News Flash – Interest Rates May Rise

Maybe it’s impossible to fully prepare oneself for the prospect of leaving NeverLand.  We get comfortable with things as they are and are easily shaken when facing the possibility they may soon change.  We have known for months that interest rates couldn’t stay at forty-year lows and that tax breaks and incentives wouldn’t remain the rule.  But with all the waling and gnashing of teeth on Wall Street during the past few weeks, we see proof of Benjamin Graham’s observation that the market is a “voting machine” in the short run, driven by the sum of individuals voting their emotions of fear or greed.  Only during longer spans of time does it settle into its more dignified analytical reputation as a “weighing machine” of the facts.   

A big question on investors’ minds in recent weeks has been when the Fed will raise rates.  That answer is becoming increasingly clear – soon.  But the more important unknown is by how much and what impact will the increases have on corporate earnings?  During the month of April both the stock and bond markets cast their short-term votes that rising rates would be bad for the economy.  Bond prices fell rather dramatically, driving both short and long-term rates to two-year highs.  The major stock averages fell despite surprisingly good quarterly corporate earnings reports.

Following a three-year bear market, investors are understandably reluctant to categorically believe the Fed, the overwhelmingly good economic and corporate news, continued improvement in productivity, low inflation, and the expanding global economy.  But, while there is much bad news in the world, most of the economic news remains positive.

Yes, rates are going to rise, but they can arguably go up considerably more before they make a significant impact on corporate growth.  During much of the go-go nineties short-term rates averaged 5.5% (five times current levels) while inflation oscillated between two and three percent.  It is now at 1.6%.  Yes it’s rising of late with economic improvement, but powerful new factors such as China and technology-driven productivity that suggest inflation will not be the problem that it has been in the past.  There just aren’t as many believers now as there were in 1999.

We hear from members of the Federal Reserve Open Market Committee that they learned just how important these economic factors are in keeping inflation low.  They have given every indication that they do not intend to stall the growth of this economy.  In a speech yesterday Mr. Greenspan said that “domestic economies are increasingly exposed to the rigors of international competition and comparative advantage. “Lower prices for some goods and services produced by our trading partners have competitively suppressed domestic price pressures.”  The Fed will likely be very cautious in raising rates.  Remember, it has been less than a month since they relaxed their concern for deflation.

The best news lately for the economy is that companies are adding to their payrolls and in a big way.  The number of jobs in the U.S. increased by 288,000 in April, exceeding the highest forecast by a wide margin.  The unemployment rate fell to 5.6% from 5.7% in March.  Jobs were added in manufacturing, construction and temporary help services.  The increase follows a revised gain of 337,000 jobs in March that was larger than estimated last month by the Labor Department.

Manufacturers added jobs for a third straight month, after revisions to February and March.  According to Bloomberg, job gains have averaged 217,000 a month, more than enough to absorb new entrants into the labor force.  Economists estimate that it takes gains from 125,000 to 150,000 to accommodate growth in the labor force.

From the corporate side we hear from General Electric Co. Chief Executive Officer Jeffrey Immelt who said economic conditions are “extremely strong” and repeated forecasts for this year and next for the world’s biggest company by market value.  “We’re also seeing volume up in theU.S.,Europe, in every one of these businesses.”  General Electric is a bellwether for the economy because of its diverse product mix and global presence.  First-quarter earnings for S&P 500 companies are double what analysts forecast at the beginning of the year.

After last year’s significant market rally, we are now in a period when good news is bad and bad news is bad.  The good news of the strengthening economy is met with fear that the Fed will be forced to raise rates aggressively, thereby stunting the economy’s growth.  The bad news is fueled byIraq, government deficits, trade deficits, and missile testing inNorth Korea, etc. etc.  Bull markets love to climb a ‘wall of worry.’  That means that a certain amount of pessimism is actually healthy for the market.  It keeps a lid on speculation and the harmful excesses that accompany it.  We don’t have to look back too far to remember the bevy of ills rampant speculation brings.  While that wall all but disappeared by the end of last year, it is now quickly reappearing.

As investors come to terms with higher rates, adjusting their earnings models accordingly, they will likely keep markets under pressure.  It is our belief that once the rate increases actually begin (June or July) investors will again focus on the bright potential of globalization and all the promise it brings for improved standards of living for all countries that participate.