The 2005 year-end equity rally, like the one in 2004, makes sense based on steady economic growth, consumer resilience, solid corporate profits, and the realization that rate hikes are reducing the inflation threat without slowing the economy. It also looks like 2006, in economic terms, might be a repeat of 2005 and 2004: steady growth (despite talk of slowdowns), falling unemployment, strong growth abroad, and more Fed hikes than suggested by interest-rate futures.
The current scenario reminds me of the movie Ground Hog Day
, in which Bill Murray repeats the same day several times until he gets it right. Fortunately, these have been reasonably good days for the U.S. and global economies.
I disagree with the latest version of the theory that “bad news is what’s good for equities,” whereby some hold that stocks are rising because the economy and housing are getting weak, which will force the Fed to pause and even consider rate cuts. I agree that equities will rally some when the Fed nears a pause, but I don’t think we’re at that point yet. Equities went up in 2003 and 2004 even though the Fed didn’t “help” them do so. In June 2003, the Fed didn’t further reduce the fed funds rate to 0.75 percent. It then hiked earlier and more than many expected in 2004. I note the same backdrop for the current 2005 year-end rally: a sturdy, profitable economy and higher interest rates.
Rate hikes will probably continue, disappointing those who are counting on a pause. I expect the Fed to hike to 5 percent (from the current 4 percent) due to economic growth, falling unemployment, a moderate inflation bulge, and a big reservoir of excess liquidity in the global economy.
The consumer and housing market are, in my belief, relatively well insulated from rate hikes, arguing for the fed funds rate to rise above expectations and higher than the 4.75 percent peak in less-insulated England.
In fact, an early rate pause would require a substantial economic slowdown, a decline in core inflation (now at the limit of the Fed’s tolerance zone), a Fed interest rate overshoot with a related plunge in gold and commodity prices, a prolonged decline in housing (the Fed wants softness, so that won’t cause a pause), or a substantial yield-curve inversion (I agree with the Conference Board’s August shift in methodology to measuring the “cumulative inversion” and not the flattening.)
That said, the biggest risk to equities is the scheduled tax hikes in 2008 and 2010, which will come if Congress does not act to extend the tax cuts of 2003. If core inflation bulges, the Fed might overreact, causing a slowdown and hurting equities — but I think that’s an issue for late 2006. In the meantime, stocks should continue to outperform bonds. The S&P 500 has returned a healthy 9.65 percent in the 12-months through November 23, 2005, while 10-year Treasury bonds have returned just 3 percent (change in price plus yield and dividend).
Like Murray in Ground Hog Day, we just might do this year again. But these are days worth repeating.
– David Malpass is the chief economist for Bear, Stearns.