The last Federal Reserve rate hike occurred on June 29, 2006 as the Federal Open Market Committee decided to raise their target for the federal funds rate by 25 basis points to 5.25 percent. At the time, they cited economic growth was moderating, reflecting a cooling off of the housing market. If they only knew. It has been over nine years since the last rate hike and the Fed appears poised to pull the trigger at the upcoming December 15-16th meeting. Their narrative this time will discuss the six-year zero interest rate policy and the need to begin the process of normalizing rates as employment and the economy improve. The Fed will be very clear about the deliberate nature of any future rate hikes.

If the Fed does move, and I believe they will, what impact will it have on the stock and bond market?

The bond market has been bracing for an inevitable 25 basis point hike for the entire calendar year. In fact, the short end of the U.S. Treasury yield curve already reflects the expectant rate hike. We started the year with the one, two and three year Treasuries yielding 0.25, 0.66, and 1.07 percent respectively. These yields at the end of November, 2015 were; 0.51, 0.94, and 1.24 percent respectively. A graph of the entire yield curve since the beginning of the year shows a minor shift higher across the curve.

When the Fed finally moves; it will be a non-event on the short end of the curve and may actually be bullish for longer term rates. The 10 and 30 year points on the yield curve will embrace low inflation, slow economic growth, and a Federal Reserve willing to take a monetary tightening stand.

The stock market is also well aware the Fed sits on the brink of a 25 basis point rate hike. We believe this is already reflective in today’s stock prices. This is both good news and bad news. On the positive side, the stock market would be encouraged with the Fed’s confidence in the economy if they raised rates at the December meeting. On the flip side, a rate rise would mark the beginning of a new tightening cycle and the stock market will quickly handicap the pace and degree of future Fed action. The Fed will use words like slow, deliberate, data dependent, and calculated to describe future monetary policy. A blow to the stock market would be a faster than anticipated rise in short-term interest rates. With our dovish Fed, this scenario seems highly unlikely.

The November stock market was able to hold on to October gains despite unsettling headline risk over the past month. In November, the S&P 500 was led by financials. The laggards were the utility and telecom sectors. Based on these November results, the stock market is betting on higher short-term interest rates which would benefit financial stocks and hurt the higher dividend paying utilities. December will determine if 2015 is the seventh consecutive positive return year in stocks, or first down year since 2008.

What’s ahead? If a crystal ball could tell us the price of oil and the dollar/euro relationship a year from now, one could reach a reasonable conclusion regarding the fate of the 2016 stock and bond market. Based on what we know today, the U.S. central bank will be raising rates and foreign central banks will be easing; thus the dollar should to continue to strengthen and reach parity with the Euro in 2016. This is better for foreign companies. A stronger dollar and slow world growth will likely keep a lid on oil prices. U.S. stocks will face lighter headwinds in 2016, and once again we expect mid-single digit returns. International and emerging market stocks may catch enough of a tailwind from local currency weakness to boost their income statements and relative stock performance.

In the bond market, expect tight trading ranges in the months ahead. The yield on the ten-year Treasury may spend a lot of time in the 2.00-2.50 percent trading range. Expect bonds to be boring with low single digit returns into the foreseeable future. Note the emphasis here is on “low”.

MARKETS BY THE NUMBERS:

Ringo Starr’s first big post Beatles hit was titled, “It Don’t Come Easy”. While Ringo was singing about love and relationships, he might as well been singing to investors dealing with volatile markets. Lines like, “Forget about the past and all your sorrows” or “Got to pay your dues if you wanna sing the blues”, or “I don’t ask for much, I only want your trust” are solid tips for these topsy-turvy markets.

In unusual fashion, the October stock market was as good as September was bad. In October, all ten sectors in the S&P 500 showed positive results and the major indexes had their best monthly returns in four years. The leaders this month were the downtrodden energy and material sectors while financials lagged. Major stock markets around the world generated high single digit returns for the month. The October rally now gives the U.S. stock market a fair chance to post a record setting seventh consecutive year of positive returns. In the rear view mirror it all looks easy, but the string of short-term market corrections along the way continue to throw nervous investors to the sidelines.

