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How Will the Federal Reserve Impact Your Portfolio?

A strong employment report last week substantially increases the odds of a December interest rate hike by the Federal Reserve. The markets have been anticipating this event for several years and rates will remain at historically low levels even after the Fed begins to normalize policy. Nevertheless, we highlight some areas we will be watching in response to the policy change:

  1. U.S. Dollar: The U.S. dollar has surged over the past 18 months in anticipation of wider interest rate differentials stemming from divergent central bank policies. A break in the dollar to new highs would likely prolong headwinds to U.S. profit growth since nearly half of corporate profits come from abroad. Limited-to-no profit growth means market gains must be fueled by P/E expansion, which may be constrained since valuations are already at historically high levels. Dollar strength is also posing a challenge to the manufacturing sector and our trade balance as U.S. goods become less competitive in the global marketplace. Commodity-related sectors, which are already reeling from massive price declines, would likely also be hurt by further dollar gains.

  1. Emerging Markets: Some view Emerging Markets as a potential victim of the Fed rate cycle as fears of a 1998-type crisis linger. However, historical precedent is mixed and market prices may already reflect Fed actions. Valuations for the asset class are inexpensive and currencies have already fallen nearly 40% since 2011 in response to softer growth conditions and in anticipation of tighter Fed policy. While short-term uncertainty exists, we believe the asset class offers attractive longer-term return prospects.

 

  1. Yield Curve: The yield curve tends to flatten after the Feds first rate hike. Investors may be surprised by the limited extent to which rates rise this cycle.

 

  1. Economically Sensitive Sectors: Economically-sensitive sectors may face headwinds as tighter Fed policy could serve to suppress economic conditions.

 

  1. Stimulus Overseas: Muted worldwide growth and tighter Fed policy is likely to encourage further stimulus measures from foreign central banks, most notably the European Central Bank, Bank of Japan, and Bank of China. This is a key reason, along with earnings and cheap valuations, to be optimistic in regard to return prospects in international stocks.

 

  1. Fiscal Spending: Now that monetary policy has carried the stimulus baton for several years in an effort to boost growth, fiscal spending is likely to play a greater role as the 2016 elections approach.
Investment Advisory Team
Hefren-Tillotson

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