Economics

Can the Rally Continue

With a strengthening economy and tax reform in place, what could derail the stock market’s massive run? As a former chairman of the Federal Reserve once said, the Fed’s job is to “take away the punch bowl just when the party gets going.” 2018 may be the year the Fed takes away the punch bowl.

Robert Spendlove and Joseph Mayans Jan 26, 2018

At the start of 2017 the Dow Jones Industrial Average sat just below 20,000; now, roughly a year later, it has risen over 30 percent, breaking 26,000 and shattering all-time highs. With the other major stock indices following suit, it is reasonable to question the foundations of this rally and wonder if stocks can continue their record-breaking run in 2018.

Starting with the election of President Trump, the markets began their staggering ascent with the prospect of pro-growth, pro-business legislative reforms. Initially, the jump in equities was based merely on hope for reform, not grounded in economic fundamentals; however, the tide began to shift as 2017 wore on. In the second-half of the year, economic growth improved to 3 percent for the first time since 2015; the unemployment rate fell to a 17-year low of 4.1 percent; and, the U.S. labor market kept-up the longest-running employment growth streak on record. To add fuel to the fire, Congress ended the year by passing the largest tax reform in nearly three decades.

Graph of Dow Jones Industrial Average
Dow Jones Industrial Average
Source: Federal Reserve Bank of St. Louis

With a strengthening economy and tax reform in place, what could derail the stock market’s massive run? As a former chairman of the Federal Reserve once said, the Fed’s job is to “take away the punch bowl just when the party gets going.” 2018 may be the year the Fed takes away the punch bowl. Since the financial crisis, the Fed has kept short-term interest rates near zero in efforts to stimulate the economy and strengthen growth. However, many economists have argued that the Fed’s policies have fueled the rise in the stockmarket, by making stocks more attractive to investors than bonds, and creating the potential for a stock bubble. Now, with hints of inflation on the horizon, the Fed needs to raise rates in order to prevent the economy from overheating and give itself room to maneuver in case another recession presents itself. With three quarter-point interest rate increases penciled-in for 2018, the Fed is trying to strike a balance between reigning-in inflation and keeping the economy humming.

The concern for equity markets comes if the Fed has to raise rates faster than it has anticipated, especially in response to rapidly rising inflation. The risk of inflation has actually grown with the recently passed tax cuts, as the economy is already near full-capacity, and could pave the way for higher interest rates sooner, rather than later. Higher interest rates could have a dampening effect on the overall economy, as it becomes more expensive for businesses to borrow and for consumers to buy homes, cars, and basic necessities, all of which can have an impact on corporate profits and the equity markets in the short to medium term.

While the stock market looks to remain strong in 2018, riding on a robust economy and strong corporate earnings, it may not see the robust growth of 2017. The potential for rapidly rising inflation, poor trade relations, and geopolitical risks with North Korea, could all have a dampening effect on the current rally.

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