Market volatility continued in the fourth quarter as market participants waited to see if the Federal Open Market Committee (FOMC) would raise short-term interest rates. After seven years of near zero, the FOMC did indeed raise the Fed Funds rate by 25 basis points or 0.25%. Global equity markets rallied on the decision. On December 16th, the day of the announcement, domestic stocks as measured by the S&P 500 index rose 1.5%. For the year, total return for the index is slightly positive, up 1.4%. International stocks as measured by the MSCI EAFE Index also rallied on the news, up 1.2% on the day. International stocks however, finished the year slightly negative year-to-date, down 0.2%.
The question now turns to how quickly the FOMC will continue their fiscal tightening. The two main factors influencing this decision are currently moving in opposite directions. Employment continued to surprise to the upside as the October and November jobs reports were very strong. The most recent read on the unemployment rate came in at 5%, and many believe this could be nearing full employment. Inflation, however, remained benign as commodity prices continued to fall during the quarter. Oil fell to a seven year low following OPEC’s decision to keep output high. The pace of interest rate increases will depend on how these two factors change over time.
Overall, corporate earnings will end the year lower. The headline number is misleading however, as steep declines in earnings from companies in the energy sector caused the majority of the decrease. Looking at other sectors’ earnings tells a very different story. The information technology, healthcare, and consumer discretionary sectors are growing at mid-single digit rates. Yields on investment grade fixed income remained stable over the quarter and weakness in the high yield space generally centered on energy companies. Default rates remain low elsewhere relative to history.
In the wake of the FOMC decision, we do not think the U.S. economy is likely to be derailed by what we believe will be shallow and measured rate hikes. Since the financial crisis, the country’s economic system has resolved many structural issues and is now on solid footing. In 2007 and 2008, there was a housing glut. Now we are experiencing a shortage of homes in many regions of the country. Oil peaked at nearly $145 a barrel, but thanks to the fracking revolution and help from OPEC, it is now below $40 a barrel. Banks were over-leveraged and now are more highly-regulated and very well-capitalized. Corporate balance sheets are healthy with record levels of cash. Consumers are experiencing high savings rates and low debt-to-income ratios today as compared to pre-crisis times, when they suffered with high household debt.
Stock markets tend to perform favorably in the year following a rate hike. Markets prefer certainty and a well-telegraphed rate tightening cycle, which we anticipate, will improve executives’ ability to better predict future costs and thus spur capital investment. We continue to favor stocks relative to bonds and prefer large companies over small companies. If it has been a while since you’ve visited with us about your financial goals, please feel free to contact your account administrator. They will find a mutually convenient time to review your account and determine if the current asset allocation is still appropriate for your circumstances.