November 28, 2018

Stocks opened higher again this morning (Dow +433 pts; SPX +1.46%), soothing the frayed nerves of panicky traders. All eleven major market sectors are in the green, led by tech (+2.2%) and consumer discretionary (+1.9%) sectors. The VIX Index is nearly unmoved at about 19. We’re seeing a relief rally, especially in riskier assets. The dollar fell on Fed comments (see below) and commodities are getting some relief. WTI crude oil bounced back to nearly $52/barrel. Bonds are up in price, down in yield, also responding to the Fed. The 5-year and 10-year Treasury yields ticked down to 2.86% and 3.04%, respectively.

The Federal Reserve published a report on financial stability in Corporate American in general, and the banking system in particular. This is the first time the report has been made publicly available. The Fed says the financial system is in much better shape than before the last recession. Banks are well capitalized and household debt is at low to moderate levels. Consumers aren’t financially extended like they were before the housing crisis. But in many ways, the report is a series of warnings about risks well known to investors. Near-term risks to our economy include trade tensions, Brexit, and slowing growth across emerging markets. An important medium-term risk is business leverage (that is, corporate debt), which is near the highest level in 20 years. In some cases, debt has been rapidly increasing in companies with weak balance sheets. This could become a real problem in the next economic recession. Finally, the Fed once again expressed its view that asset markets (i.e. stocks, bonds) are overvalued. “An escalation in trade tensions, geopolitical uncertainty, or other adverse shocks could lead to a decline in investor appetite for risks in general. The resulting drop in asset prices might be particularly large, given that valuations appear elevated relative to historical levels.” Finally, the report also acknowledged that further interest rate hikes could have a negative impact on the economy. One might be tempted to think this report is an indictment of the economy and that the Fed is panicky—in other words, that this is bad news. To the contrary, this will be warmly greeted by investors, who have been waiting impatiently for the Fed to acknowledge that perhaps the economic outlook isn’t strong enough to warrant more interest rate hikes in the near-term. All of the risks listed above are already well known by investors.

In a speech today, Fed Chairman Jerome Powell just walked back all his hawkish comments made in early October that helped spark the stock market correction. This is a big deal for traders, and an interest news item for investors. He now says that current interest rate levels are “just below” the neutral level. That is, he’s implying very few rate hikes are needed to return to a more normal level that neither stimulates nor damages the economy. Mr. Powell also said the economic impact of rate hikes will not be known for a while (maybe a year), and he emphasized that the Fed is not locked into a “preset” path of monetary tightening. These comments seem to imply the Fed may pause its path of monetary tightening in 2019. As soon as the words left his mouth, the Dow shot up 450 points. This speech sort of removes one key overhang for stocks: the worry that the Fed will blindly tighten until it pushes the economy into recession.

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