The economic backdrop has not changed significantly from September to October, rather the market’s perception of facts and expectations has repriced the market. The facts remain:

– The U.S. and global economies are in a slow growth mode.
– Central banks around the world are trying to help their economies prosper and grow via easy monetary policies and weak currencies.
– Interest rates are low.
– Third quarter corporate earnings are weak as advertised.
– Inflation is low and deflation is still a concern.
– Oil prices have temporarily stabilized in the mid $40 a barrel range.

While there will be plenty to worry about in the upcoming months, we are cautiously optimistic heading into 2016. Year over year comparisons will soon reflect the past impact of extended lower oil prices and a strong dollar; thus creating manageable hurdles to clear in the near future.

Statements from the U.S. Federal Reserve lead me to believe they will continue their accommodative monetary policies, although a token 25 basis point rate hike should be expected in December or early 2016. This may well be a “one and done” move until more economic data is known later in 2016. U.S. Treasury interest rates have been stable over the past year as depicted in the chart below.

Expect tight bond trading ranges in the months ahead. A yield on the ten-year Treasury visiting 2.00 percent when stock market worries run high and a 2.50 percent yield when stock markets are strong provides a reasonable trading range in this slow growth world. At the end of the day, expect bonds to deliver low single digit returns into the foreseeable future. Note the emphasis is on “low”.

Volatile markets always test investor resolve. It’s never a straight line up no matter how much we want it to be. Ringo had it right, “you know it don’t come easy”.

Ten months ago we forecast that things would be more difficult for the US stock markets in 2015. We looked at:

• The slumping price of oil
• The strong dollar
• Near zero year over year corporate earnings growth
• Above average market valuations

and surmised there would be a good chance stock markets would be flat for the year. Through October the US markets are indeed relatively flat, primarily as a result of sluggish corporate earnings growth. At this point we don’t see a lot changing through year end.

As 2015 progressed the US market was strong out of the gates (up close to 5%), started to fade into the summer, went through a volatile period (down 12% from the peak) in August, and subsequently recovered in October. The strong dollar and rock bottom oil prices are simply causing an “earnings recession” in the S&P 500 this year, and keeping stock prices in check.

The question is will an earnings recession turn into an economic recession. We don’t think so. In fact, the US economy is doing quite well, check out the data below:

• Second quarter GDP was revised to a strong 3.9%
• Consumers are increasingly confident
• Household net worth is rising
• Inflation remains low

Despite good economic data there are still questions. If the earnings growth picture isn’t good, is there a chance we could go into a recession? One thing that’s signaled recent recessions is an inverted yield curve. This occurs when short-term interest rates become higher than long-term interest rates. The chart below shows how an inverted yield curve (red circles) signals an approaching recession and has occurred before every recession (shaded bars in the chart) dating back to the 1960’s:

Today the yield curve is positively sloped (10 year interest rates are at least 2% higher than short-term rates). This lends support to our belief that even though we’ll have market corrections (even like the big correction of 1987), a recession and an ensuing end to the bull market is not in the cards right now.

I think a disconnect exists between investor skepticism on the economy and actual economic data. The lack of earnings growth due to the effects of the strong dollar on corporate profits and low oil prices on energy sector profits is souring investors, but these effects are not permanent and could potentially become additive to earnings in 2016.

We know actual earnings in the 3rd quarter of 2015 will be down year over year, but what would earnings look like if we exclude the impact of oil and the dollar? The chart below shows actual 3rd quarter forecasted earnings of -4% (blue line) along with underlying earnings growth excluding oil and dollar impacts (light blue line):

 

If we strip out the temporary drag of oil and the dollar, underlying earnings growth is actually quite robust. All in all the economy continues to grow in 2015 and underlying earnings growth (ex oil and dollar effects) is good. This could potentially set the stage for a good 2016.

As of October 19th, 2015:

Dow Jones US Moderately Conservative Index is up 0.10% (TR) for the year

Dow Jones Industrial Average closed at 17,230 down 1.49% (TR) for the year

S&P 500 closed at 2,032 up 0.41% (TR) for the year

Russell 2000 closed at 1,163 down 2.35% (TR) for the year

MSCI Emerging Markets down 9.31% for the year

U.S. 10 year Treasury Futures are yielding 2.03% down 0.14% for the year

WTI Crude Oil futures closed at $45.92 down $7.79 for the year

Gold closed at $1,173 per ounce down $10 for the year

To expand on these market reflections or discuss other portfolio strategies please don’t hesitate to reach out to us at 775-674-2222.