The widening gap between markets and the Fed over the appropriate stance of monetary policy warrants a cautious investment approach. Last December, as they finally started the re-normalization process of raising the Fed funds rate by 25 basis points, the Fed remarked that the markets could expect four more rate increases in the Fed funds rate in 2016.
Currently, in the Fed Funds Future Market there is approximately a 25% chance of only one more rate hike between now and June and only a 40% chance of a second rate hike by December, 2016. This could amount to only a 15-25 basis point increase in the Fed funds rate by the end of the year. Eventually, we believe that the Fed will back off of the four rate hikes in 2016 but the markets may have to riot first for this to happen. Moreover, any significant rally in risk assets (stocks) would be of a high risk nature because it would remove pressure on the Fed to slash rate hike intentions in line with market intentions.
Generally, we are monitoring five key pressure points that can affect the Fed’s thinking and the markets themselves: energy markets, core inflation, currency markets, downside economic risks and the profit environment. Let’s take a look at each one:
The first source of pressure on the Fed comes from the energy markets. While we have no idea what energy prices will do over the next three to six months, we are starting to believe that they will be higher a year from now. Higher oil prices could bleed over to our next concern, which would have an impact on the Fed’s rate hike thinking.
The second source of pressure on the Fed to back off of the frequency of rate increases is the lack of domestic inflation. The Fed’s preferred measure of underlying inflation is core personal consumption expenditures (PCE). While it has edged higher for five consecutive months, it is still only at 1.4%, year over year. The Fed wants this number to be 2%. At that level, the Fed would be more comfortable in raising the Fed funds rate. Declining oil prices would decrease core PCE and most likely put a hold on raising the Fed funds rate.
The next source of deflationary pressure impacting the Fed and its thinking comes from the currency markets. Central banks abroad are looking for ways to implement effective monetary stimulus, which makes it harder for the overbought dollar to meaningfully correct. In effect, the U.S. has imported deflation from abroad via a stronger dollar, argues the Bank Credit Analyst.
In effect, raising interest rates while we are importing disinflation or even deflation is counter-cyclical to what the Fed wants to be doing, as this is only going to strengthen the dollar. This and the fact that the European Central Bank and the Bank of Japan are LOWERING their rates makes one wonder if we are doing the correct thing. Granted, the Fed wants to gently take away the “punch bowl”, but timing is everything. This is another “headwind” or concern for the Fed in their effort to raise the Fed funds rate.
Downside Economic Risks
The fourth concern the Fed has is the downside economic risks. The labor market remains resilient as the number of jobs being created remains slightly above 200,000 per month and the unemployment rate has dipped just below 5%. However, profits and pricing power are not improving based on Q4 profit results. Also, the Institute of Supply Management (ISM) survey for January showed that the manufacturing sector (12% of the economy) has slipped into contraction territory while the non-manufacturing sector (mainly, the service sector) is still expanding. The U.S. economy is holding up in the face of external headwinds, but there are rising odds that GDP growth, at this point, might be closer to 1% than 2%.
The fifth and final source of pressure on the Fed to back away from raising interest rates relates to soft pricing power and profitability. Contracting profits add pressure on the Fed to shift their goal of raising rates four times this year. According to the Bank Credit Analyst, 4th quarter revenues are in line to decline 3.5% from a year earlier, while 4th quarter earnings growth is in line to decline 4.1% from a year earlier. These declines are led by the energy and material sectors, which should be no surprise.
There is probably a limited downside to energy’s earnings for 2016 given how far they fell in 2015. However, the commodity weakness is spreading to the rest of the market. Earnings are declining in six of the ten sectors (led by energy) and revenues are decreasing in four of the ten sectors. This goes to show how pervasive commodities are in our economy.
Summarizing this last point in terms of the broad market, the near-term earnings outlook remains weak. Factory orders, which are highly correlated with forward earnings are contracting. Profit margins continued declining in Q4. The main culprits here are massive losses in energy and materials where the majority of the losses have either already been realized or the markets have already “baked” these expected future losses into their respective stock price.
Margins are also under attack as companies have to pay more to attract the kind of talent they need. With very little pricing power, this increase in wages only hurts the bottom line. On top of that, poor productivity growth implies that margins will remain under pressure.
The above five points are why our portfolios are defensively positioned, with the money market fund at 10-12%, our equity exposure at about a 7.5% underweight, and our bond portfolio is essentially in all high grade intermediate term bonds.
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Disclaimer: This blog is intended for informational purposes only and should not be construed as individual investment advice. Actual recommendations are provided by RAA following consultation and are custom-tailored to each investor’s unique needs and circumstances. The information contained herein is from sources believed to be accurate and reliable. However, RAA accepts no legal responsibility for any errors or omissions. Investments in stocks, bonds, and mutual funds may increase or decrease in value. Past performance is no guarantee of future results. Any of the charts and graphs included in this blog are not recommendations for the purchase and sale of any security.