Following The Fed’s rate hike on Wednesday, the market has been volatile to the downside as many feared would occur. Still, keep in mind that the immediate market response to the Fed’s interest rate hike Wednesday was positive: the S&P 500 rose +1.45% that day (this was likely due to the length of time the rate hike had been on the radar; the equities markets had priced in this near certain eventuality). So, where does the market and the domestic economy go from here?
Stay steady and read on. While downside volatility has indeed emerged, our expectations are for 2.2% – 2.5% GDP growth for 2015 and slightly higher growth for 2016, with modest inflation in the 1% – 1.5% range. Moderating growth could be accompanied by a ‘leveling off’ of earnings, which would imply modest single-digit returns for domestic equities. Does this mean it’s time to change your portfolio strategy?
Still Too Early to Turn Bearish
I’ve written this before, but it’s important to restate today given the decision to raise rates now and in the future: stocks can still do well even during a rising rate environment. A quick survey of historical stock returns during monetary tightening cycles tells us this:
Performance of the S&P 500 During Past Tightening Cycles
To be sure, the above table does not tell us with certainty that stocks will do well as the Fed incrementally raises rates. What it does tell us is that stocks can do well and have done well, which means we have good statistical probability of stocks posting positive returns as long as the economy continues to grow. And, we think it will continue to grow.
Janet Yellen said in her statement that she expects the FOMC to raise rates to 1.5% by the end of 2016 and to 2.5% by late 2017, with a longer-term goal of getting the benchmark rate to historical averages (3.5% or so) by 2018. For the most part, you can simply ignore these types of projections. The economy is too dynamic and its structural influences too complex (labor markets, inflation, credit, trade, currency strength, energy prices, etc.) for anyone to make a viable projection any more than twelve months out.
But, her goal of moving the benchmark interest rate towards its long-term average is noble. As she rightly pointed out in her statement, rarely does it make sense to raise interest rates when inflation is as weak as it is currently. At the end of the day, however, “normalization” of interest rates and borrowing costs is important as a monetary policy mechanism so that the Fed will have tools to fight the next recession. Think about it this way: if interest rates were still near zero when the next recession hits (which could be just a couple of years down the road), the Fed would be trapped! They would only have quantitative easing as a tool to stoke the economy and inflation. As we’ve seen with Japan, that remedy really doesn’t work well at all.
The Bottom Line for Investors
Here’s to hoping the economy has a few more years of modest growth ahead. With Europe on the mend, China slowing and Emerging Markets economies feeling the pressures of a stronger dollar, it’s a mixed bag globally. On balance, there’s growth – but I think it will continue moderating in the years ahead. In these valuable growth years, however, I think the Fed should continue its course of moving rates higher even though that will likely put additional pressure on borrowing costs for consumers and businesses. That could imply a weakening housing market and moderating stock buybacks from here, among other things.
Equities are likely to feel these headwinds in fits and spells in the coming year or two, meaning that I expect a higher frequency of market corrections and downside volatility than we’ve seen in the last 3-4 years. The base case, however, remains that equities should post moderate single digit returns in 2016 which, in my view, still make it a favorable asset class over bonds or cash.