Is The Rate Hike Good, Bad or Ugly?

PaulNolte-2“This time for sure!” Having been scared from raising rates in September and putting forth a more hawkish tone after the October meeting, the Fed was greeted Friday with a very strong employment report. There was little to complain about regarding employment as wages and payrolls grew at their fastest pace all year. Investors now assign a 75% chance of a rate in December from less than 10% in September. But, the Fed has surprised everyone before, whether wanting to see more economic strength or fears of global market volatility. Other economic news last week was also strong, with the service sector showing continued strength, although manufacturing was a bit weak. Still, global central banks are cutting rates or embarking upon various “QE” policies to keep money “easy”. The upshot is that the dollar is likely to remain strong and commodity prices weak. The job picture may argue for higher interest rates, the still falling commodity prices and weak global outlook should give the Fed pause. “Now for something we hope you’ll really like!”

Charts that investors can really love are those moving from the lower left to the upper right. Over the past six weeks, stocks have done exactly that and in rather dramatic fashion. At one time investors worried that the weakening of the Chinese currency would have major impacts around the world, their markets subsequently fell 40% and many believe we would as well. Within the past month, the US dollar regained its strength, the Chinese markets are up over 20% from the bottom and investors now expect a Christmas rally. How quickly things change. The markets have moved back into the trading range that dominated the first six month of the year, as though nothing has happened over the past four months. The markets continue to be expensive from a valuation perspective. Many will highlight the large impact of lower energy earnings on valuation. However, earnings would be even lower if not for the blockbuster gains from Apple, Amazon and Google. Even if the Fed begins to raise rates in December, it is likely to be on a very slow and low trajectory. This means that the competition for investor’s dollars remains weak outside of the stock market. So, even with high valuations and the potential start to a rate hike cycle, stocks should continue to do well.

The strong employment report caused treasury and corporate interest rates to rise dramatically Friday as investor’s begin to anticipate a December increase. We saw this in August as investors anticipated a hike in September. Today the 30 year bond is yielding a quarter point more than August. Utilities are down roughly 6% and the SP500 is unchanged. Commodity prices are down 6% and gold stocks have fallen 7%. In 2004, commodity prices had been rising at a steady 10% annual clip and the 30 year bond had increased by a full percentage point from the prior year. Today there are more than a few whiffs of deflation in the air vs. persistently higher prices in ’04. Negative rates still exist in various countries around the world today. Ten years ago, the thought of negative rates was merely a fantastical tale that occurred rather infrequently. While investors are more certain of a rate increase than any time this year, it is by no means the beginning of persistently higher interest rates.

A one percent gain in stocks on the week can hardly be called a correction. The rise was focused (again) on the largest US stocks, with some help from small cap stocks for a change. International holdings remain in jail, hurt from the stronger dollar. As outlined above, the dollar is likely to remain stronger for longer as the Fed seems bent on raising rates in December. Within the SP500, the reaction to higher rates was rather predictable as consumer staples, REITs and utilities all fell hard on Friday, while banks were the primary beneficiary. Investors have been piling into higher yielding issues for the past three years in order to get higher incomes than from the zero bank account. The problem is that if/when rates begin to rise, the rush for the exits is swift and dangerous. These sectors are also favorites when the markets are volatile. And of late, the “volatility” is all to the upside.

The volatility over the past few weeks has been of the kind that investors don’t mind, up 100 points, down 10 and up 150 points. The expectation for higher short-term rates may actually come to fruition in December, but it is not likely to derail the market advance through year end. We have been focusing our investments in the technology sector as well as large cap US stocks in general. We will be reviewing taxable accounts in the weeks ahead to do some tax loss selling to avoid any capital gain issues at year end.

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.