Will the Fed Confound Expectations?

Crystal balls have never worked when it comes to the stock market, and it’s looking like they’re about to flop on the future of interest rates as well.

In December, the Fed raised rates for the first time in nine years, the opening move in a long-awaited normalization cycle. The Fed statement that accompanied that hike was interpreted to mean that four more quarter-percent rate hikes were on the way in 2016, pushing the Fed Funds rate to 1.375% by the end of the year.

Now the consensus is shifting, as investors and Fed-watchers point to the wobbling stock market and certain weak economic indicators. Markets are acting as though the Fed’s next rate move isn’t going to happen in March as anticipated.

If you’re surprised, it’s likely because you trusted the Fed’s trajectory as interpreted by Wall Street and the financial media. The truth is that all the authoritative-sounding commentary about the Fed’s intentions is only an informed guess. That’s true even when the commentators are citing statements by the Fed itself.

The Fed is infamous for leaving plenty of wiggle room within its proclamations. The obfuscation may have reached its peak under Fed chair Alan Greenspan, whose “Greenspeak” was a marvel of dry, wordy ambiguity. But the careful statements from Janet Yellen’s Fed still leave the central bank plenty of latitude in its decision-making.

Fedspeak can serve a useful purpose in preventing over-reaction by the markets. But it’s also an implicit acknowledgement that it’s difficult for the Fed to know when and how to raise or lower rates.

Rate increases are based on interpreting an ocean of ever-shifting economic data from the economy, and once put into effect, they can impact the markets in unforeseen ways. One dynamic that is currently hampering the Fed’s efforts to create a rising-rate environment is the global flight to invest in the highest-quality currency, i.e. the U.S. dollar. The demand for greenbacks has created downward pressure on interest rates, working against the Fed’s goal.  

And as the phenomenon of Fedspeak suggests, the Fed also wants to avoid spooking the markets. It’s possible to see the Fed’s pronouncements as trial balloons, launched to gauge the reaction of investors. So far, the market reaction to the Fed’s latest remarks hasn’t been positive.

What’s ahead for this year? We would not be surprised to see two quarter-point rate increases rather than four. We’d be very surprised if there were no increases this year. Consider the larger picture, as the Fed does: Has anything changed in past several weeks that we didn’t already know about? Nope. China’s economy has been slowing for three years. Oil prices have been in decline for two and a half years. Employment is growing moderately, and inflation is stable and somewhat positive, which is exactly what the Fed wants.

Yes, markets are down. But we believe this is simply a healthy repricing of assets that had become too richly valued.

So what does this all mean for you as an investor? We don’t expect a barn-burning year in the market, nor a meaningfully negative one. We may see 3% to 6% returns, in line with a total rate increase of a quarter- or half-point, and muted but stable earnings for U.S. corporations.

With so many moving pieces in play in the market, we recommend sticking with quality blue-chip stocks. It’s important in this relatively late stage of the bull market to be a stock picker rather than a market buyer. Especially attractive are companies that are managing international exposure well and that are growing their sales. Sales growth can be a good signal even if earnings are weakened by the conversion of overseas revenues to the strong dollar. The strategy has worked nicely over the past 18 months, and we expect that to continue for the next 6 to 12 months.


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