Quick Thought Of The Week: Stench

Something smells bad. I think I know what it might be.

The US economy is growing nicely. It expanded 2% in the first three months of 2018. And it probably grew a bit faster than that in the second quarter. On a year-on-year basis, it might be growing around 3%, if not more.

Meanwhile, US unemployment is low – it’s at 4%. Inflation is relatively subdued too. That is running at a rate of 2.9%.

By all counts, the US stock market should be on fire. But it’s not. Since the start of the year, the Dow Jones Industrial Index is up just 1.3%.

So, if the US stock market is supposed to be a barometer of the economy, then it could be telling us that something is not right.

Unusual behaviour

The Chinese stock market has been flashing red. As are the markets in Hong Kong, Indonesia, the Philippines, Malaysia and Singapore. They are all lower now than at the start of the year.

If everything is supposed to be hunky dory, then why aren’t stock markets reflecting this? What’s with the lethargy?

Could it be the trade wars that America has waged against China, the Eurozone, Japan, Canada and Mexico.

Probably not. Trade wars are ugly. But there are ways to work around them.

But that doesn’t mean they are not inflationary. That’s because it is can be expensive to find new suppliers, new factories and train new workers.

All that costs money. And the fresh investments in new supply chains need to be recouped through higher prices.

Who pays? We, consumers, of course.

Nervous disposition

So, it is probably the inflationary aspect of the trade war rather than the trade war itself that is making investors nervous. It is even making the chairman of the Federal Reserve jumpy too….

….in his recent testimony to lawmakers, he said it is “difficult to predict” what the ramifications [of the trade war] will be on the economy.

Consequently, it could be inflation and the prospects of higher interest rates that are keeping many away from the stock market. Interest rates can act like gravity on share prices.

So that is the smell that I can detect. It is the smell of the fear – the fear of the unknown.

Here is what we do know, though. The Fed will most likely raise interest rates another two times this year. It will probably raise them again next year.

The pace of interest rate hikes will depend on how quickly prices rise. But we’ve been here before. At least I have.

I know the damaging effects that inflation can have on our savings. And the best way to counter the eroding effects of inflation is not to stay out of the market.

Instead, look look for companies with pricing power; companies that have recurring revenues; companies that have strong cash flow; companies that have manageable debts.

In other words, look for good businesses with a strong moat, and use stock-market volatility to your advantage.

A version of this article first appeared in Stock Advisor Singapore and Stock Advisor Gold.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore Director David Kuo doesn’t own shares in any companies mentioned.