First Western Investment Research
September 18, 2015
In the most highly anticipated Fed decision in recent memory, the Fed chose to leave interest rates unchanged, foregoing the opportunity to raise them for the first time since 2004. Prior to the meeting, economists and pundits were evenly split on the likelihood of a 0.25% rate increase. In opting to stand pat on rates, the Fed Chair Janet Yellen pointed to “uncertainties abroad” (i.e. China), as well as a persistently lower-than-desired inflation rate. The two are not mutually exclusive. China’s slowing economic growth has placed significant downward pressure on global commodity prices and rippled across the economies of commodity-producing countries. That, in turn, has put downward pressure on inflation. While the Fed continues to describe the current pressures on inflation as “transitory”, it did note that inflation is likely to experience further downward pressure in the “near term”. The Fed now expects that its 2.0% inflation target will not be reached until 2018.
Given the emphasis that the Fed placed on “heightened uncertainties abroad”, it would appear that the requests from the heads of both the International Monetary Fund and the World Bank to wait on launching rates had some impact on the Fed’s reasoning. Dollar strength that would likely have accompanied a rate hike would have further strained many emerging market economies whose governments hold dollar denominated debt. Paying off that debt becomes ever more expensive as their local currencies lose value against the dollar.
One could argue that the Fed’s announcement and accompanying press conference will only increase the uncertainty surrounding the first rate hike as one must now also factor in international developments in addition to domestic economic data. The Fed appears to have added international factors as a third mandate alongside employment and inflation. The market’s volatile swings both up and down in the aftermath of the Fed’s decision highlight the confusion as to how to interpret the Fed’s current stance.
One positive, somewhat lost in Thursday’s headlines, was the Fed’s views on the U.S. economy. Ahead of the announcement, there was some concern that a decision to leave rates unchanged might be construed as a lack of confidence in the U.S. economy. However, during her press conference, Fed Chair Yellen commented on several occasions about the strength of the domestic economy, noting, “domestic developments have been strong”. Despite these constructive comments, we believe that the Fed wants to see additional wage growth which should lead to higher inflation before they make their first rate move.
Given the Fed’s emphasis on global economic developments and its desire to wait and see how those might impact the U.S. economy, it would appear that the first rate hike might very well not occur before 2016. In an accompanying release showing FOMC members’ views on the appropriate timing of policy firming, 13 believe it will still be appropriate to raise rates in 2015, while three do not expect a raise until 2016, and one member now believes it will be 2017 before the first rate increase. However, we find it hard to believe that the Fed’s questions surrounding the impact of global slowing and inflation pressures can be answered by December.
We believe that the Fed’s decision to leave rates unchanged emphasizes the uncertain impact of EM slowing on the U.S. economy. Given that the markets hate uncertainty, we think that the Fed’s inaction will lead to sustained volatility in the markets. We are about to enter earnings season. Corporate profits coupled with management’s outlook will weigh heavily on stock action in the fourth quarter. We believe that second half 2015 earnings will support a moderate upward trend in stocks toward the 2100-2150 level on the S&P 500, in line with our earlier expectation for the market this year. We remain constructive on core intermediate bonds, expecting low, single digit returns for the year. Given the uncertainty surrounding the timing of the Fed’s initial rate move, we would continue to advocate a 15-20% short duration allocation as a defensive stance.
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