Optimism about the growing economy has lifted some major U.S. stock indexes to record highs in recent weeks. The question now is whether...
Optimism about the growing economy has lifted some major U.S. stock indexes to record highs in recent weeks. The question now is whether Wall Street will succumb to a recurrent fear: that the growth might be too much of a good thing.
The government reported Friday that a net 207,000 jobs were created in July, a strong showing that affirmed the health of the economic expansion this summer. Other recent data also have been upbeat, and second-quarter corporate-earnings reports have mostly been a pleasant surprise for investors.
All of this helped to drive up stock prices last month and stoke optimism about the longevity of the current bull market, which will be 3 years old in October.
But the rally stalled late last week, and stocks ended broadly lower Friday after the employment report. The problem: Good news about the economy is having the usual effect on interest rates — driving them higher.
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Federal Reserve policy-makers will meet today and are expected to raise their benchmark short-term interest rate, the so-called federal-funds rate, from 3.25 percent to 3.5 percent. It would be the Fed’s 10th rate increase since June 2004.
The jump in job creation in July added “supporting evidence that the Federal Reserve will continue to increase interest rates for the rest of the year,” said Eugenio Aleman, senior economist at Wells Fargo in Minneapolis.
A popular theme on Wall Street for much of 2005 has been the Fed would pause in its credit-tightening, giving both the stock market and the bond market a break.
But the economy’s strength suggests that “Fed officials are probably boosting their estimate of how far the funds rate ultimately needs to rise,” Goldman Sachs economists warned clients Friday.
To many stock market bulls, this is a nice problem.
“I think the employment report is good news for stocks,” said Ed Keon, investment strategist at Prudential Equity Group in New York. He reasons that a healthy economy bodes well for earnings growth in the second half of the year, which could underpin share prices.
Instead of slowing, Keon said, “it looks as though profits may actually accelerate in the second half.”
One driver should be a restocking of business inventories depleted in the second quarter, according to Joseph Carson, economist at Alliance Capital Management in New York.
The government estimates the economy grew at a real annualized rate of 3.4 percent last quarter. The rate would have been faster if businesses hadn’t allowed inventories to decline, Carson said.
It appears many companies were expecting a moderate pace of demand from consumers and other businesses, and were “blindsided by the strength in sales” in spring, Carson said. By restocking in the current quarter, the corporate sector should help spur the economy to a hefty 4.2 percent growth rate in the period, he said.
For most of July, investors seemed thrilled by the economic data and by second-quarter earnings. With 80 percent of the companies in the blue-chip Standard & Poor’s 500 index having reported quarterly results, operating earnings for the index are on track for a year-over-year gain of 11.5 percent, according to research firm Thomson Financial in Boston.
But most stocks have pulled back since Thursday. The losses were relatively modest, but they raised concern investors were beginning to focus on economic growth as a negative for the market because of the effect on interest rates.
Peter Boockvar, investment strategist at Miller, Tabak in New York, thinks investors have good reason to fear higher rates. The economy, in his view, is heavily dependent on low interest rates, in large part because cheap money has fueled the booming housing market, which in turn has supported consumer spending as people have tapped their soaring home equity.
The risk is rising rates could cause trouble for the economy much faster than investors might expect if the housing market were to slow substantially, Boockvar said.
In the stock market, the hope that stronger earnings growth could trump rising interest rates is “playing chicken with the Fed,” he said.
Besides threatening spending, higher rates pose another challenge to stocks by making fixed-income instruments, including bonds and bank savings certificates, more competitive.
Because there is little question the Fed will continue to raise short-term rates, some analysts say the fate of the stock market’s summer rally might rest with long-term rates, which the central bank doesn’t directly control.
At 4.39 percent Friday, the 10-year Treasury note yield was up from 3.9 percent in late June but still within the range of 4 to 4.5 percent that has prevailed for most of the past two years.
Economists have offered many reasons investors have kept long-term rates tame since 2003, including a global savings glut that has translated into heavy competition to lock in long-term yields.
Some analysts also say low bond yields reflect investors’ collective belief that economic growth and inflation are more likely to slow in the years ahead than speed up.
In any case, the biggest test for long-term rates looms: As the Fed further pushes up short-term rates amid a revving economy, will bond investors be willing to accept the same skinny yields or will they demand significantly more?
A sharp jump in long-term rates could reinforce the stock market’s fears about faster economic growth being a bad thing, analysts say.
If long-term rates remain restrained, by contrast, they might give equity investors confidence to bet a growing economy and rising corporate earnings mean share prices have further to run.