Market Watch: What’s In Investor's Best Interest?

For months, analysts have speculated that the Federal Reserve’s plan of increasing rates might not stay at a gradual pace for long. However, news of the unemployment rate dropping to 3.9 percent when trade tensions continue to grow has analysts believing prices will rise sooner than planned and raise inflation faster than expected. With these challenging assumptions in mind, investors should be aware of signs of sudden interest rate hikes and how it affects spending.

During the latest policy meeting, the Fed announced that they would stick to their plan of gradually raising interests rates with two more rate hikes set for this year. As fiscal stimulus from tax cuts and government spending is underway, the Fed trusts that inflation won’t grow fast enough to necessitate more than the planned amount of interest rate hikes. Though they acknowledged an increase in business investment and low unemployment, the Fed remained certain that rates can increase gradually. Fed official John Williams said in an interview with CNBC that even if the inflation rate passes their target rate of 2 percent by a small percentage, the Fed could continue with their current plan. Others have shared this sentiment, as seen in the previous policy meeting minutes released in April where some Fed officials agreed that waiting would benefit the economy’s growth without changing consumer expectations of rate hikes and keep them from too much spending.  

However, after the most recent meeting, some Fed officials have shared concerns similar to analysts about how the economy is close to overheating with current market behavior. Trade tensions created from the aluminum and steel tariffs imposed on the markets leaves many producers uncertain over their supply costs, which puts pressure on businesses to raise prices. Consider the food industry as the  Chinese Commerce Ministry announced plans to impose tariffs on numerous U.S. agricultural products in retaliation to the metals tariffs. General Mills has already lowered their earnings expectations for their fiscal year, concluding at the end of May, due to higher costs of ingredients for their food products. With these tariffs proposed by China, businesses like General Mills are expected to increase the price of their products even more to offset the likely chance of U.S. farmers raising the cost of production.

Although the Fed excludes the food industry from calculations for inflation as its considered a volatile industry, analysts and investors should still consider the uncertainty producers feel with retaliatory trade measures from countries like China that hold great market power across industries and its effect on the costs of capital. The manufacturing industry, already dealing with the  enacted aluminum and steel tariffs, is also vulnerable to China’s proposed tariffs as small passenger planes and some automobiles were included in the number of commodities the Commerce Ministry levied against. Investors should be concerned since if businesses fail to adjust their expected earnings to these shifts in production costs fast enough, it can lower returns for stockholders.

Sluggish wage growth in the past months has eased investors’ concerns over the pace of inflation and kept them confident that the Fed will continue to gradually increase rates, leaving stock market expectations of interest rates influence unchanged. Admittedly, hourly and weekly earnings reported by the Bureau of Labor Statistics (BLS) increased minimally during the consecutive months of record low unemployment rate since October of last year. Standard economic theory for an economy with a tight labor market at full employment suggests employers must increase wages to incentivize current and potential employees to remain with their company as the competition for jobs decreases.

Many economists reasoned that wage growth hadn’t accelerated because the market was not yet at full employment. Rather, the labor market had more room to grow as discouraged workers and others on the market’s sidelines joined the workforce, as evidenced by a large number of jobs added across industries each month. Northern Trust Chief Economist Carl Tannenbaum said in an interview with The Wall Street Journal that employers have been able to fill jobs without increasing wages by enticing older workers to stay in the labor force and recruiting those receiving disability benefits from outside the labor force.

However, the BLS has reported lower than expected job growth for the last two months, a respective 135,000 and 164,000 jobs – down from 324,000 added in February. The jobs report for April also announced that the unemployment rate dropped even lower to 3.9 percent, the lowest in eighteen years. These trends suggest that wage growth may finally pick up to accommodate a tighter labor market. While it’s still early to see the pace that wages will increase, analysts caution investors and policymakers that greater wage growth may be on the horizon and increase inflation faster. As the unemployment rate gets remarkably lower, businesses will be pressured to accommodate their labor with higher wages and widen the margin for production cost increases.

When factoring for the potential of significant wage growth and increasing capital costs, companies are more likely to increase their prices higher than expected. Thus, the Fed raising interest rates aggressively becomes more plausible with the addition of this cost-push inflation. Should the Fed outline more interest rate hikes that were previously expected, household consumption would generally slow down. Unexpected interest rates hikes would also mean higher borrowing costs and slower growth for businesses, which investors in the stock market would respond immediately too.

While this decreases stock returns, investors can still take advantage of more interest rate hikes by shifting their interests to bond investments. U.S. debt securities have become increasingly sought after by both domestic and foreign investors as rates rise and government spending increases. On April 24, the 10-Year Treasury Note, the index that influences treasury yields across the bond market, reached a phenomenal 3 percent for the first time in four years. It has since fallen from that threshold but remains in the high 2.9 percent range, with the current yield at 2.989 percent at the time of this article’s release.  

Although the U.S. and China haven’t finalized their proposed tariff plans and wages haven’t shown significant growth yet, investors should still consider the influence of trade tensions and a tightening labor market on business decisions. Businesses rely on expectations and credible assumptions of future market price changes to decide production costs. According to the General Administration of Customs, Chinese exports increased more than expected last month by 12.9 percent. It’s safe to assume this came from companies purchasing more materials for production before the U.S. and China finalize any of their proposed levies. As debates over the Fed’s pace of rate hikes continue, investors should make sure to stay updated with the latest market news and not underestimate the power of uncertainty over supply costs and market prices.