Last year US stock markets experienced the least volatile year on record, hitting new highs seemingly every day.  Then came the tax reform bill to end 2017, and a huge January with the S&P 500 rising 5.6%.  Investors, especially individuals who finally became convinced that the rally would go on, piled in.  It wasn't massive 1999-style euphoria, but many investors finally succumbed to the fear of missing out.

And as if on cue, sentiment (but not fundamentals) shifted, and stock markets gave up their 2018 gains.  The S&P 500 - as of the close on February 8th - was down 10.2% from its all-time closing high set on January 26th.

Everyone wants to find a "reason" for a correction, to explain what happened, especially when it takes them by surprise.  And these days the prime culprit, according to the financial press, is interest rates heading higher.  Some attribute this increase to rising wage pressures and inflation, some blame ballooning budget deficits.  But beneath it all is a widely-held belief that stock market gains have been propped up by easy money and low interest rates – a sugar high.  

Our answer to this: No!  The stock market has been driven higher by earnings growth.  In fact, given the recent downdraft in stock prices and the simultaneous increase in earnings estimates, the S&P 500 is now trading at roughly 16.7 times 2018 earnings estimates.  That's not high by historical standards. In fact, that is lower than the 30 year average of 19.4.

More importantly, we have been expecting interest rates to go higher and have urged the Fed to raise rates more quickly.  Given the pace of economic growth, the Fed is a long way from being tight.  At the same time, economic data has been strengthening and earnings are booming.  With 337 S&P 500 companies having reported Q4 earnings as of the 8th of February, 76.9% have beaten estimates, and earnings are up 17.0% from a year ago. This double-digit earnings growth is forecast to continue through 2018, even with higher interest rates. Corporate balance sheets are stronger than they have been in decades, spending is accelerating and the recent tax cut is an unambiguous positive.

Corrections scare the snot out of people.  For many, who thought markets only go up, they feel like the end of the world.  This is especially true when pundits start trying to explain the drop in stock prices by arguing that there are fundamental problems with the economy.  This time is no different.  But, in our opinion, this is an emotional correction, not a fundamental one.  The US is not entering a recession, and higher interest rates over the next few years do not spell doom for the economy or markets.

In fact, because of better policy, economic growth this year looks set to accelerate to 3%+ (we are forecasting 4% real GDP growth in Q1). That is why interest rates are rising, because of better than expected economic growth.  This is a good thing!  Not a reason to sell stocks.  In this case higher interest rates are a byproduct of a stronger economy, not the unwinding of QE or higher deficits.

Retail sales rose 0.4% in December, are up 9.0% annualized over the past six months and are up 5.5% year over year.  January's ISM Manufacturing and Non-Manufacturing indexes just hit the highest readings for a January in seven and 14 years respectively.  In January, hourly earnings were up 2.9% from a year ago, the best reading since 2009. At the same time, initial claims have been below 300,000 for 153 consecutive weeks.  Private payrolls were up 196,000 in January, and the unemployment rate is down to 4.1% and headed lower.  And no, this is not a "part-time" recovery.  In the past twelve months, full-time employment has grown by 2.39 million jobs while part-time employment is down 92,000!  With 5.8 million unfilled jobs and quit rates at the highest levels of the recovery, there should be little question why the Fed continues to hike rates.

We use a Capitalized Profits Model (the government's measure of profits from the GDP reports divided by interest rates) to measure fair value for stocks. Our traditional measure, using a current 10-year Treasury yield of 2.85% suggests the S&P 500 is still massively undervalued. The model needs a 10-year yield of 3.9% today to conclude that the S&P 500 is already at fair value with current profits.  Fair value, not over-valued.

What we focus on are the Four Pillars of Prosperity: Monetary Policy, Tax Policy, Trade Policy, and Spending & Regulation. So, let's see where those stand:

1. Monetary Policy – The Fed is still easy and will be for the foreseeable future. Remember, there are still over $2 trillion in excess reserves!

2. Tax Policy – Tax policy has improved dramatically on the margin, a tailwind for growth and earnings.

3. Trade Policy - The protectionist talk coming from Washington is worrisome, but, so far, there has been much more hot air than substance. In fact, total trade (exports + imports) sits at record highs.

