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Investment Insights: Yellen’s magic trick

Posted by Wade Balliet
Investment Strategy

This weekly report presents insights from our Global Investment Management team.

As widely expected, the Federal Reserve voted to increase interest rates at its meeting Wednesday.

View of the Federal Reserve Building, slightly from the side, on a sunny day.The Fed made a clear effort to openly prepare markets for the move, and it seems to have paid off. The S&P 500 Index gained just over 60 basis points in trading Wednesday as of noon (Pacific time). The central bank’s tightening stance signals improvement in the domestic economy, specifically relating to the Fed’s dual mandate of employment and inflation, but higher rates can be a headwind.

The effects of higher rates are far-reaching, but our foremost concerns revolve around an even higher U.S. dollar, corporate earnings, and debt yields. A higher dollar typically has a negative effect on trade which, coupled with the potential tariffs and growing “me first” trade policies in many countries, could cause a significant slowing in foreign trade. Corporate earnings are also a factor as a strengthening dollar decreases profits from multinationals’ overseas operations, and higher rates would likely add to borrowing costs for businesses. Last, but not least, the bond market bear may be getting ready to roar.

The 10-year Treasury yield has been largely range-bound for the past 5 years, fluctuating between 1.5% and 2.5% for most of that time. Due to changes in monetary and fiscal policies as well as general improvement in growth, that trend seems to be changing. After declining to a 20-year low of 1.45% in July last year, the benchmark yield shot up after President Trump’s surprise victory – and it’s still on the rise. As of yesterday, the 10-year Treasury was yielding 2.60%, closing in on what some technical analysts believe to be a threshold that could spell the beginning of a longer-term trend for bond yields. Barring shocks, a gradual move higher as the economy improves should be expected.

Central banks have long been the governors of growth via monetary policy, but we believe the Fed’s bag of tricks may be spent. Our view is that the torch must be passed to fiscal policy-makers to stoke the fire and push the economy above the current sub-par growth.

We continue to believe this Fed hike was the first of three this year, and our team expects the latter two to occur in June and December; however, geopolitical events or financial market disruptions may alter our forecast. Based on valuation data and current risks in the market, we are looking for opportunities to pare back U.S. stock allocations if the current rally continues. We prefer less currency-sensitive stocks in international developed markets and possibly more defensive alternative investments.

Chart showing various market returns as of 3/14/17

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Investing involves risk, including the possible loss of principal and fluctuation in value. Economic and market forecasts reflect subjective judgments and assumptions, and unexpected events may occur. Therefore, there can be no assurance that developments will transpire as forecasted. The information in this newsletter is for informational purposes only and is not intended to be investment advice or a recommendation. Nothing in this newsletter should be interpreted to state or imply that past results are an indication of future performance.

Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.

International securities involve additional risks such as currency fluctuations, differing financial accounting standards, and possible political and economic instability. These risks are greater in emerging markets.

Diversification and asset allocation do not ensure a profit or guarantee against loss.

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