In addition, the overall macro environment – one of low inflation, low interest rates and accelerating growth– is a favorable one for stocks and is supportive of modestly higher valuations. Historically, investors have paid more for a dollar of earnings when inflation is lower.
Market Realist – The graph above shows inflation rates year-over-year (or YoY) and the federal funds rate for the last ten years. We’ve used the YoY increase in the Consumer Price Index (or CPI) to track inflation. The funds rate remained close to zero since the start of 2009.
The Fed uses the funds rate to send a signal to the commercial banks (XLF)(KRE) to reduce or hike interest rates. During the financial crisis, the Fed cut the funds rate to boost the ailing economy. However, if the economy keeps improving at the current speed of 3.5% gross domestic product (or GDP) growth rate, it could increase inflation. This could cause the Fed to hike rates.
Inflation rates have also been at bay over the last few years. Currently, inflation rates are 1.7%. This is below the Fed’s long-term target of 2%.
Market Realist – The graph above shows GDP growth rates for the U.S. since 2012. In the last two quarters, the U.S. economy grew at 4.6% and 3.5% quarter-over-quarter. However, it’s important to note that the 4.6% growth in the second quarter came after a low base. The low base was due to -2.1% growth in the first quarter.
All of the factors discussed above are positive as far as equities (SPY)(IVV) are concerned. However, this isn’t necessarily positive for bonds (BND). Interest rates can’t fall more. Remember, bonds perform well when interest rates fall and not necessarily when interest rates are low and constant.