4. Spending & Regulation – This is a mixed, but still positive, bag.  On the regulation front, 2017 saw the biggest decline in regulation, at least since the Reagan-era, and possibly in history.  That's great news for growth.  The spending side is still a concern.  The recent budget deal reached in the U.S. Senate boosts spending at least as fast as GDP growth over the next couple of years.  That's not a recipe for long-term economic acceleration, but also not an immediate threat to growth.

The bottom line shows that the fundamentals of the economy are strengthening.  Higher interest rates are a byproduct of a stronger economy. And, out of the four potential threats to the economy, only one is moderately negative.

It's not often you get a substantial pullback in the market when both economic and earnings growth are strengthening.  Stay calm. Stay invested in equities.  Don't fight the fundamentals.

Brian S. Wesbury - Chief Economist
Robert Stein, CFA – Deputy Chief Economist 

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Implications: The trade deficit expanded in December, coming in at $53.1 billion, the largest trade deficit since late 2008.  This may cause worry, as larger trade deficits are considered by many as a negative, but we see this report as a positive for the global economy.  Exports and imports both hit new record highs, rising by $3.5 and $6.2 billion, respectively.  Both exports and imports are up strongly from a year ago: exports by 7.3%, imports by 9.5%.  Expanded trade with the rest of the world is good news and total trade (imports plus exports), which is what really matters, is at a record high, up 8.6% in the past year.  Look for more increases in total trade in 2018 as economic growth accelerates in Europe and Japan.  Exports of goods to the EU and Japan are up 7.8% and 13.8%, respectively, in the past year.  In addition, the composition of US trade may change dramatically over the next few years, reducing the US trade deficit.  A lower corporate tax rate means firms that had previously placed production facilities and "paper" assets (like intellectual property) abroad, so they could claim a lower foreign tax rate, will locate some of those assets back in US.  As a result, the sales generated by those assets will count as domestic production, not imports, reducing our official trade deficit.  In the meantime, although rising imports are a positive sign about the underlying strength of the US economy, for GDP accounting purposes, they mean growth in production is temporarily lagging growth in spending.  As a result, international trade was a substantial drag on fourth quarter GDP, and the 1.1 percentage point subtraction from the initial estimate of the real GDP growth rate due to trade looks it will be revised slightly higher.  Plugging today's data into our estimates, as well as recent figures on construction and factory orders, it now looks like real GDP grew at a 2.4% annual rate in Q4 versus the original estimate of 2.6%.  However, we are still projecting growth at a 4.0% annual rate in the first quarter of 2018 and 3.5% growth for all of 2018.  The protectionist talk coming from Washington is worrisome, but, so far, there has been much more hot air than substance.  We will continue to watch trade policy as it develops, but don't see any reason yet to sound alarm bells.

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Implications:  A booming report from the service sector to start 2018, as the ISM non-manufacturing index rose to 59.9, the highest reading for the index since 2005.  While a pickup in activity was expected, the surge in January easily exceeded the estimates of all sixty-six groups providing forecasts. Fifteen of eighteen industries reported growth in January (three reported contraction), while all major measures of activity stand comfortably in expansion territory.  The most forward looking indices – new orders and business activity – both rose in January and stand above their five-year averages.  And with tax reform passed in late December, survey respondents noted expectations that the new tax bill will increase activity in the months ahead.  Supplier deliveries were unchanged in January, but remain elevated from the levels that we saw in mid-2017, before the hurricane season. While there may still be some lingering remnants of storm impacts, this also reflects a pickup in orders and activity due to an accelerating economy.   The prices paid index rose to 61.9 in January, with rising prices cited across fuel types and metals.  In total, twenty-one commodities were reported up in price while just one, chicken products, was reported lower.  On the jobs front, the employment index rose to 61.6 from 56.3 in December. Jobs data out last Friday shows a more complete picture of the jobs market, which – along with the ISM services and manufacturing indices – paints a picture of a growing economy putting upward pressure on wages.  The stage is set for the pickup in economic activity so evident in other economic data to continue into 2018.  A policy shift toward growth oriented, supply-side policies in Washington have the potential to make 2018 a breakout year for the private sector.

