Well, that didn’t go very well. On Wednesday, the Federal Reserve conducted its last policy meeting of the year, at which the Central bank decided/announced it would raise short term interest rates again to a target rate of 2.25 percent to 2.5 percent.
While this result was widely anticipated, the Fed also critically indicated it plans to stay the course on interest rate policy, with additional targeted increases during 2019.
The stock market responded to this news with a dramatic move lower, contributing to the already negative trend U.S. markets have been caught up in since early November. It's getting kind of late for a Santa Clause rally, and at this point I’d settle for some market stability as we go into the holidays.
As an adviser I have persistently lamented the artificially low interest rates put in place after the 2008 financial crisis, which have persisted for 10 years now. I’ve felt these low rates had the effect of dragging investors toward risk they may not have been entirely comfortable with during all market conditions, including the one we’re in now, as rates on conservative bonds, cash and CDs have been nearly non-existent.
In many ways, I welcome higher short-term interest rates as they make retirement planning and retirement income funding all that much easier. But it's also important how we get to a higher rate environment, and it's important to understand why the current approach is being reacted to negatively.
It's no secret that stocks, especially in later stages of a bull market like we are in currently, tend to go down in reaction to interest rates increases. The current bull market has survived two what I call “interest rate tantrums” during the current cycle. One of these tantrums occurred in 2013, the other in 2015. Both looked very similar to the pattern we are seeing in stocks now, and neither ushered in the arrival of a long-term bear market.
This time, however, things really are different. While during those two previous tantrum periods it was hard to say stocks in general, as based upon valuation fundamentals, were overvalued or expensive, now this is clearly not the case. After a spectacular multi-year run stocks are looking relatively expensive, meaning in simple terms there’s more room to go down.
In addition, stocks are ultimately powered not just by corporate profits, but more fundamentally by corporate profit growth. After years of increasing profit growth rates, there is nearly unanimous sentiment in the financial press that profit growth will slow, and some experts are promoting the idea that the highest corporate profits in this business cycle may be behind us.
As icing on the cake, there are certain economic indicators (the stock market being one of them) which are viewed as the earliest precursors to an economic slowdown or recession. Over the past five years none of these indicators have been in the red zone. Recently however, the winds of change have begun to blow, and early indicators can best be described as mixed.
Which is why investor reaction this time to the Fed’s interest rate increases and continued policy of future rate hikes may be less of a tantrum and more a vote of no confidence. With the resources of the Fed, it's hard to believe the central bank is unaware of some of these issues, and so the conclusion may be that it's ambivalent, or worse yet being politically stubborn.
Time will tell, and we may not have to wait long. If the Fed does not openly change their policy bias from “onward march” to “wait and see,” I don’t see a way to restart the stock market rally. But I’ve been wrong before; let's hope this is the case right now as well.