Three Likely Scenarios For The Economy and Markets

Monetary policy drives the economy and the markets.

Taxes, trade, and other issues influence economic growth and the markets. But monetary policy is the main driver. Easier monetary policy leads to rising financial markets and a growing economy. Tighter monetary policy has opposite effects.

Once the Federal Reserve began raising interest rates and tightening monetary policy in earnest, three scenarios were likely for the economy and markets. Those scenarios still are likely today, though the probability of each has changed.

The first and worst-case scenario is that the Fed tightens too much. That would trigger a bear market in stocks and a recession. This result would be a serious problem today, because the Fed has so few tools left to reverse a recession. In normal times, the Fed would lower interest rates and take other actions to increase liquidity in the economy.

After the financial crisis, however, the Fed embarked on its period of extraordinary monetary policy. It brought interest rates down to near zero and expanded its balance sheet by buying treasury bonds and mortgages. Interest rates no longer are near zero, because the Fed started raising rates in 2015. But interest rates are well below historic norms. The Fed would have to reduce rates below zero to reduce them as much as it normally does to combat a recession. Additional purchases of bonds and mortgages also are likely to have less of an effect than they did following the financial crisis.

The second scenario is the most optimistic.

It would be a repeat of early 2016. That’s when global markets were tumbling and there was talk of a worldwide deflation. Central banks around the globe quickly implemented strong stimulus policies. They increased liquidity and the monetary base throughout the world. Markets and the global economy quickly recovered.

The third scenario is that the Fed enters a period of neutral policy. It doesn’t try to tighten monetary policy, but it also doesn’t take any actions to expand monetary policy or stimulate the economy.

I had real concerns in late 2018 about the first scenario becoming a reality. In public comments Fed officials indicated they would raise rates as long as the labor market was strong and said they weren’t concerned about the stock market. The Fed had tightened interest rates several times in 2018 and said it was firmly committed to raising rates at least twice in 2019.

Investors also were very concerned about this scenario. Markets tumbled around the world in the last quarter of 2018.

That’s why in December 2018 Fed officials changed their rhetoric. They began saying interest rates had been normalized and that it was time to watch the data before deciding which actions to take next. The change was made official in the Fed’s meetings early in 2019. Monetary policy officially went on pause. It’s possible the Fed tightened too much, because it takes a while for a change in monetary policy to fully work its way through the economy. But so far the data indicate the economy hit a bottom in early 2019.

The second scenario, in which the central bank decides to stimulate the economy, seems unlikely. The economy would need to turn sharply lower for the Fed to start bringing rates back down near zero and resume buying securities. The Fed has shown no inclination to take these actions, though market pricing indicates most investors expect one or more interest rate cuts in 2019.

For now it seems we’re going to experience the third scenario. The Fed stands pat and follows the data. If the economy continues to grow, even at a slow rate, the Fed probably won’t take additional action.

The markets responded favorably when the Fed switched from its tightened policy to a neutral stance. But investors are likely to be disappointed.

Investors seem to be betting that 2019 is going to be like 2015.

Back then, the labor market also was strong and the economy was growing. The Fed decided to end quantitative easing. As the year went on, there was a debt crisis in Greece, a stock market tumble in China, and another debt problem in Puerto Rico. Interest rates rose and stock markets declined. The economic data became worse.

By early 2016, global markets were in panic mode. The Fed responded by boosting the monetary base, and other central banks took similar actions. The economy and markets recovered so well (aided by the 2017 tax cuts) that the Fed began its fairly aggressive tightening policy.

A repeat of 2015 and the following years is unlikely. As I said, the Fed is unlikely to unleash stimulative policies now without economic and market downturns similar to those that occurred in 2015 and especially early 2016. We’re also not likely to have fiscal stimulus because of divided government in Washington.

With both the Fed and Washington on pause, we’re likely to have a period of steady, moderate growth for some time. Earnings growth and profit margins are likely to be less than in recent years and than what’s priced into the markets. The economy also faces headwinds from slower growth in China, weakness in Japan and Europe, and a potential crisis in Italy.

U.S. stocks are priced for a continuation of economic growth exceeding 3% and strong earnings growth. That looks too optimistic to me given the headwinds facing both the economy and earnings. This is a good time for investors to be cautiously optimistic. They should own diversified, balanced portfolios and have a a margin of safety in each position.

This article was written by Bob Carlson from Forbes and was legally licensed through the NewsCred publisher network. Please direct all licensing questions to legal@newscred.com.