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Back in the 1970s, supporters of the status quo said there was nothing to be done about stagflation (high inflation and slow growth).  It was a "fact of life" that Americans had to accept after experiencing faster growth and lower inflation during the decades immediately following World War II.

Then, along came the supply-side and monetarist economists with new ideas about how the "policy mix" mattered, that marginal tax rates affected the incentive to work and invest and that the supply of money helped determine inflation.  Simple ideas, in retrospect, but decried as radical notions at the time by supporters of the stagflation status quo.  Supply-side economics was dismissed as "voodoo economics."

Similar arguments have come back into vogue in the past decade, with apologists for slow growth arguing the US simply can't grow as fast as it used to.  "Secular stagnation" means growth will be permanently slow.  Rapid growth, they claim, is a thing of the past.

In the 1980s, when supply-side policies were tried, they worked.  Growth picked up, inflation fell.  Now, the U.S. is going through another major shift in the "policy mix," with the federal government focusing on deregulation and tax cuts.  In a nutshell, we've gone from a political philosophy that said "you didn't build that" to one that says "please build that."

As a result, expectations about the economy are changing rapidly.  The Atlanta Fed is now projecting real GDP growth at a 5.4% annual rate in the first quarter, which would be the fastest growth for any quarter since 2003.  We think that's on the optimistic side and expect growth at more like a 4.0% annual rate, but, either way, the economy is showing signs of an overdue acceleration and we are now projecting growth of 3.5% for 2018 (the fastest "annual" growth since 2003). 

Friday's jobs report brought news that wages are now accelerating as well.  Average hourly earnings grew 0.3% in January and are up 2.9% from a year ago.  Some analysts said wages were probably lifted in January due to unusually bad weather, which was also the culprit behind the drop in the number of hours worked for the month. 

It is true that the number of workers missing work due to weather was the second highest for any January in the past 20 years.  But we've had other months with nasty weather since 2009, and this is the first time since then that wages were up 2.9% over a twelve-month period.  Meanwhile, jobs increased 200,000 for the month, so we doubt bad weather was the key trigger.                     

Surprisingly, even uber-dove Minneapolis Fed President Neel Kashkari, who has dissented against rate hikes in recent Fed meetings, waxed enthusiastic on Friday about the faster pace of wage growth, saying it "could have an effect on the path of interest rates."  Kashkari and the rest of the policymakers at the Fed will have more than six more weeks to mull over the incoming data and decide whether they warrant a new path for short-term interest rates.  We think a steeper path is not only warranted, but likely.  

At the last meeting in 2017, which was the last time the Fed issued it's "dot plot" for the expected path of interest rates over the next few years, the median forecast was three rate hikes this year, with the odds of two rate hikes or less outweighing the odds of four rate hikes or more. At the press conference following that meeting, Fed Chief Janet Yellen said some, but not all, of the policymakers had incorporated the tax cut into their forecasts.

But now that the tax cut is a fact and the economy is accelerating, we think the new forecast to be released on March 21 will show close to an even split between advocates of three or four rate hikes.  We'd put our money on four, and we don't see a slowdown in economic growth during 2018, like we might have seen in some recent years, giving the Fed an excuse to pause its rate hikes during the year.    

No wonder the yield on the 10-year Treasury has gone from 1.86% on Election Day 2016 to 2.84% on Friday.  The "animal spirits" are restless, monetary policy is gaining traction, and the "secular stagnation" of the past several years is looking less secular by the day. 

In this environment, as markets reassess what's possible, we may have more days like Friday in the equity market.  But more economic growth will ultimately be a tailwind for equities, not a headwind.  Stock market investors who can't take a one-day 2.1% drop in equities, or even a 10% correction, shouldn't be in the stock market to begin with.  Those who can remain calm and stay invested will be rewarded.  

Brian S. Wesbury - Chief Economist
Robert Stein, CFA – Deputy Chief Economist 

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Source: St. Louis Federal Reserve FRED Database