If stocks are relying on low rates, the rally is in trouble.
The Federal Reserve has already hiked its benchmark short-term interest rate three times in the past year, and it's looking increasingly likely that rates will be raised again in December.
The simple reason why? The economy is strengthening, and inflation could soon start to rise.
Consider Friday's non-farm payrolls report. Even though the headline number came in negative for the first time in seven years, in the wake of hurricane devastation and distortion, the markets shrugged that off.
Instead, stocks rallied as the impressive 0.5 percent average hourly earnings gain came into focus, a data point which suggests U.S. economic growth is finally translating into higher wage growth after months of stagnation on that front.
Some analysts argued that the numbers were heavily skewed as the storms forced many of the lowest-paid workers off the payrolls while the storms rolled in; leisure and hospitality payrolls were down by 111,000, so there is more than a grain of truth to that criticism. Still, July and August earnings data were revised sharply upward, and there is little doubt that wages are now running at a healthier 2.5 percent year-on-year clip.
This should provide the Federal Reserve with plenty of support to vote for another 25 basis point interest rate hike in December, and tells us the era of easy money made during times of historically low interest rates, incurred in the wake of the financial crisis of 2008, is nearly over.
Indeed, investors must remember that the pace of balance sheet expansion is slowing, even as arguments have been made that central banks around the world are still growing their balance sheets. The only central bank committed to quantitative easing is the Bank of Japan. The European Central Bank has already signaled that it will consider winding down its own easing program, and the Federal Reserve will begin reducing its multitrillion-dollar balance sheet this month.
Since the crisis, quantitative easing has been an incredibly powerful tailwind for financial assets, particularly for stocks. Since 2008, total U.S. gross domestic product has grown by approximately 26 percent, while the S&P 500 has gained some 200 percent.
So, where do we go from here? Investment returns in the long term, as this era nears its conclusion, may suffer.
By almost any measure, equity markets are frothy. Barring some massive transformative technological change that would boost productivity markedly, history suggests that stocks' 10-year forward returns could be in the low single digits as markets' mean reversion takes hold.
This process can be quite slow in the making. For now, there is little coming down the pike to threaten the markets, as economic growth remains robust in the U.S. and appears to be picking up in Europe and Asia.
For the rest of the year, as tightening continues in the U.S., economic growth will be equity markets' focus (barring any jarring geopolitical shock). As long as GDP and earnings continue expanding at their projected pace, equities will continue climbing. Valuation only matters when exogenous shocks hit the system. If the world remains a relatively peaceful place, the natural momentum of the global growth should push equities higher still.
Of course, hitting even a minor bump on a highway when speeding can be life-threatening. Equity investors find themselves in a similar situation. Even a seemingly minor event at this juncture could create a stampede out of stocks, and this time, central banks may not step in to smooth out the fall.