Stocks Wobble On Rate Fears

9/26/2016


Stocks have been volatile, with worries regarding central-bank policy weighing on investor sentiment. Near-term trading is likely to remain choppy, but we are keeping the equity exposure of our buy lists at 78% to 81% for now. If the Dow Transports close above 8,109.19, our equity exposure will increase. 

Monetary focus

While the U.S. Federal Reserve announced no change in interest rates on Sept. 21, its statement said "the case for an increase in the federal-funds rate has strengthened." That means monetary policy will remain in focus on Wall Street, where many fear stocks will tumble once the Fed begins to raise rates in earnest.

Bears argue that with stocks unusually expensive and corporate earnings declining, it must be Federal Reserve accommodation that keeps share prices afloat. There is little doubt that low interest rates help support today's premium valuations on stocks, and that the Federal Reserve would like to lift short-term rates. Doing so would reduce the risk of bubbles developing in real estate and elsewhere, and it would help rebuild ammunition for fighting the next recession with interest-rate cuts.

But stocks are more sensitive to yields on longer-term bonds than to the overnight cost of money reflected in the federal-funds rate, and U.S. long-term yields partly reflect low rates in Europe and Japan. Moreover, the Fed now calls for a very gradual increase in the federal-funds rate.

In the forecast released with its Sept. 21 statement, the Fed signaled it expects one interest-rate hike before year-end and two more next year. That would put the target for the federal-funds rate at 1% to 1.25% at year-end 2017, up from 0.25% to 0.50%.

More notable, in our view, was the reduction in the Fed's long-term forecast for economic growth, to 1.8% from 2.0%. Such forecasts should be taken with a grain of salt, especially considering the Fed's forecasting record since 2009.

Still, it's worth remembering that all interest-rate increases are not equal. As demonstrated at the beginning of this quarter, stocks can perform well if expectations for both growth and interest rates rise. But if rates move higher because of inflation or bubble worries — without a pickup in economic growth — stocks will likely struggle.

Conclusion

If growth in corporate profits improves, the Fed's rate increases are unlikely to trigger a bear market. Against that backdrop, a move to significant highs in the economically sensitive Dow Transports would be bullish.


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