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Long Time Coming
It is official. The Federal Reserve raised the target Fed Funds rate from 0.00%-0.25% to a range of 0.25%-0.50%, the first rate increase in seven years. The financial markets took this announcement in stride. The increased target rate was no surprise. This has been the most well-telegraphed rate increase in Federal Reserve history and the markets were prepared. The question marks have surrounded the pace and magnitude of interest rate increases into 2016 and beyond. The Fed says what it always says... its actions will be data dependent. Data overwhelmingly suggest the cycle will be slow and low as growth and inflation are both slow and low. To quote Fed Chairwoman Yellen in her press conference immediately following the decision, "As I will explain, the process of normalizing interest rates is likely to proceed gradually, although future policy actions will obviously depend on how the economy evolves relative to our objectives of maximum employment and 2 percent inflation."
Yellen went on to explain that Committee Members recognized overall strength in the labor market while acknowledging points of weakness including a lower than demographically-justified participation rate, lack of sustained wage growth, and a high level of involuntary part-time employment.
With respect to inflation, the Fed believes our current very low rate of inflation will pass quickly and is the temporary result of the rapid fall in energy prices. As energy prices stabilize, so will inflation. Inflation is expected to reach 1.6 percent next year, 1.9 percent in 2017, and finally 2 percent in 2018 according to the Fed's projections.
The Fed estimates real GDP growth has been 2.25% through the third quarter of 2015 and it believes this pace should continue into 2016. Yellen specifically noted the strength in automobile sales, home building and business spending as solid. The energy and mining sectors were cited as weak. The Fed believes new home starts are still lower than they should be.
As you may remem-ber, the Fed delayed this rate increase. The markets were prepared for the first to occur in Sept-ember, but inter-national financial market develop-ments kept the Fed on hold. This was referenced in the press conference as Yellen mentioned the risks of developments abroad
while
saying these risks had faded since the summer months.
What does this mean for financial markets? The idea of "low and slow" is one that financial markets like. While we will continue to debate the timing and magnitude of future increases, the Fed has just given us a list of indicators to watch for 2016.
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Market Outlook for 2016
Short-term forecasts are notoriously difficult and variable, but we still attempt an educated guess at which way the winds might blow next year. Markets are impacted by marginal changes to trends and unexpected financial or geopolitical events. The marginal changes to trends are somewhat predictable thanks to the many economic and market data sets available to investors today. We make marginal changes to portfolios based on these items in an attempt to add performance without unduly changing a client's risk profile. The unexpected events are by definition not predictable. These unexpected risks should be protected against through your asset allocation decision as opposed to market timing attempts.
Entering 2016, we see some trends we believe could influence market returns. The most obvious is the role of central banks. In the U.S., we are beginning the early stages of an interest rate increase cycle. Monetary policy is still accommodative, and will be for many months to come, but it is the trend that may influence markets. The U.S. Dollar is likely to hold its strength from last year and may strengthen further. Energy prices seemed to stabilize in the mid $40 area during the middle of 2015 but have now dropped into the mid $30 range. While a strong Dollar and low oil is good for U.S. consumers, neither is good for U.S. manufacturing or exports. This can clearly be observed in Purchasing Manager's Index (PMI) survey data showing an expanding services sector but a contracting manufacturing sector.
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GDP growth in the U.S. is steady around 2.5%, but unlikely to meaningfully increase. Inflation is extremely low now but likely to rise marginally as the Fed explained. That is not a bad thing at these levels, but again, a trend change. Corporate earn-ings growth will most likely be flat to slightly down in 2015. Expectations are for a return to single digit positive growth rates of 8% in 2016 according to FactSet's consensus estimates, but those expectations are lower than forecasts published 6 months ago. The chief culprit is falling earnings within the energy and industrial sectors consistent with the weakness in the manufacturing PMI.
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The story in the U.S. is basically unchanged. While growth has been slow, it has also been steady for an extended period of time sufficient enough to place the economy on much better foot-ing as compared to a few years ago. It likely remains close to current growth rates for next year.
Contrast our situation in the U.S. with the situation overseas. Emerging markets are negatively impacted by falling commodity prices and the stronger U.S. Dollar. Add China's current complicated situation and Brazil's stagflation to the mix and we can confidently say we have little interest in emerging markets right now. However, the developed international markets are different. Specifically, we view Europe and Japan more favorably now than we have in many months. Again, it is less about current levels and more about trend.
The European Central Bank and the Bank of Japan are both still adding stimulus to their respective geographies while our Fed is tightening. The Euro and the Yen are likely to weaken further against the Dollar at the same time consumers in those countries will benefit from lower energy prices. These factors are lifting both the services and manufacturing sectors.
GDP growth for both Europe and Japan remains low. Eurozone annual GDP growth stands at 1.6%, though this is an increase from 0.6% a year ago. Japanese annual GDP growth stands at 1.5%. This is an increase from -1.5% a year ago. With PMIs rising in both geographies, central banks still active, energy prices still low, and currencies still weak, there may be further acceleration to growth coming for 2016.
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In an effort to capitalize on these trends for 2016, we have made changes to our tactical asset allocations for the first time since the early summer. In July of 2015, we viewed weak-ness in China and currency market volatility as negative for stocks. We reduced our weighting in stocks at that time. We had previously exited high yield bonds several months earlier as we viewed those valuations as expensive and saw little upside remaining in that asset class. We increased our exposure to investment grade bonds and cash. Now at the end of 2015, we are changing course. Our weighting towards stocks has increased with the additional funds directed mostly towards developed international markets with a preference for Europe and Japan. Our allocation to U.S. investment grade bonds is now lower while our allocation to developed market debt is higher. We continue to stay away from high yield bonds.
Conclusion
Next year appears similar to 2015 in several ways. We believe the U.S. equity markets should produce a positive but low level of return next year. Interest rate increases, a strengthening currency, tepid earnings growth and a weak energy and manufacturing sector are headwinds. We believe U.S. bonds will struggle as the Fed increases rates. However, rate increases should be gradual so we do not fear a dramatic bond market decline. International developed markets appear marginally more attractive for both stocks and bonds. Continued central bank easing, a weaker currency and low energy prices should benefit all sectors of the economies in developed markets. Bonds in these geographies have very low yields, but may offer better principal returns next year than U.S. bonds. In the end, we believe there is likely a small difference between the performance of U.S. and developed market sovereign debt in 2016.
The U.S. Federal Reserve will be in the headlines just as much next year as it was this year with the phrase "data dependent" ringing in your ears. As always, we will watch the data for needed changes in strategy. We shall see what 2016 holds!
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Tracy Bell, CFA
Senior Portfolio Manager/Investment Strategist
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Disclosures
Views are as of the date above and are subject to change based on market conditions and other factors. The views expressed are those of the author(s) and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor.
The information contained in this presentation has been compiled from third party sources and is believed to be reliable, but its accuracy is not guaranteed and should not be relied upon in any way, whatsoever. This information does not constitute, and should not be construed as, investment advice or recommendations with respect to the securities or sectors listed. Diversification and asset allocation do not assure a profit nor protect against loss.
The actual return and value of an account fluctuate and, at any time, the account may be worth more or less than the amount invested. Past performance results are not indicative of future results.
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Presentation is prepared by: IBERIA Wealth Advisors
Copyright © 2015, by IBERIA Wealth Advisors; All rights reserved.
Investment Products: * Not FDIC Insured * Not a Bank Deposit
* Not Insured By Any Federal Government Agency * No Bank Guarantee * May Lose Value
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