Markets Pause While Awaiting Federal Reserve Activity
March 2, 2015
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The Fed contemplates options but remains idle for now.
Interest rate increases, when they occur,
will likely cause equity market volatility
A combination of improving global growth
and reflationary monetary policy should act
as a tailwind for equities.
U.S. equities were mixed last week, with the S&P 500 declining -0.2%.1 The
Federal Reserve (Fed) had a busy week, as the nuanced debate continues
around when to begin policy normalization. The global policy divergence
grabbed headlines, but the focus was mainly on negative yields in Europe and
inflows to non-U.S. equities. Following the bounce in U.S. equities over the last
few weeks, discussion emerged about potential headwinds such as valuation
and near-term Fed tightening. Consumer sectors were the best-performing,
while energy, utilities and industrial sectors showed weakness.1
Weekly Top Themes
- The Fed continues to leave the door open to options. Janet Yellen indicated
"there will not be a rate hike in the next couple of meetings." All options seem to
be on the table beginning with the June FOMC meeting. The Fed wants greater
flexibility to raise interest rates, and economic data will become more important.
Increased uncertainty should put pressure on longer-term rates.
- U.S. economic conditions no longer require a zero interest rate policy. The
Fed should begin to normalize interest rate policy relatively soon. We anticipate
the onset of policy tightening, which has not occurred in the United States in
almost a decade,2 will act as a revaluation catalyst for the long end of the global
- Historically, equities have performed well at the start of a rate hike cycle.
Generally, equities seem to produce gains when interest rates start to creep up,
then often pause for a few months before continuing to climb.1
- The oil price decline should be a net long-term positive for U.S. and global
growth. Over time, the benefits of declining prices should make up for the
near-term pullback in oil production.
- The bull market is nearly six years old. Investors have faced many steep walls of
worry. The economy has been growing, and the stock market has been rising as
a result of profits from entrepreneurial activity. We anticipate these trends will
continue until corporate profits fall sharply, interest rates rise significantly or the
stock market increases beyond the current value of discounted earnings.
The Big Picture
In the near term, significant crosscurrents lie beneath the surface. Risks are
emerging, as the market appears complacent and leadership is less prominent. The
market’s view of the Fed seems aligned with FOMC statements and data, and
although inflation is not a concern, disinflation discussions are growing stale.
As we think about the intermediate term, we highlight key reasons to stay
optimistic, as recently discussed by Potomac Research Group:
Assessing the environment overall, equities are hovering near the top of the range
that began last fall. Reduced U.S. liquidity will force profits - which have entered a
difficult phase - to become the primary driver of capital appreciation. Pricing power,
rising wages and a strong U.S. dollar have dampened earnings projections. We
believe the global economy is slowly healing, and low inflation allows policymakers
to provide reflationary support. The extension of the Greek bailout program provides
potential for the global economy to shift into higher gear by enabling the fledgling
European recovery to gain traction. However, high levels of debt, geopolitical
turbulence, low inflation and concerns about financial bubbles require caution. A
combination of improving global growth and reflationary monetary policy underpins
our pro-growth investment stance, including an overweight to equities. We believe
equities will achieve positive returns in 2015, and likely outperform cash, bonds,
inflation and commodities, but not without a bumpy ride.
1 Source: Morningstar Direct, as of 2/27/15
2 Source: Federal Reserve
Last Week's Commentary
Global Reflation Should Allow Equities to Push Higher
February 23, 2015
Financial markets reacted well to the
provisional Greek bailout extension, but risks
for Europe remain elevated.
Wages appear to be starting to climb, which
would increase pressure on the Fed to begin
rate increases this summer.
There is a valid bearish case to be made, but
we think the positives for equities outweigh
U.S. equities climbed last week amid a fairly uneventful trading environment.
The S&P 500 Index rose 0.7%, putting it 6.5% above the low of just a few
weeks ago.1 The drama surrounding Greece’s financial woes dominated the
headlines, while Walmart’s decision to boost pay for one-third of its workforce
also received its share of attention. For the week, the health care sector was
the best-performing, with leadership from the biotech industry, while energy
companies struggled in the face of a downturn in oil prices.1
Weekly Top Themes
- The “pro-growth” investment trade remains in effect but slowed last week.
Global economic data was mixed. Europe showed some improvement, but
Japanese fourth quarter economic growth came in well below expectations at
2.2%.2 Bond yields were marginally higher last week, while commodity prices fell
and cyclical stocks slightly outperformed defensive sectors.1 Nevertheless, U.S.
stocks ended the week at another record high.1
- The provisional Greek debt deal is a positive, but the risks are still high. The
four-month extension of the bailout program effectively served as a capitulation
by the new Greek government in their stance to abandon anti-austerity measures.
Greece still has much work to do, but the agreement to have its budget programs
approved by the so-called “troika” of the European Central Bank, the European
Commission and the International Monetary Fund reduces the risk of a messy
exit by Greece from the European Union. Even assuming the provisional deal
goes through, however, it only lasts for four months. The worries over Greece
have only faded, not vanished completely.
- The eurozone economy appears to be slowly improving. Business, investor and
consumer confidence have been ticking up,3 which should translate into an easing
of deflation fears and better growth. Europe still faces a number of headwinds,
including the need for more structural reforms. At the same time, political
turmoil in Greece and Russia could cause issues for the eurozone.
- Modest wage increases appear to be on the horizon. Last week’s news from
Walmart continues a trend of companies announcing pay increases, and we
believe the government’s official wage data will soon start to reflect higher
salaries for American workers. The growth in new jobs and the decline in the
unemployment rate are also putting upward pressure on wages. Wage levels are
one of the Federal Reserve’s key economic barometers used to judge the state
of the economy, so such increases should prompt the Fed to begin normalizing
interest rates. We believe this summer is the most likely timeframe for the Fed to
- When the Fed does begin to increase rates, we believe it will have a number
of effects on financial markets. For the bond markets, we expect Fed action
would cause short-term yields to move up while longer-term yields would move
erratically higher. This would result in a flatter yield curve (known as a “bear
flattener”). We also think credit spreads may widen and the U.S. dollar should
rise. For equity markets, we believe a move by the Fed would increase volatility,
but we would still expect equities to grind higher.
The Bullish Case for Equities Appears Intact
Equities are currently testing the tops of their recent trading ranges, and we think
whether this is resolved by stock prices moving higher or by falling back will depend
on the tug-of-war between ample global liquidity and a slight softening in corporate
profits. Easy monetary policy, the drop in oil prices and the rise of the U.S. dollar
have all been positive factors for the consumption-oriented U.S. economy, but they
have also put downward pressure on U.S. profits.
The bulls believe global reflation and a stronger U.S. economy will help global
growth and allow investors to look past the current corporate profit softness. The
more bearish case is that still-lingering deflation will work its way into the U.S.
economy just as the Fed is starting to raise rates. We acknowledge the downside
risks, but lean more toward the bullish arguments.
1 Source: Morningstar Direct and Bloomberg, as of 2/20/15
2 Source: Cabinet Office of Japan
3 Source: The European Commission