Interest Waiting Game

Contrast

We celebrate and give thanks each year in November, but this November was a month riddled with somber events all over the world. Friday, November 13th was an especially dark day for those affected by the horrific terrorist attacks in Paris, and Europe as a whole continues to struggle to handle the inflow of refugees from Syria, Iraq, and Libya. Debate sparked in the U.S. over the same issue, and no simple answer appears to be in sight at the moment. These events are shaping both geo-political dynamics and financial markets, but interestingly most financial markets shook off these issues and moved higher over the latter half of the month. While there is much to cover there were a handful of issues that took center stage in November: continued focus on the Federal Reserve’s plan for interest rates; a focus on the S&P 500 earnings season; the volatile path of oil prices; and the larger outlook for future global growth.

77.5%

 At the time of this writing, Fed Funds futures prices are betting on a December rate hike with an implied probability of 77.5%. The Federal Reserve Board’s October meeting minutes seemed to reaffirm the probability of a rate hike event before year-end, and chatter from several Fed members suggests a December rate hike is likely. But, then again, didn’t everyone think the same thing before the September meeting? It certainly feels like it, but the September Fed Statement threw us all a curve-ball when the Fed pointed to “developments abroad” requiring monitoring as a rationale to delay a rate hike then.

Still, a slew of economic data reported in November suggests the Fed might actually follow through with a rate hike this go-round.   Third quarter GDP was in line with estimates of 2.1% – not great, but not terrible either. Jobless claims declined to 260k, a reduction of 12k. And even homeowners generally saw their net worth increase as the September FHFA Housing Price Index rose 0.8% versus the expectation of a 0.4% hike in value. Also, only five of the regional Fed banks asked for a 25 basis point hike (one-quarter of one percent) in the discount rate back in July, and that number rose to eight in September. Then, last month, the Boston Fed joined the rate hike crowd, bringing the total to nine. There were a few data points that fell short of expectations, including mortgage applications, personal spending, and the University of Michigan Consumer Sentiment reading.

Basic financial policy logic would suggest that a zero interest rate policy is fit for an economy in crisis. But since it seems that conditions for crisis have waned since the depths of ’08-’09, a zero interest rate policy makes less sense to more and more people now.

So what happens when rates go up?

Well, no one is extremely certain, but let’s first focus on what most economists expect:

-The Dollar… When rates go up, then U.S. yields look attractive, especially in a world where other Central Banks are slashing rates. When yields look attractive, then foreign investment will follow, which would send the U.S. Dollar higher, especially in a world where other countries are devaluing their currency in foreign exchange or via pumping capital into markets (i.e. European Central Bank, Japan, and China).

-Commodities prices… Commodities are expected to suffer. Oil is priced in dollars, and dollar strength over the last year is one of the driving factors behind falling oil prices (don’t forget about OPEC’s strategy to kill oil plays in the shale and fracking communities). Precious metals like gold also lose their luster versus yield assets like bonds which generate income.

-Bonds… And speaking of bonds, all things being equal, the price of a typical bond will fall as broader interest rates rise. There is a technical explanation in the shape of a statistic called ‘duration’, but the main thing to remember is the path to normal interest rates is going to be very slow and very incremental.   Bonds will still play a role in the investment world, and active management becomes all that much more important.

Higher interest rates are beneficial for savers who have been wondering if rates would ever go up again. Higher rates are also good, then, for financial institutions and lenders.

Winter is coming… for earnings

S&P 500 earnings are all but done for the third quarter, and there was a blended earnings decline of -1.3%. Coming off of a Q2 earnings decline of -0.7%, we’ve seen back-to-back quarters of earnings declines for the first time since Q2 and Q3 of 2009. We’re also looking at three consecutive quarters of year-over-year revenue declines for the S&P 500.

The outlook for earnings is bleak. The biggest detractor is the Energy sector, however if you excluded the Energy sector from the S&P 500, earnings would jump to +5.7% from -1.3%. If you did the same for revenues, you would see a jump to +1.2%, from -3.9%. The Energy sector is having a big impact on the S&P 500, and if we throw into the mix further weakness in commodity prices and a stronger dollar, the outlook gets even bleaker.

The following companies have commented on dollar strength hurting their business in recent earnings calls: Coca-Cola, IBM, General Electric, Johnson & Johnson, Alcoa, Monsanto, Pepsi Cola, Costco, Nike, AutoZone, General Mills, Oracle, and several others. Companies who operate overseas lose some profits via the currency exchange when they bring foreign profits home. The strong dollar’s impact on U.S. business is certainly one of the main reasons the Fed is struggling to move forward with a rate hike.

The Cost of Terrorism

Geo-political dynamics and global growth also weigh heavy on the Fed. When the Fed alluded to “developments abroad” in its September statement, they were essentially talking about China. In previous newsletters, we’ve written about the growing pains China is experiencing as it shifts from an infrastructure and export-based economy to a domestic / consumption-based economy. In November, China continued to manage its economic issues. At the end of the month, the International Monetary Fund approved the addition of the Yuan to the Special Drawing Rights basket of currencies, and China lifted its ban on IPO issuance. While the IMF’s promotion of the Yuan to one of the world’s reserve currencies won’t go into effect until late in 2016, this event is a major milestone for China’s economic standing in the world.

However, China’s slowing economy is still a big detractor to global growth as economists expect a smaller Chinese contribution to global GDP yet again this quarter and next year. The larger concern at the moment is The Islamic State, or ISIS, which has stepped up its attacks around the world. ISIS — which this year claimed responsibility for the attacks in Paris and Beirut, as well as for the downing of the Russian plane in Egypt — has now overtaken the Taliban in Afghanistan as the world’s deadliest terrorist group, killing more than 20,000 people last year, according to a study by the Institute for Economics and Peace. Terrorist groups are now deadlier than ever, killing 80% more people in 2014 compared to the previous year.

While the human toll of these attacks is horrific, the economic cost is staggering as well. In 2014, acts of terror cost the world nearly $53 billion. After the attacks in Paris, hotels, restaurants, and other travel-related businesses reported business volume plummeting between 30%-50%.   Airlines also suffer when terror fears are heightened, and the U.S. government’s decision to move to a high alert status until February 24, 2016, hasn’t helped business. Warnings have been announced for crowded events, football games, and amusement parks, and there could very well be a link between the recent terrorist attacks and the drop in consumer sentiment. In light of these and many more issues, the outlook for global growth is weakening as we near the year’s end.

On the Horizon

There are two critical meetings in December. On December 4th, OPEC member states will meet to review their global supply strategy. Saudi Arabia has pledged to work with other OPEC members to stabilize the price of oil. Then, on December 15th, the Fed will kick off its two-day monetary policy meeting, and on the 16th, Janet Yellen will hold a press conference to answer questions about the Fed’s most recent and highly anticipated policy decisions. These two meetings will shape both how 2015 ends and how 2016 begins. Right now stocks are trading at average price-to-earnings multiples, meaning the stock market is thought of as fairly valued. From here, stock prices will move significantly higher only when we see sales and earnings improve. But we’ve all seen how geopolitical events can send prices down quickly during periods of fear. Investors that don’t adhere to an investment policy, philosophy, or process will find it difficult to navigate uncertain markets. We’re always vigilant, but we do not stray from our investment discipline and process.

The S&P 500 for November remained unchanged. However, that doesn’t mean it was free from volatility. At one point during the month the S&P 500 was down a little over 2.5%, but add in a 4% rally off the bottom and the market ended unchanged.