More Macro - Still Matters
Next Steps
Next Steps
Reviewing my blog, it is clear there is a lot to share, some of it is poetry and may need a separate category; some of it is macro-economics and could be a rich seam of commentary. Why would anyone want to hear about that from me? Well, there are many ways to learn to do anything or understand anything. Everyone learns a bit differently. Processing things through my software may result in something interesting for some people. The cost of sharing is not high. In fact it has a benefit for me because it forces me to to process things in a more organized way. Sharing means caring about the quality of the shared content.
So, building on a post from over a year ago on the state of the economy and geopolitics, le’s review where we are at the moment. The economy and the stock market are not the same thing. The economy, however, provides major signaling for the market. Things the market ought to care about include jobs/employment; wage growth; interest rates; corporate earnings; productivity measures; factors influencing commodity prices (Houthis bombing ships, a hot war in Europe). The thing the market seems to care about most is how the Federal Reserve processes all these things and what steps it takes to make sure markets are functioning as required by the various policy goals they are pursuing.
Why does this matter so much? Because the stock market is all about expectations. Stock prices capture expectations about future growth projections for the underlying businesses whose stocks are being valued. They also depend on the discount rate applied to these future earnings projections, which mean they depend on the level of interest rates. If interest rates are higher, ignoring for the moment the impact that higher rates have on future earnings, then those future earnings will be discounted at a higher rate and be lower in present value terms; hence a lower stock price. The market also has expectations about the impact interest rates will have on future earnings. The assumption is that the Federal Reserve uses interest rates as a tool to squeeze down the availability of credit. This tool is assumed to be the regulator valve for an economy that is running either too hot or too cold. Too hot and the Fed nudges rates up; too cold, it eases. Whether the effect of rates is actually what it is assumed to be is another question; but let’s assume for the moment it is.
Pain and suffering in the stock market can be defined in a few ways. One is the overall level of stock prices; another is the direction of travel, up or down and the speed of that travel - also known as volatility. Most people, volatility traders excepted, don’t like volatility. Ideally, people like a smooth 45 degree line up and to the right for their investment portfolios. The Federal Reserve likes that too, especially in an election year.
The stock market is not the only market the Federal Reserve cares about. In fact, historically, it is not the main market it is supposed to care about. One of its key mandates is the smooth and orderly functioning of the bond market. With government debt at $32T and growing currently at about $2T per annum, keeping that market orderly and liquid is extremely important. And here is where it gets complicated. The Federal Reserve uses raising interest rates as a tool to turn down the temperature of the economy. Unfortunately, as one of the biggest debtors in the world, the US government has to pay more for its debt when rates are higher. All that interest expense for the government means interest income for those that own government debt. And so, that interest income increases GDP (gross domestic product), which, all else equal, is inflationary...which means the Federal Reserve has to keep interest rates higher for longer.
The reason the Federal Reserve cares so much about the stock market is because rising stock prices and gains associated with that drive tax receipts. Tax receipts are over 50% of the government’s revenue needed to fund interest expense, defense spending and social programs. Looping back to expectations, the Federal Reserve is well aware that managing the gap between reality and expectations is very important. If the market expects four interest rate reductions in 2024 and it only gets 3, then the market will throw a tantrum and stock prices will decline, reducing tax receipts, which will increase the government deficit, which will means the government will need to issue more debt at higher rates etc rinse, repeat. So, while the stock market is rising and people are worrying whether this is sustainable, people’s focus shifts away from the fundamental factors that should drive stock prices and toward what the Federal Reserve is doing to keep spinning the various plates with whose stability it is charged. Many economic factors, as measured by things such as ISM (a whole group of indices produced by the Institute for Supply Management to measure various aspects of an economy’s health) are not so positive right now and have not been for a while. However, there is a broad-based feeling that, in an election year, the Federal Reserve will use whatever levers it has at its disposal to keep things moving up and to their right.
Are there ways out of this slightly concerning loop? A couple of things: productivity and energy miracles. Taking the last first, finding more natural resources - think shale oil - or producing limitless supplies of energy through something such as nuclear provide more revenue and increase GDP in a good way. On productivity, think AI. Both of those things merit a longer discussion because each is complex. Before closing, it is worth pondering why there is such a gap between the economy the various ISM measures suggest we should be seeing reflected in the stock market and what we are actually seeing. Could it be that there is something of an energy miracle happening that is not being widely discussed?