U.S. stocks have fallen nearly 10% since September. Does this decline represent routine volatility or has a new bear market begun? The answer may depend on how policy makers respond to market weakness.
Two policy-related concerns have contributed to the volatility. The first is worry that America’s trade standoff with China is worsening. The second is that the Federal Reserve remains intent on raising interest rates despite trade tensions and an apparent slowdown in the economy this quarter. Markets likely can withstand either assertive trade policy or an assertive Fed, but are struggling to cope with both at the same time.
The question becomes whether President Trump or the Federal Reserve will continue on their present course. As regards trade policy, all eyes will be on this weekend’s G-20 meeting to see if the U.S. and China can find common ground. President Trump has said he would like to make a deal, but investors are wait-and-see.
The Federal Reserve next meets on December 19, with markets anticipating a 0.25% rate hike to 2.5%. The Fed would like to raise rates to a level that it believes is “neutral” i.e. that neither stimulates nor restricts economic growth. It would also like to raise rates high enough that it has room to cut rates meaningfully during the next recession (whenever that may be). Some investors fear that the Fed, in its eagerness to prepare for the next recession, could inadvertently cause one.
Fortunately, there is room for both President Trump and the Fed to adjust course. The administration has no incentive to push the trade issue to the point that it causes lasting damage to the economy and markets. Likewise, the recent decline in energy prices and inflation gives the Fed room to postpone rate hikes. Accordingly, we ultimately expect either the administration or the Fed will back down from their present stance, which should stabilize markets and refocus investors on strong corporate fundamentals. Indeed, U.S. corporate earnings grew at an impressive 26% year-over-year rate in the third quarter.
However, if trade tensions instead worsen and the Fed does not modify its plans to raise rates repeatedly in the coming quarters, it could represent the type of policy error that has led to bear markets in the past.