The last week’s market highlights:
Quote of the week:
“Well, this is it. The storm won't subside by tonight. We — we'll have to cancel Christmas.”
– Santa, Rudolph the Red-Nosed Reindeer (1964)
Should markets be this worried about the Fed and the economy? We don’t think so.
On December 19, the Fed raised its target benchmark interest rate, the federal funds rate, by 25 basis points (0.25%), to a target range of 2.25% to 2.50%. This was the fourth and final hike of 2018 and ninth of the current cycle. In its accompanying statement, the Fed maintained an upbeat view of the U.S. economy, although its outlook softened slightly from September. Officials still expect to increase rates in 2019, but no more than twice.
In response, markets behaved as if the Fed had committed a policy error. Equities in particular sold off as investors hoping for a more dovish message questioned the wisdom of any further rate hikes given heightened market volatility and fears that the slowing U.S. economy could fall into recession.
We think the markets are mistaken. In our view, economic and corporate earnings fundamentals remain on solid footing, and we see little evidence of an impending recession or bear market. Moreover, we expect the divergence between volatile market behavior and steady economic data to resolve in favor of the data, as it has in every bull-market correction of the past decade.
It’s also worth noting that the Fed was dovish in a few key ways: It removed a third potential rate hike from its 2019 “dot plot” expectations, mentioned global economic and financial conditions in its statement, albeit obliquely, and added “some” in front of “further rate increases” to convey that this hiking cycle is almost done.
In short, the Fed was as dovish in its tone and forecasts as it could afford to be in an economy that is (a) growing well above potential, with (b) a 3.7% unemployment rate that remains well below the Fed’s 4.4% estimate of the longer-run rate at which the economy would be at full employment; and (c) roughly at-target (2%) inflation. Looking ahead, there’s room for the Fed to become more dovish, either by pausing in March or by removing the 2020 rate hike from its forecasts at some future date. We continue to expect two rate increases in 2019, probably in June and December.
What might the current Fed-driven market psychology mean for investors? Potential upside opportunity for those with patience to weather short-term turbulence. December’s downturn has contributed to more attractive pricing on equities and other risk assets. Indeed, S&P 500 valuations are at their lowest since August 2013, based on the next 12 months’ earnings estimates, and high yield bond spreads have gapped 90 basis points wider this month, to their widest level since July 2016.
A note to our readers
The Weekly Market Update is taking a two-week break and is scheduled to return on Monday, January 7, 2019. In the meantime, for further market insights, be sure to read the 2019 Outlook published by Nuveen’s Global Investment Committee, available here. We wish you a safe and happy holiday season!