Written by John Szramiak/Vintage Value Investing
The Federal Reserve Board met last week and raised interest rates by 25 basis points (0.25 percentage point). The case for a hike was strong:
We expect two to three rate hikes by year-end, which would put the federal funds rate at 1.25% to 1.50%, a level consistent with the Fed’s—and Vanguard’s—assessment of the economy’s strength.
/ Pixabay
Market behavior reminiscent of the ‘80s
The more interesting, and puzzling, economic analysis is happening in the stock market. U.S. stocks have been on a tear. The market is priced for long-term economic growth rates of 3%-plus, maybe 4%. (This estimate is based on our calculation of the earnings growth estimates implied by current stock prices.)
But like big hair and acid-washed jeans, those growth rates are an artifact of the ’80s. These days, the labor force is increasing slowly. Productivity growth, which could be turbocharged by a 21st-century Edison or Ford, is modest for now. And we’ve sworn off the growth-boosting but risky leverage that inflicted so much pain during the global financial crisis. The economy’s long-term potential growth rate is about 2%.
Where we were versus where we are
We can see the economic differences between the ’80s and today through the lens of bond yields. (This analysis comes from Vanguard’s Economic and Stock Market Outlook for 2017.)
During the ’80s, the 10-year U.S. Treasury note yielded an average of more than 10%. At the end of 2016, it yielded 2.5%. The following drivers, illustrated in the chart below, explain the change:
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