The Federal Reserve will be meeting this week, followed by a news conference on Thursday at which time Chairwoman Janet Yellen may indicate the degree to which recent market turbulence has affected the Feds plans. The Fed has stated its intent on raising short-term interest rates in 2015 as a second step (following the end of quantitative easing) to slowly normalizing monetary policy. However, many have speculated elevated market volatility will encourage the Fed to delay actions. While well wait along with everyone else to hear whether the Fed will start raising rates now or later, we believe it wants to begin normalizing policy and will take a very slow and deliberate approach in doing so.
As the Fed slowly moves to return rates to a more normal level, the U.S. dollar may benefit, although the pace of gains seen over the past 16 months (+20% from May 2014) is likely unsustainable. The strong dollar is serving to suppress profits, exports, and inflation. In effect, the dollars gains relative to most currencies is serving as a de-facto tightening in policy. For example, earnings for the S&P 500 have essentially flat-lined since last September, rising only 0.5%, and at least partially explaining why the equity market has struggled to move higher over the past year. As a result, we would not be surprised to hear when the Fed does begin raising rates (either this week or down the road), they communicate a relatively dovish stance and a slow pace of rate increases.
The picture is very different overseas. Soft global growth is encouraging central banks around the world to ease policy in an effort to stimulate growth. An expansion of quantitative easing programs in Europe and Japan are very possible and we expect additional monetary and fiscal stimulus efforts by Chinese authorities. While corporate margins and profits are well-above longer-term averages in the U.S., profits are depressed overseas, offering meaningful recovery potential. For example, S&P 500 earnings are 7% above their long-term trend line whereas earnings for the MSCI EAFE and Emerging Markets indices are 15% and 18% below their long-term trend lines. Should stimulus efforts overseas prove fruitful, we would expect the share prices of foreign stocks to benefit from a coinciding profit recovery and close the unusually large performance gap between domestic and foreign stocks.