Back to Normal Interest Rates

In my humble opinion the health of the economy is a priority over the short term preference of the stock market. Monetary tightening should have started three to four years earlier. Interest rates have been kept at a very low levels for seven years after the recession in 2008 allowing adequate time for the economy to recover. After the December 2018 hike of key rates to 2.25-2.5% range they have come close or just below the normal rate which will slow credit formation and money supply. This is a move from stimulative to neutral monetary policy (2.75% to3.0 percent) rather than restrictive monetary policy which is 3.25% or higher.

Running down the Federal reserve Balance sheet at a rate of USD 500 billion a year or roughly 50 billion a month will further restrict money supply and if the program continues for one or two years (in the absence of a surprise slowdown in the economy) will run down the Federal balance Sheet to 3.0 trillion from a peak of 4.5 trillion. This will help the Fed to better position itself to stimulate the economy through monetary policy and purchase of treasury securities when the anticipated recession knocks the door. Moreover, the Fed has almost moved away from accommodative policy together with running down the balance sheet which will help fight against anticipated inflation due to deficit spending.

Yes capital markets are feeling the pain, but the long term benefit of the economy will always outweigh short term corrections of the stock market. The S&P 500 index has benefited from a good run in 2017 and 2018 that raised the PE multiple to 24.9X in January 1, 2018. The index increased from 2695 on January 2 nd to 2872 on Jan 26 and declined to 2581 thereafter on April2 and compensated to 2930 on Sep20 and declined to 2455 on Dec 20. This is an increase of volatility coupled with a net decline in the index. As a result the price earning multiple of the S&P 500 index has declined from 24.97 in the beginning of the year x to 18.9X on December 20.

Law 115-97 introducing the tax cut in the United states on November 2, 2017 has helped boost personal and corporate income which has resulted in high growth of earnings in 2018. However, the growth in corporate income is more moderate in 2019 as the synergies from the corporate tax has already set in 2018. This being said the PE multiple of the S&P 500 Index is 18.9X and is in the vicinity of the median value of the index of 15.73X. While mean reversion is not a must especially that tax policy is in the favor of corporate income. The down side risk is only 16.77%.