The Fed decided to not raise interest rates last week, and the wisdom of the crowd deserves some applause here. Fed Fund futures had somewhat predicted the outcome, by denoting a hike possibility of under 30% in the days leading up to Thursday’s announcement. Meanwhile, bond market behavior was far more composed than would be expected in the face of tightening, with a prescient ‘markets may be flashing a wait sign’ column appearing in the WSJ two days before the decision. Tuesday’s data showed good retail sales numbers – in line with economic improvement and a case for hiking – but the markets went up. Then, on Wednesday, CPI data – an important inflation gauge, underwhelmed, and equities rallied again, projecting that the Fed would stay put. The S&P 500 was up 1.5% in the week leading up to the Fed announcement. On Thursday, the market proved right, and the Fed stayed on hold.
In that case, shouldn’t the upward trend have continued once the Fed confirmed that accommodative monetary policy was sticking around for the after-party?
What took investors by surprise, it seems, was the level of international concern that Janet Yellen provided in her press conference. The resulting pullback on Friday led to the Dow losing over 300 points, and overseas markets falling even further. Seeing that market volatility and international weakness may have now joined the Fed’s data points, we’re in for a pretty wild winter. Today, the markets are actually pricing in a 2016 hike, with opinions all over the place in terms of the first hike timing and length of tightening. Even the Fed’s dot plot shows a whole variety of opinions; one of the FOMC members is actually calling for negative rates, let alone tightening. The bottomline? The markets hate uncertainty, and it is going to be around for a while – given that global economic slowdowns don’t just reverse course in a few weeks with no identifiable catalysts.
What’s next? Popular terms including ‘secular stagnation’, a ‘new normal’, and ‘lower for longer’ come to mind even more so after last week’s outcome: a world with lower growth, lower inflation, and lesser growth concentration – a very bleak scenario where some, especially those with exposure to riskier assets such as stocks win, but many – including the middle class, simply survive. The Zero Interest Rate Trap theory mentioned in the WSJ paints a scary picture – where due to lower rates, the incentive to lend or invest reduces, causing a vicious circle where rates remain low, but inflation doesn’t rise. Companies, then, would spend less in capex, take fewer long term risks, and perhaps seek risk aversion instead of growth. Returning money to shareholders is an easy example; since 2012, quarterly EPS for S&P 500 companies has grown by 6.7% – with over 20% of that coming from buybacks, according to Deutche Bank. The long term impact remains to be seen over such decisions.
The Bank of England is up to bat regarding monetary policy, and may provide another data point on how developed economies react to tightening in today’s global era before the Fed’s turn comes again. Sweden and Japan, for example, both had to backtrack in the past 3 years on rate hikes when they turned out to be premature. All in all, the uncertainty’s going to remain, in our opinion, until the earlier of the following two outcomes occur: the Fed raises rates, signaling a strong US economy and international stability, or massive policy changes targeted at structural reform (immigration changes, spending on infrastructure, deficit reduction target changes, etc.) from influential economies around the world, including China, the US, Japan, and the Eurozone.
On a side note, we remain optimistic in the long term due to the potential of productivity in rescuing the world. Last week’s Dreamforce conference, for example, added another set of smart ideas that could define the future; the FOMC meeting’s media attention in recent times has helped the markets overlook the role and progress of concepts such as Big Data, the Internet of Things, and asset utilization being pioneered in Silicon Valley. The key for investors, of course, is to have the vision, and not panic when the times are tough on Wall Street. If you conform to that ideology, then the market continues to provide bargains on the companies that millennials love – and enterprises, and other investors, soon will too.
What it means for you: Long term aside – amid all the short term uncertainty, don’t discount US consumption. Oil price declines YTD set up well for a robust holiday season; note that the consumer discretionary sector is up 4.7% YTD – the best performer in the S&P 500. The recent pullback has caused stocks to price at a more modest 15.4x forward P/E (Yardeni data), and if yields stay lower for longer, the pressure reduces for firms with high yield debt, thereby limiting insolvencies and jobs losses; the same goes for emerging market nations and dollar denominated debt worldwide. Housing growth and auto sales should also continue to drive economic activity amid low borrowing costs; for example, auto loans crossed the $1 trillion mark for the first time ever last month, according to WSJ data. Next week, we’ll be reviewing a fascinating article in the HBR pointing to where corporate profits may be headed in the next 20 years. Earnings growth, after all, drives stock returns, and it’s best to think long term while short term uncertainty continues to guide investor sentiment on Wall Street in the coming week.
