Will Faster Growth Mean Lower Stock Returns?

Will Faster Growth Mean Lower Stock Returns?

That might seem a ridiculous question but it isn't as easy to answer as one might think. A conventional analysis says the recent tax cuts will create higher growth through a number of channels but I think primarily through increased corporate investment. As growth improves, interest rates will rise as monetary policy is "normalized". Stocks and other assets will need to adjust to this new interest rate regime. A bull would say that once this adjustment is done, stocks and other assets can then rise in step with the new, higher growth rate. I guess real bulls would say that no correction is even required, that stocks can just rise from here based on the new higher growth rate. Maybe, but markets and economies are messy beasts and there are a lot of offsetting factors involved here.

Would anyone disagree that the Fed's policies since 2008 have inflated asset prices? If one believes the Fed has a clue what they are doing, one need look no further than Ben Bernanke's own words to confirm that was one of the goals of QE:

Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.

It sure sounds like Bernanke expected QE to raise stock prices. The obvious question then, now that the Fed is committed to a tightening path - raising interest rates and shrinking its balance sheet - is, will stock prices now reverse? What part of current stock prices are a result of QE and how much is due to organic economic growth? Can tax reform create another avenue to maintain GDP growth - and stock prices - even as the Fed tightens? Will Fed tightening just be an offset to the positive of tax reform? For that matter what is the actual relationship between economic growth and the stock market? Does more growth necessarily mean higher stock prices?

It certainly seems logical to assume that GDP growth and stock returns are correlated. Higher growth means more earnings and dividends and therefore higher stock prices. Right? A study completed in 2002 by Dimson, Marsh and Staunton actually showed almost no correlation at all between yearly changes in GDP and stock returns. Other studies completed by various researchers since then have confirmed the finding. Of course, markets are forward looking so you might expect that stock market returns would predict future GDP growth. And looking at things that way does improve the correlation but only to an R-squared of about 25%, a statistically significant but still weak result. So, even if tax reform delivers the growth the stock market seems to be anticipating, it may not lead to higher stock market returns.

The recent stock market correction was widely blamed on an inflation scare but the facts and the market action of the last week belie that interpretation. If stocks sold off due to inflation fears why didn't the hot PPI and CPI last week induce more selling? Furthermore, most of the rise in inflation expectations preceded the stock market sell off. What did coincide with the correction in stock prices was a rise in real interest rates, a proxy for real growth expectations. 

Inflation expectations had been rising steadily prior to the stock market correction. This can be seen easily by observing 10 year nominal Treasury yields and 10 year TIPS yields. The 10 year breakeven inflation rate, derived from those two rates, rose from 1.86% at the end of November to 2.09% by January 26th when the stock market peaked. It continued to rise to 2.14% on February 2nd before falling back over the last week to 2.11%. And what did stocks do while inflation expectations were rising? From December 1st to January 26th, the S&P 500 rose 8.5%. If anything, the logical conclusion is that rising inflation expectations are positive for stock returns, not negative.

Let's zero in on those 10 year TIPS yields. They barely budged during most of the rise in inflation expectations. The rise in the nominal 10 year Treasury was all about inflation expectations until late in January when the 10 year TIPS yield started to rise rapidly. From January 17th to today, 10 year TIPS yields are up from 53 basis points to 79 basis points, a 49% rise. The rise in real yields is both an effect and a cause. Higher real yields reflect higher real growth expectations and also create conditions that lead to higher economic growth. Markets lead the economy not the other way around; higher real yields change behavior and therefore the economy. 

What about the yield curve, our best indicator of future growth? There is ample evidence of the yield curve's predictive power when it comes to economic growth. The simplified observation is that flatter curves are associated with weaker growth and steeper curves are associated with stronger growth. Actually it matters - a lot - how the yield curve is changing, especially when it comes to stocks but the simpler explanation will suffice in this instance. As inflation expectations rose through December and January, the yield curve continued its previous flattening trend, with short term rates rising faster than long term rates. The 10/2 curve did steepen by 3 basis points from the beginning of January to the stock market peak on January 26th. 

But during the stock market correction, from January 26th to February 9th, the curve steepened by 25 basis points, rising from 53 to 78 basis points. A steepening yield curve and rising real interest rates are signs of rising real growth expectations and, in this case, were coincident with the stock market correction. And since the stock market found a bottom the yield curve has flattened back to 66 basis points as stock prices have reclaimed much of their lost ground.

So, the fairly obvious interpretation of these market movements is that, contrary to popular belief, it was not an inflation scare that produced a stock market correction but rather a rise in real growth expectations. That seems odd but the facts are what they are, so the question then is why? Can we draw a connection between rising real growth expectations and weaker stock prices? I think we can.

Faster economic growth may not mean higher corporate profits beyond the one time step up due to the change in the corporate tax rate. Companies are already facing higher input costs due to higher commodity prices and rising labor costs. Commodity prices are rising primarily because the dollar is falling which is a subject that will require an entire future article to lament. Labor costs are rising due to one time bonuses (likely a one off like the change in the tax rate) and rising minimum wages. Can companies pass through those extra costs quickly? With slow income growth, a meager savings rate and rapidly rising revolving credit balances, I have my doubts. That means lower margins, a very logical explanation for lower equity prices. By the way, if you are still wedded to the idea that higher than expected average hourly earnings in the last employment report were the catalyst for the correction, this is how that makes sense. Not that higher wages would increase inflation - the Phillips Curve seems to be on the fritz right now - but because higher wages depress profit margins.

Faster economic growth - assuming tighter monetary policy isn't just an offset for newly eased fiscal policy - also implies an increase in investment which means a rising demand for capital. With that low savings rate and rising demand, it is easy to see why real interest rates are rising. The problem for the stock market is that capital has to come from somewhere and the most likely source of funds is the stock market. Well, maybe not directly but if you have lamented that companies have been engaging in financial engineering - aka stock buybacks - rather than investing in their business, I'd say be careful what you wish for. If companies do indeed invest more, they will have to decide between stock buybacks, dividends and borrowing to fund it. Since companies are unlikely to cut dividends and tax reform makes borrowing less attractive, buybacks are the logical place to cut back to fund more investment.

I don't have a crystal ball so I don't know if this is how things will turn out. I actually have serious doubts about whether tax reform will have the intended impact. And I wonder too how much of what is going on is being driven by a weaker dollar. A large part of the rise in investment over the last 18 months was in the energy sector, a function of higher oil prices which are themselves at least partially a function of a cheaper dollar. If real growth expectations rise, if the yield curve steepens, will the dollar rally and kill off some of the recent shale investment? Will tax reform raise investment in some other industries fast enough to offset any fall in shale investment? 

None of us have the answers to those questions and so a large dose of humility is generally a good habit for an investor. The market will provide answers in its own time but in the meantime you have to work from reality, not simple assumptions. Better economic growth, more evenly distributed economic growth, would certainly be welcome right now. But that may not mean higher stock prices, at least in the short run. And tax cuts are not a magic elixir. Even if they do result in a higher rate of growth eventually, it will take time to work. In the meantime, the Fed doesn't seem to be waiting around to see how it works out.