Investment Commentary: The Market and the Fed’s Delicate Dance

What a difference a couple months makes! After one of the worst starts to the year in the stock market, it finished the quarter roughly where it began. From the opening bell this year through February 11th, the S&P 500 was down 10.5%. From February 12th until the end of March, it was up an equally impressive 12.6%. In December, Janet Yellen and the Fed felt the economy was strong enough to warrant an increase from the 0% interest rates we’ve had since 2008. And while they were probably right, the market didn’t like it one bit and started its descent. That spooked the Fed and caused them to back off of their initial statement of increasing rates four times in 2016 (increasing interest rates is akin to tightening monetary policy which is meant to keep the economy from overheating).

I can envision this dance continuing for quite some time: the economy and market do well for a while so the Fed increases rates, then the market has a fit and sells off forcing the Fed to say it will not increase again until they have the data justify it, which then causes the market to bounce back and the cycle starts all over again. As long as the underlying fundamentals of the economy are improving, I’m not too concerned about the path we take to higher interest rates. It does appear the Fed is anxious to have lifted at least a couple percentage points above zero before the next recession hits. Time will tell if they were able to achieve this goal.

Regarding Employment– One of the Main Barometers of the Economy:

One of the main barometers of the economy the Fed is focused on, (and making them optimistic), is the employment situation. Something frequently talked about is the headline unemployment number and its relationship with the labor force participation rate (the % of population employed or actively seeking work). Headline unemployment is around 5% which is considered to be full employment (i.e. a strong economy). However, the labor force participation rate has fallen to lows not seen since the 1970’s. Therefore, it is argued the job market is worse than the headline number portrays because it doesn’t take into account discouraged workers who have dropped out of the workforce. While there is merit to that argument, another reason for the decline in the participation rate is simply the aging of the baby boomers. Recently, however, the participation rate has started to tick up. In fact, March was the fourth increase in a row, something that hasn’t happened since ‘92. A positive way to read this is the job market has improved to a point where it is now pulling people back into the workforce.

So what does all this mean for your investment portfolio?

I believe if the employment situation and economy continues to improve, interest rates should move higher. I also believe this is a good thing for savers/investors longer-term. However, increasing interest rates can be a headwind for all asset prices (stocks, bonds, real estate, etc.), so managing this risk in portfolios on the way to higher rates is important. A way to do this is to have relatively short duration in fixed income and have limited exposure to interest rate-sensitive equity investments. Once interest rates have settled at a higher level, future returns for all asset classes will be much better than currently forecasted. Lastly, I would try to detach emotionally from the temper tantrums the market tends to throw following the Fed’s decisions.

If you have any questions, please don’t hesitate to reach out to your Advisor, or contact our Private Client Services Division.

Statistics sourced from Yahoo News and Bloomberg.

Michael Gallagher, CFA® – Portfolio Manager at The Partners Group

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