It's About the Consumer (02/17/2016)

The stock market volatility that began in 2016 continues. Going back to the beginning of 2015, and measuring the market decrease since that time, overall U.S. equity value is down by about 10%, which represents a market correction.

For some time I’ve been indicating that consumer spending would increase, wages would rise, unemployment would be reduced, and inflation would remain under control. With the results of December and January now available: consumer spending has increased each month by 0.2%, unemployment is below 5%, and inflation remains unchanged! The University of Michigan’s January gauge of households reported that 45% of the households surveyed believed that their financial situation had improved. This is the highest rating in six months. Finally, retail sales were up an amazing 0.6% in January. Fortunately, the consumer isn’t following the stock market pessimism.

If the economic fundamentals are so good, remembering that the consumer represents about two-thirds of U.S. GDP, why is the stock market down? I believe a part of it relates to the new capital regulations imposed on banks. Under these new regulations, large sums of capital are required if a bank wants to hold a bond position. Instead of being able to take positions in bonds as they used to do, which helped the liquidity of the bond market, banks are now acting as middle men between buyers and sellers. This has brought about a reduced level of liquidity in the bond market, especially among lesser quality bonds. Overall, uncertainty over what the Federal Reserve might do, problems in China and low oil prices are making traders less willing to take on risk. For this reason, the interest rates on U.S. Treasury Bills, Notes and Bonds have dropped significantly, as money has been directed to acquire these very safe investments.    

Over the next several months, ultra low yields on the safest investments, when measured against less safe investments that give a higher yield, are likely to create a change in the market. Ultimately, the market balances risk and reward. As the relative reward grows, the willingness to take risk grows.

Ed Mallon