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Market Recap – Investors React to Interest Rate Hike by Fed

Market Digest – Week Ending 12/16/2016

US Stocks finished flat for the week as investors reacted to an interest rate hike by the Fed. The raise was widely expected, but suggestion of three more hikes in 2017 was not. As a result, the dollar rose and bonds fell. International stocks fell, primarily due to currency.

Weekly Returns:

S&P 500: 2,258 (-0.1%)
FTSE All-World ex-US: (-1.4%)
US 10 Year Treasury Yield: 2.59% (+0.08%)
Gold: $1,134 (-2.2%)
USD/EUR: $1.056 (-1.0%)

Major Events:

• Monday – Donald Trump tweeted that the F-35 fighter costs are “out of control”, leading some to believe he may crack down on some types of defense spending.
• Monday – Oil surged after non-OPEC members led by Russia also pledged production cuts.
• Tuesday – Google parent Alphabet named its self-driving car business Waymo and said it would be stand-alone business.
• Wednesday – Amazon made its first commercial drone delivery which took place in England.
• Wednesday – Prominent technology CEOs met with Trump in a meeting that was described as conciliatory and cooperative.
• Wednesday – The Fed expressed optimism for the economy and voted to raise interest rates to 0.75%. It also signaled future rate hikes may come faster than previously anticipated.
• Thursday – US inflation rose 0.2% in November, a fourth consecutive month of gains.
• Friday – President Obama said Russia will pay a price for allegedly disrupting the 2016 election and added that the steps taken won’t be public.

Our take:
On Wednesday the Fed delivered its second rate hike of 2016 and indicated it may hike three more times in 2017. Interest rates are a topic which causes great concern to many people. Indeed, they are important, but we think much of the fear is overblown.

For the economy, decisions to invest are rarely decided because of a 1-or-2% difference in the cost of capital. Some industries, like most banks, actually do much better when interest rates are higher. And if they are more willing to lend, it can help the general economy. Very high interest rates are bad. Moderately higher rates need not be.

For investors, higher rates immediately translate into losses on bond holdings because existing bonds with lower rates aren’t as attractive. The US aggregate bond market has an effective duration of a little over 5. That means if (and this is a very big if) rates go up 1% next year, the bond market would see a price decline of about 5%. But after interest payments it would mean a loss of only about 2%. Not good, but not disastrous (note: holding a lot of long maturity bonds can be much more risky). Meanwhile, yields would then be higher looking ahead. For stock investors, higher rates tend to mean lower prices because safer alternatives become more attractive. This makes sense and for most of history stock PE ratios and interest rates have been inversely correlated. But there are long stretches of time when this has not been the case so we can’t assume just because interest rates go up that stocks must go down. There are always many factors at play at the same time. Interest rates are just one.

The idea that “interest rates are going to rise” has probably been the most common thing people have been wrong about in the investment world for the last 10 years. Now that the Fed is suggesting they will, it seems more likely. But the Fed can change its mind. Stock prices are high by historical measures, and bond yields are still low. This creates an environment where investors should be cautious – not greedy. But a well-constructed diversified portfolio still has a much better expected return than cash – even if that cash may now earn you closer to 1% than 0%.

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