PMC Weekly Review - March 17, 2017
A Macro View: Don’t Fight the Fed – Monetary Tightening and Global Markets
As expected, the Federal Reserve raised the federal funds target rate from a range of 50-75 basis points up to 75-100 basis points at this week’s FOMC meeting. The Fed has telegraphed its desire to normalize monetary policy for some time, but over the past two years, economic data precluded it from doing so more than once at the end of each calendar year. With more robust macroeconomic data to start 2017, the central bank jumped on the opportunity to raise interest rates, a move that markets had priced in as a near certainty, following aggressive forward guidance. Both debt and equity markets rallied on the news, as the statement accompanying the rate hike was viewed as more dovish than many expected. The question remaining for investors, however, is how aggressive will the Fed be going forward, and what will this mean for markets in the months ahead?
We all know that rising interest rates are bad for bond valuations. When interest rates go up, the income earned by bondholders on their current holdings suddenly becomes less competitive than what is being offered in the new issuance market, making their bonds less valuable. One way bond investors have been able to avoid this problem historically is by holding securities that are less vulnerable to changes in interest rates and more sensitive to underlying credit fundamentals. However, the difference in this tightening cycle is that investor’s yield-chasing behavior in the years since the financial crisis has greatly reduced the spread offered by riskier fixed income assets, which in the past has helped protect these securities from price erosion due to rising rates. Based on the heightened level of current valuations across the majority of fixed income sectors, there are fewer places to hide from the negative impact of rising rates.
Historically, equity markets have performed well during the onset of a rising interest rate environment, but then declined as the tightening cycle tends to eventually stall the economy and adversely affect corporate bottom lines. One exception is the Financials sector, which benefits from the increased spread between borrowing and lending. Unsurprisingly, income-generating stocks can be more susceptible to rising rates, and in general, these stocks already trade at high valuations—the result of an aggressive bid from yield-hungry investors. Ultimately, historical tightening cycles have occurred in different economic environments, and have had mixed results for equity markets. The last sustained period of rising interest rates was more than 30 years ago, and from a much higher base, meaning there may be some uncertainty around how an upward trajectory in rates might affect equity markets this time around, and uncertainty usually means higher volatility.
Fed policy also has a multitude of macroeconomic effects that affect both global and domestic markets. In the near term, the yield differential caused by the increasing divergence between the Fed’s policies and those of other major central banks (namely the European Central Bank and Bank of Japan) should further encourage capital flows into the US, placing a ceiling on US rates and strengthening the US dollar. However, over the longer term, investors should consider the potential effects of the eventual unwinding of quantitative easing in Europe and Japan (making bond yields more attractive to investors in their respective markets), which should lead to reduced demand for US bonds and the dollar, likely undermining many of the market trends that have developed over the past few years. Higher borrowing costs could hamper the US consumer, the engine of the American economy, as well as firms with less viable business models, or those that rely heavily on debt financing. In addition, a strong dollar makes US exports more expensive for foreign buyers and imports cheaper for American companies and consumers. This can be either positive or negative for US corporations, depending on whether the firm is a net importer or net exporter. Further complicating matters is the uncertainty surrounding the new administration’s policies, particularly those related to foreign trade and domestic growth and inflation, the latter of which could induce more aggressive Fed tightening in the future.
Clearly, the Fed has embarked on a policy path that will likely influence significantly both asset prices and the real economy. Although it remains to be seen how many additional rate hikes we’ll ultimately see in 2017, investors must be cognizant of the impact these decisions might ultimately have on their portfolios, and position themselves accordingly.
The information, analysis, and opinions expressed herein are for general and educational purposes only. Nothing contained in this weekly review is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. All investments carry a certain risk, and there is no assurance that an investment will provide positive performance over any period of time. An investor may experience loss of principal. Investment decisions should always be made based on the investor’s specific financial needs and objectives, goals, time horizon, and risk tolerance. The asset classes and/or investment strategies described may not be suitable for all investors and investors should consult with an investment advisor to determine the appropriate investment strategy. Past performance is not indicative of future results.
Information obtained from third party sources are believed to be reliable but not guaranteed. Envestnet|PMC™ makes no representation regarding the accuracy or completeness of information provided herein. All opinions and views constitute our judgments as of the date of writing and are subject to change at any time without notice.
Investments in smaller companies carry greater risk than is customarily associated with larger companies for various reasons such as volatility of earnings and prospects, higher failure rates, and limited markets, product lines or financial resources. Investing overseas involves special risks, including the volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. Income (bond) securities are subject to interest rate risk, which is the risk that debt securities in a portfolio will decline in value because of increases in market interest rates. Exchange Traded Funds (ETFs) are subject to risks similar to those of stocks, such as market risk. Investing in ETFs may bear indirect fees and expenses charged by ETFs in addition to its direct fees and expenses, as well as indirectly bearing the principal risks of those ETFs. ETFs may trade at a discount to their net asset value and are subject to the market fluctuations of their underlying investments. Investing in commodities can be volatile and can suffer from periods of prolonged decline in value and may not be suitable for all investors. Index Performance is presented for illustrative purposes only and does not represent the performance of any specific investment product or portfolio. An investment cannot be made directly into an index.
Alternative Investments may have complex terms and features that are not easily understood and are not suitable for all investors. You should conduct your own due diligence to ensure you understand the features of the product before investing. Alternative investment strategies may employ a variety of hedging techniques and non-traditional instruments such as inverse and leveraged products. Certain hedging techniques include matched combinations that neutralize or offset individual risks such as merger arbitrage, long/short equity, convertible bond arbitrage and fixed-income arbitrage. Leveraged products are those that employ financial derivatives and debt to try to achieve a multiple (for example two or three times) of the return or inverse return of a stated index or benchmark over the course of a single day. Inverse products utilize short selling, derivatives trading, and other leveraged investment techniques, such as futures trading to achieve their objectives, mainly to track the inverse of their benchmarks. As with all investments, there is no assurance that any investment strategies will achieve their objectives or protect against losses.
Neither Envestnet, Envestnet|PMC™ nor its representatives render tax, accounting or legal advice. Any tax statements contained herein are not intended or written to be used, and cannot be used, for the purpose of avoiding U.S. federal, state, or local tax penalties. Taxpayers should always seek advice based on their own particular circumstances from an independent tax advisor.
© 2017 Envestnet. All rights reserved.