interest rates. When you see the economy getting as close as we are to full employment, to stable inflation, it would suggest to me that the time has come to do that."
There are a couple of things worth considering at this point:
1) As I addressed previously, the economy is very closely tied to the cost of capital. When you consider that a large chunk of corporate profitability as of late has been created through the use of cheap loans to buy back shares, rising borrowing costs make this option much less lucrative. Rising borrowing costs also directly impact the consumer spending through variable rate credit, auto sales as loan payments rise, and housing through increase mortgage payments. (The referenced article has further points on this issue)
2) With regards to the statement, on full employment there is really only one type of employment that ultimately matters which is full-time. Part-time and temporary employment do not foster household formation, higher levels of consumer spending or increased tax revenues. The issue is that even though the unemployment rate is approaching levels of "full-employment," it has been primarily a function of the shrinking of the labor force. As shown in the chart below, full-time employment is basically at the same level as it has been since the financial crisis as "real employment" has primarily been a function of population growth and little else.
3) There is little evidence that current levels of inflation are stable. As I wrote in "Will The Fed Move To Soon", the decline in economic growth globally, along with increased deflationary pressures, is likely to be reflected in the domestic economy sooner than later. Furthermore, given the fact that it is highly likely that the U.S. will have another exceptionally cold winter, the reality is that current levels of inflation have been little more than a transient surge. (See: Worse Than 1930's Depression, Europe's Recession)
There is little argument over the fact that the current economic growth rate has been "sluggish" at best and that growth has been primarily supported by the Federal Reserve's ongoing balance sheet expansion. The Federal Reserve is now going to start increasing interest rates, removing that accommodation, at a time when economic growth is at extremely low levels. The question that we must consider is whether the "patient" can survive without "life support."
4) Lastly, the table below shows the history of Federal Reserve rate hikes, from the month of the first increase in the 3-month average of the effective Fed Funds rate to the onset of either a recession, market correction or both.
The average number of months between the first rate hike and a recession has been 42.4 with a median of 35 months. However, if we take out the two extremely long periods of 98 months following the 1961 increase and 84 months following 1994; the average falls to just 28.6 months. Given the fact that the current economic cycle is extremely weak and, at more than 60 months, already the fifth longest Post-WWII recovery, it is likely that even 28 months is on the long end.
The average stock market correction following the first rate has occurred 21.2 months later. If the first rate hike occurs in 2015, this would put the next market correction in 2016 which would correspond with my recent analysis on the collision of the "Decennial and Presidential Cycles:"
However, the IMPORTANT FACT is that the number of times the Federal Reserve has hiked interest rates without a negative economic or market impact has been exactly ZERO.
2. Stock Buybacks On The Decline
As discussed above, one to the impacts of rising interest rates is an increased cost of capital which makes two things MUCH less lucrative. The first, and most importantly, is the "carry trade" which has been a primary driver of asset prices over the last five years. Banks have been able to borrow capital at effectively zero, leverage it, and then buy higher yielding assets to capture the spread. This has created an immense amount of profitability for banks, in particular, in recent years. However, higher borrowing costs significantly reduce that profitability.
Secondly, corporations have been using exceptionally low interest rates to borrow capital, not for the purposes of ramping up production and capital investments, but to buy back stock to artificially boost profits per share. The focus on share buy backs has been intense over the last couple of years as the benefits of cost cutting, employment reductions and wage suppression met their inevitable limits. Like other profitability gimmicks, share buybacks are also finite in nature. After more than two years of increased share repurchases, recent data suggests that this may be coming to an end. As Brett Arends penned:
"U.S. corporations have been spending hundreds of billions of dollars a year buying in their own stock, simultaneously increasing the demand for the stock and reducing the supply. And this matters right now because…er…they just stopped.
The amount spent on share buybacks plunged by more than 20% last quarter…As SG notes, 'US corporates (have) been the major net buyer of US equity in recent years, purchasing over $500 billion of stock last year alone.' But, notes the bank, this happy trend may be drawing to a close."
The ready supply of "free capital" has been a "punch bowl" to corporations from which they have drunk deeply. According to the Federal Reserve, corporate debt has risen 27% over the past five years to $9.6 trillion. So, much for those deleveraged balance sheets and when the Federal Reserve does increase interest rates; a major supporter of asset prices in recent years will disappear.
3. The Taper Effect
The team at GaveKal Capital did a great piece of research confirming something that I have discussed many times in the past which is simply that everything is tied to the Federal Reserve's liquidity interventions.
As the Federal Reserve has begun to taper their ongoing bond purchases, now at $25 billion and expected to be eliminated by October, the effect has been felt on a host of asset classes and economic statistics from inflation to stocks. To wit:
"…the number of stocks trading above their 200-day moving average has dropped back in line with what the taper model would suggest. If this continues to follow suit, we could see the fewest number of stocks trading above their 200-day moving average in over 2+ years."
There are two important points to take away from this analysis. First, as I discussed previously, there is an ongoing belief that the current financial market trends will continue to head only higher. This is a dangerous concept that is only seen near peaks of cyclical bull market cycles. While the analysis above suggests that the current bull market could certainly last some time longer, it is important to remember that it is "only like this, until it is like that."
The problem for most investors is that by they time they recognize the change in the underlying dynamics, it will be too late to be proactive. This is where the real damage occurs as emotionally driven, reactive, behaviors dominate logical investment processes.
via Zero Hedge http://ift.tt/1ziQDu1 Tyler Durden