February 12 update:
The correction or pull-back of about 10% is running its course. Much of the attention focused on headwinds created by higher interest rates (as the 10 year government bond heads for 2.9% is an overstated concern. Imagine you are flying a small airplane into a headwind. The FED has helped you (the stock market) fly faster by buying government bonds (and other dept) to keep interest rates lower. This builds up the FEDs balance sheet. Unwinding the balance sheet puts downward pressure on stock valuations and increases short-term interest rates. This tends to also cause longer term rates to go higher, but more on the basis of expected growth rate increases and inflation. The higher interest rates in turn, increase the headwinds for your airplane (stock market) making it fly slower. Thus, the sell-off.
This type of “fiscal-drag” is not likely to become severe. Our interest rates are greater than those in many other countries and the dollar has stabilized or even increased in value. From a foreigner’s point of view, a higher dollar value plus higher US interest rates make for an attractive investment. As foreign investment flows into the US it does two things: 1) It reduces our interest rates because foreigners are now playing the role of an accommodative FED by buying up our bonds. 2) It keeps the dollar from falling too much, or it causes it to increase in value. This increases the return to foreign bond purchasers and attracts even more portfolio capital into the US. In other words, the reduction in headwinds is due to foreign portfolio capital inflows. This allows our small airplane (stock market) to continue flying faster.
Problems of increased headwinds are actually elsewhere. Increased deficit financing for government infrastructure expenditure is a potential headwind increase because the increased supply of bonds will increase domestic demand for savings and thereby increase market interest rates even more. Still, this would only attract more foreign savings in the form of portfolio capital inflows from foreign sources and offset interest rate headwinds. Bigger problems are potential trade wars that lead to retaliation, reduced exports, and net job losses. Trade restrictions also result in a loss of welfare to consumers through higher prices. Moreover, losses of consumer welfare are always much greater (by a factor of 10 or more) relative to the value of the few jobs saved through trade protections. Hurting the consumer and reducing national income will also hurt the overall economy and become a threat to economic growth. This is the biggest head wind to worry about. Luckily, offsetting this recessionary head wind s the supply side stimuluses of the tax cut and deregulation policies.
While it is a case of reading the macroeconomic tea leaves in order to interpret future economic growth and earnings potential, it seems that the balance of weight comes down on the side of continued bull-market forces without too much in the way of interest rate or other heads winds slowing down the stock market.
