After almost 10 years of artificially low interest rates, the Federal Reserve raised its key lending rate back in December amidst signs of a strengthening U.S. economy. That action was a little premature. Since then the stock market has plummeted and rallied and it remains volatile. And a raft of weak economic indicators suggests the U.S. economy is not as strong as first thought. As a result, the Federal Reserve may have to rein in its plan to hike interest rates four more times in 2016.
Federal Reserve Raises Rates for First Time in 10 Years
During the 2007-2009 financial crisis, the Federal Reserve initiated three rounds of quantitative easing, eventually buying $3.5 trillion worth of bonds and artificially lowering interest rates to zero. The idea was that low interest rates would encourage businesses and individuals to borrow more, spend, and kick-start the sluggish economy.
While the economy didn’t exactly rebound as expected, the stock market soared as income-starved investors sought a place to park their money with interest rates at zero. Since the markets bottomed out in early March 2009, the S&P 500 has advanced almost 200%, while the Dow Jones Industrial Average is up more than 160%.
Back in mid-December, the Federal Reserve announced it was raising its key lending rate for the first time in nearly a decade. The Federal Reserve, cautiously optimistic that the U.S. economy was healthy enough, raised its rate to 0.25% to 0.5%. It also suggested it would raise rates an additional four times in 2016—but that would be dependent upon the shape of key economic figures.1
U.S. stocks did not respond well to the rate hike. In the first six weeks of 2016, U.S. equities were routed on fears of weak economic projections out of China, a sub-one-percent fourth-quarter U.S. GDP, fears of a global recession, and tumbling commodity prices.
U.S. Economy Not Doing as Well as Thought
Since initiating its bond-buying program (quantitative easing), the Federal Reserve has hinted it would only raise interest rates when employment figures were stable (five percent or less) and inflationary goals of two percent were achieved.
The official U.S. unemployment rate stands at 4.9% and U.S. inflation is at an annualized rate of 2.3%. Unfortunately, the U.S. economy is not as stable as the data suggests. The vast majority of jobs created in the U.S. are part time and most are in the food-service and retail industries.
On top of that, fourth-quarter earnings from S&P 500 companies were bad and the future looks bleak. First-quarter year-over-year earnings projections are forecast at -8.4%, which is below the expected earnings growth rate of 0.3% announced at the start of the fourth quarter. If this is the final reading for the quarter, it will mark the first time the S&P 500 has seen four consecutive quarters of year-over-year declines in earnings since the fourth quarter of 2008 through the third quarter of 2009.2
Not surprisingly, the U.S. government’s second estimate for 2015 fourth-quarter GDP was just one percent. That’s a disappointing figure for the world’s biggest economy, and one the Federal Reserve has been helping to create with artificially low interest rates.3
U.S. Interest Rates to Rise Gradually
At its March meeting, the Federal Reserve lowered its expectation for the number of interest-rate hikes this year, citing the continued economic slowdown in China, weak commodity prices, and a bleak economic outlook.4
Instead of four additional rate hikes in 2016, it now appears as though the Federal Reserve will only hike rates twice. Rate hikes this year are expected to be modest. The last thing the Federal Reserve wants to do is raise rates and derail an already fragile U.S. economy.
The dovish outlook was cheered on Wall Street. That’s because fewer rate hikes means lower rates for longer, which translates into cheaper money pouring into the stock market. Despite weak economic data from around the world, U.S. stocks, while volatile, are still trading near record levels.
In light of this fact, will U.S. equities be able to maintain these lofty levels? And what can investors do to profit from the uncertainty?
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- “Decisions Regarding Monetary Policy Implementation”, Federal Reserve web site, December 16, 2015; https://www.federalreserve.gov/newsevents/press/monetary/20151216a1.htm.
- “Key Metrics,” Factset.com web site, March 18, 2016; https://www.factset.com/websitefiles/PDFs/earningsinsight/earningsinsight_3.18.16.
- “Gross Domestic Product: Fourth Quarter and Annual 2015 (Second Estimate),” U.S. Department of Commerce web site, February 26, 2016; https://www.bea.gov/newsreleases/national/gdp/2016/gdp4q15_2nd.htm.
- Press Release, Federal Reserve web site, March 18, 2016; https://www.federalreserve.gov/newsevents/press/monetary/20150318a.htm.