The market has been on a steady climb in recent weeks. That’s following a “stealth” correction earlier in the year, when the S&P 500® treaded water for four months and many stocks declined.
Meanwhile, bonds have been doing pretty well, also. The Fed is almost done tapering, and unlike a year ago when the Taper Tantrum sent investors fleeing from bonds, this time they’re acting as though the Fed isn’t tapering at all.
So, for now at least, we remain in this low-volatility and low-yield world, and the stock market just grinds higher with barely anyone noticing. In this environment, without a shock to the system, investing has become a lot less adrenaline-filled than it used to be.
The market continues to benefit from a steady mid-cycle economic expansion. Although, inflation has perked up a little in recent months, it has thus far not been enough to move the Fed off its path of slow and gradual policy normalization, nor enough to make the bond market nervous.
The Fed appears on track to exit quantitative easing (QE) in the fall and then may eventually start raising the fed funds target rate sometime in 2015, until it reaches a neutral zone of roughly 2%–3%. Corporate earnings are expected to grow at around 7% in 2014, according to Bloomberg, and P/Es are in the mid-teens. So, take 7% earnings growth and add 2% for dividends—an estimate from S&P—and maybe another point for share buybacks, and you may get a 10% return with OK-but-not-great valuations.
What could change equilibrium
So far so good, but many investors are asking the inevitable question: What will upset this equilibrium of low volatility, low rates, and high stock prices? I think an inflation scare might be the most disruptive shock to our low-volatility, low-yield world order. A sustained upturn in inflationary expectations could leave the Fed too far behind the curve, and force it to normalize policy faster—and to a higher rate—than is currently priced into the markets.
As unlikely as this scenario may seem, I think it would have the most impact. Why? Because there is a widely held consensus that, yes, the Fed will be raising policy rates in the coming few years, but it will do so very gradually and only by a modest amount. In other words, what the Fed is planning to do and what it has prepared the markets for is not really tightening but gradually bringing policy back to a neutral zone. And even then this neutral zone is expected to be well below what it normally would be during previous Fed cycles.
Normally the Fed has tended to be somewhat behind the curve, in that it tends to react to incoming data, and therefore, by extension, to the bond market. Thus we see that, since hitting the zero lower bound, it did so by announcing that monetary policy would stay very accommodative, well beyond the point at which the targets for its key benchmarks (the unemployment rate and the inflation rate) have been reached. So far, all of this hasn’t been an issue, because inflation remains below the Fed’s threshold (2%), and the unemployment rate remains just above it (6%).
Deflationary mindset prevails
So, we remain in this low-volatility, low-yield world order. But if all of a sudden we do get an inflation scare, and growth accelerates on top of that, then the Fed may be forced to get a lot more hawkish and start ratcheting up its rhetoric in terms of forward guidance.
The question, of course, is how likely is the inflation-scare scenario? According to our economic team, the odds of its happening are low, for the reasons mentioned earlier. The headwinds remain, and the deflationary mindset prevails. But it’s a risk that possibly lurks somewhere ahead, and it’s something to keep in mind.
For now, investors are probably best served by having a plan that makes sense for them and to keep following it, almost no matter what.
Investment decisions should be based on an individual’s own goals, time horizon, and tolerance for risk.
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