The economy’s picking up steam

Many are wondering about the future of the Federal Reserve’s interest rate policy. Additionally, many are worried about the durability of the current stock market’s upward move, if and when the Fed starts to raise interest rates. We, too, are concerned about this issue but believe there is some time in front of us for the Fed to stay on the sidelines regarding interest rate shift.

Don’t get us wrong. We believe eventually the Fed will start to raise interest rates, and the following are some items to think about before that occurs.

Historical Precedent

The economy is growing. GDP is responding positively to all of the stimulus actions taken by the world’s central bankers, dating back to 2008. Statistically, the U.S. economy started growing during the third quarter of last year. During this period of time, the Fed has kept shortterm interest rates very low, at an average of 0.12 percent for Fed Funds. Moreover, the unemployment rate has fallen from a high of 10.1 percent to the current read of 9.7 percent.

Historically, as the economy has gathered momentum, the Fed has started the process of raising interest rates. This process normally starts with “jawboning” – the Fed starts to talk about monetary policy becoming neutral and statements about ending “monetary ease” occur. In our opinion, this has started. The jawboning phase has turned to more aggressive action as economic growth continues.

During this process, unemployment tends to continue falling. In the past, the Fed has waited for unemployment to fall by roughly 1.0 percent from peak before raising interest rates. Stated another way, we expect the economy to create roughly 500,000 jobs before the Fed seriously considers raising interest rates, or if the economy generates new jobs by 100,000 per month for a three-month period.

We anticipate next month’s employment data – to be released on April 2 – to indicate net job creation. This is another step towards reasonable job growth. Our expectation is unemployment may be below 9.0 percent by the end of 2010, with the unemployment rate reaching 9.3 percent (down 1.0 percent from peak) by fall of this year. Consequently, we would not be surprised to see the Fed start to move interest rates to the upside during the later months of 2010.

According to the Wall Street Journal (article dated March 17, 2010), the nation’s economists expect the economy will add an average of 132,500 jobs per month during the next 12 months. So, our outlook appears to be reasonable. 

Stock Market Action

From a historical standpoint, what happens to the stock market once the Fed starts to raise interest rates? The Fed has initiated the first rate hike on 18 occasions since 1931. On average, the stock market has experienced a negative reaction of roughly 3.0 percent during the two months or so prior to the rate hike actually occurring. Following the rate hike, the market traditionally has traded sideways (once again, on average) for the three-to-four months following the actual rate increase.

Consequently, based on past averages, the stock market has trended slightly lower during the four-to-six months surrounding the Fed’s first rate hike (Source: Ned Davis Research).

Final Word

 Is this the event which may derail the current bull market? We somewhat doubt it, but it certainly won’t help the bull’s case. As compared to the possibility of rising interest rates and a restrictive Fed, we are more worried about the following potential systemic problems:

 The state of the nation’s balance sheet

  Increasing tolerance towards protectionism and building negative sentiment towards free trade

  Rising tax rates

  The eventual potential of rising inflationary pressures

 But for the time being, the nation’s investors continue to be focused on the income statement side of the economy. As long as this continues, we expect the equity markets to grind higher. First quarter earnings will start to be released within the next couple of weeks – we expect good news. On balance, we believe the average company within the S&P 500 to report earnings growth in excess of 30 percent.

Remember, this time last year the economy was flat on its back, and corporate profits were down 31 percent from the previous year. The positive charge in earnings growth should be led by the consumer discretion companies (profits vs. losses last year), energy companies (oil prices are up 59 percent during the last 12 months), and technology companies (average up 62 percent from last year). Bringing up the end of the line may be the utilities (probably down a little), telecom and health care (up slightly).

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