Fed Losing “Patience”
The financial markets are living the “La Vida Loca” or just plain loco! Follow this logic if you can: lower energy prices since summer are supposed to be good for retail sales. However, retail sales have actually declined (even excluding gas pump sales) over the past three months. Employment growth is at the fastest pace since the tech boom, yet wage growth is among the slowest in the last 30 years. The dollar has been booming over the past six months in response to our better economic performance relative to the rest of the world. The Fed wants to increase interest rates, which will only push the dollar even higher. Inflation, thanks in large part to falling energy prices, is actually falling in the US. Commodity prices in general are falling, which will put even more downward pressure on prices in the months ahead. Yet, the Fed is bent upon saving their reputation, as they are on the record as wanting to raise rates in June. This would put additional upward pressure on the dollar (making our goods less competitive overseas). There will be a press conference following the Fed meeting this week and Janet will be explaining why interest rates must rise. This will follow Japan’s decision on rates and European finance ministers discussing Greek reforms. Look for the Fed to remove “patient” from their statement, which will open the door for a hike in rates sooner rather than later.
Save for one day last week, the Dow managed to move over 100 points in each trading session, making it seven of the ten trading days in March that have seen daily closes of greater than 100 points. After a nice rally in February, March is becoming worrisome for investors. Struggling to figure out the economic data (as outlined above), investors have alternated between rates staying low to regular rate hikes. For the week, the markets moved slightly lower, but emotions vacillated between euphoria and despair. While the knee-jerk reaction may be to sell and walk away, as of yet, the recent decline has not altered the longer term outlook for stocks. Declines are to be expected, but conditions do not seem to be present that point to massive declines in equities. Investor sentiment is beginning to get negative again, as expected with a declining market. This may be the roughest week before month end, as investors get buffeted by central banker’s commentary. Of course, once we close the books on the first quarter, earnings season will get started again as will the bigger economic reports (employment and manufacturing). No rest for the weary!
Bond investors are just as confused as equity participants, with various predictions for rates to go above 3% or back under 2%. If inflation is not a problem, why are rates rising? If the US has higher rates than many other countries, why will rates rise? If inflation is falling, why are rates rising? The answers are not always easy, but may keep a lid on longer term rates. So while the Fed is likely to raise short-term rates, long term rates may still decline, effectively flattening the yield curve. This could mean that longer term bonds actually perform better than short-term bonds in the early stages of this “rate cycle”. In either case, bonds are still likely to provide a safe haven from the wild equity markets.
While the markets go through their bump and grinds, little has changed within the various asset classes and industry groups. The strong dollar has taken the wind out of the international sails, as strength in the dollar diminishes returns from international holdings. Little too has changed within the domestic picture although small cap stocks are beginning to improve after taking last year off. Although the small cap index is near all-time highs (as are many indices), relative to the SP500, they are at the same levels as five years ago. Adding to the bearish spin, valuations on small caps are very high relative to their own history as well as to the SP500. Small caps may be benefitting from the stronger dollar though, as much of their earnings are not as dependent upon international trade as their larger cousins. Mid-cap stocks, the group between the largest and smallest by market cap tends to fly below the radar. However, over the past few months, they too are beginning to show better performance. We could be witnessing the beginning phases of “anything but the SP500”.
As much as investors worry when the markets get volatile, we believe the markets are not yet set for anything more than a “normal correction” that may last another few weeks. Small and mid-cap stocks are showing some relative strength, an indication of better underlying strength. Bond investors would normally begin shortening maturities in the face of rising rates, but given the very low inflationary environment, it actually may make sense to maintain longer maturities at this time.
The opinions expressed in the Investment Newsletter are those of the author and are based upon information that is believed to be accurate and reliable, but are opinions and do not constitute a guarantee of present or future financial market conditions.