Would You Like to Dance?

**Originally sent to email subscribers on October 5, 2018***

The dance between interest rates and equity prices is complex but often poorly choreographed.  To no one’s surprise, toes frequently get stepped upon.  Often, this can be ascribed to the conductor’s pacing rather than the dancers.  Case in point, here’s what Atlas believes we are seeing today.  

First, a brief word of introduction.  Corporations had been allowed to deduct their pension plan contributions from earnings.  That changed in the middle of last month (September 2018).  The evidence we see suggests, seeing that eminent deadline, many corporations began front-loading their contributions to such plans, attempting to take full advantage of the tax break afforded by that expiring legislation.  This source of demand caused bond prices to increase. The dynamic between bond prices and interest rates means when one rises the other falls.  

What’s the upshot?  We are now, at the beginning of October, beginning to received earnings reports for the third quarter; this should continue for the next several weeks.  If our hunch is right, corporate earnings may prove smaller than had been expected.  Despite this being a one-off, exogenous event, toes have been stepped on.  How will the results play out?  

The counterpoint reaction between bond prices and company earnings generally appears as the price of one moving up when the other is in decline.  Corporate earnings and interest rates are partners in this dance, and earnings have a huge effect on equity prices; similarly, a demand for bonds results in higher prices (thereby reducing yields).  If we are right, the expiring tax break created an artificial demand for bonds, holding rates abnormally low.  That dynamic is reversing almost overnight.  

What does Atlas expect to see happen in markets over the very short-term?   What will it look like?  Most likely, a sharp but possibly pronounced drop in equity prices as interest rates move up.  Just as quickly, the efficient markets will again embrace their partners more closely and the dance will resume a more normal rhythm. Since almost all of our indicators suggest a strengthening economy, we doubt any serious portfolio readjustment will be required.  (by J R Capps)