Without a doubt, the past few years—and probably the rest of this decade—will ultimately be memorialized in the history books as quite unique, given theread more
Why Hasn’t Goldilocks Run Back Into the Forest Yet?
With another year in the history books and equity markets off to a strong start in 2017, we can’t help but reflect on the Federal Reserve’s role in this elongated period of appreciation in the stock market. Recently, the improvement in the economic outlook has resulted in the Fed initiating a tightening cycle which has included three interest rate hikes since late 2015. During previous economic cycles, rising rates have not necessarily been well received by the stock market; however, this time it has resulted in a so-called “Goldilocks” environment.
In December of 2015, the Fed released a baby bear market in the form of the first interest rate hike in the U.S. in over nine years. The quarter point increase in the Federal Funds rate took the target from essentially zero to a range of .25 percent to .5 percent. Shortly thereafter, a combination of weak energy prices, softening international economies and uncertainties over currency fluctuations in China caused the stock market to have the worst start to a new year in history.
A second rate hike came in December of 2016 and markets reacted quite differently. Economic data was experiencing an upswing and investor sentiment had improved in response to the formation of a business-friendly, pro-growth U.S. government. Additionally, the rosy projections for low double digit earnings growth could prove to be more realistic than in years past given fourth quarter earnings results were solid.1 As another catalyst, potential tax relief and a shift towards lower business regulation could also positively impact 2017.
As was the case the year prior, the Federal Reserve communicated that we could see a few interest rate hikes in the new calendar year.2 The third interest rate hike arrived this past March, a little sooner than predicted by the market, but still didn’t cause Goldilocks to awake from her peaceful slumber.
So, if interest rate hikes are designed to slow growth, why hasn’t the stock market been under more pressure? In modern investing times, we haven’t had a backdrop of global interest rates being at, or below, zero. The move away from zero bodes well for economic growth in the U.S., as well as emerging markets, to the extent that it reflects a strengthening global economy. Although rates have been moving upward, we are far away from the much higher rates of past cycles. The average 10-year Treasury bond yield since the late 1800’s is 4.6% versus yields at present, which are currently below 2.5%.3
Market volatility has also been quite low partly due to the Fed being more transparent than in prior cycles via telegraphing their intentions well ahead of their actions to smooth the rate transitions. The Fed has continually highlighted that, at this stage, they are only gradually raising rates in an attempt to position them “just right” – low enough to be accommodative but not too high to dampen economic growth. Should the Fed move towards reducing its balance sheet, we expect this will also be done in a passive and predictable manner.
Although volatility might pick up, if inflation remains low and global economic growth persists, current market multiples can be sustained and valuation concerns may be put to rest if earnings growth continues to impress. In this scenario, Goldilocks has digested her porridge, and we anticipate that it could be some time before the bears arrive home and chase her back into the forest.
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