Below are my notes sent to CNBC before my 1:30 pm ET segment on Power Lunch and my evening segment for Nightly Business Report on PBS, both of which will be from the Federal Reserve.
We think the Fed will raise by 1/4 point today. At this point, the hike has been sufficiently telegraphed, the markets are pricing in a hike, and the last thing the Fed wants to do is surprise people. However, we also think the Fed will go to great pains to convince investors that: 1) they will go very slow; and 2) there is no pre-set path for tightening. In fact, we think the case for tightening has deteriorated rather than strengthened over the past few weeks. First and perhaps most importantly, financial conditions have tightened without the Fed having done anything yet. Yield spreads in the junk bond market have widened, and there is some evidence that bank lending standards have tightened as well. Much of this tightening can be attributed to the collapse in the energy markets, which is another factor arguing for a “lower-for-longer” posture by the Fed. Indeed, the collapse in the global energy complex has dramatic implications for the global economy. And while there is no doubt that some of the collapse in energy is due to surging domestic supply resulting from better technologies (fracking, horizontal drilling), there are other factors at play as well. The collapse in energy prices can also be attributed to weaker-than-expected demand resulting from slowing growth in China and other emerging economies, and continued sluggishness in Europe and Japan. Also, the Fed has itself to blame for some of the turmoil in the junk bond market as years of easy money led to energy investments that wouldn’t pass muster in a normalized rate environment.
The Fed must also be concerned with economic slowing outside the US, which has contributed to a rising dollar. The economic weakness outside the US and the dollar strength have pressured US exports while also contributing to disinflationary pressures at a time in which the Fed would like to see more inflation. The recent decision by China to peg its currency to a basket of foreign currencies (rather than the US dollar alone) will only cause more disinflationary pressures as a weaker yuan will improve China’s trade position vis-à-vis the US. At the same time, many emerging-market economies are suffering the fallout from capital flight now that the Fed has begun its tightening phase. Still, other emerging economies are heavily dependent on commodities, the prices of which have tanked nearly across the board. All this weakness outside the US definitely factors into the Fed’s decision-making.
These factors will contribute to the dovish language that will no doubt accompany today’s rate hike. Moreover, most of the recent economic data paint a picture of a continued slow growth environment in the US, with risks elevated in the manufacturing, export and housing sectors. Our view is that the economy has become heavily dependent on ultra-low interest rates, and therefore any rise in rates will be contained because the economy simply can’t withstand meaningfully higher rates.
So, faced with this backdrop as well as relatively high valuations, we continue to favor defensive, less cyclical sectors like Consumer Staples, Health Care and select Technology over the more cyclical sectors. In particular, we think the Consumer Discretionary sector has gotten way out ahead of the economy, especially given that consumers seem disinclined to spend their higher earnings and the windfall of lower gas prices. We are more cautious in Consumer Discretionary names as well as Financial as we think there is a little too much optimism over the magnitude of future interest-rate increases.