Global Investment Strategy
March 2, 2015 (Weekly Update)
Darrell Cronk, CFA®, President, CIO
Weekly market insights from the desk of the Chief Investment Officer
- Normalizing interest rates would give the U.S. Federal Reserve (Fed) ammunition to combat a future economic slowdown.
- A sizable gap in interest-rate expectations between Fed officials and the market still exists.
What it may mean for investors
- Investors should remain slightly underweight U.S. Treasuries and consider U.S. large-cap stocks and developed-market equities.
A Balancing Act
Federal Reserve (Fed) Chair Janet Yellen's congressional testimony on February 24 and 25 was captivating, at least if you love monetary policy and congressional banter as much as I do! The reality is that many of you likely lead more exciting lives than yours truly, so I will keep this week’s report contained to what the outcome of last week’s meeting could mean for financial markets in the near term and why we think Dr. Yellen’s comments are important for investors. We continue to believe that 2015 will be THE transition year for U.S. monetary policy, and the end of a zero-interest-rate policy (or ZIRP) that has prevailed since December 2008. As the announcement of the first rate hike in several years draws nearer, disagreements among Fed officials loom larger, the language they use becomes more critical, and volatility in the bond market is on the rise.
In our view, investors should be more concerned about the path of monetary policy following the first interest-rate increase, rather than the mere departure from a zero-interest-rate level. The task of restoring interest rates to normal levels likely will take years to complete. As the current economic recovery continues to gain traction, it is plausible that some Fed officials might choose to increase interest rates so that they have the option of responding to any downturn in the economy by lowering rates again. In other words, normalizing rates could allow the Fed to counter with monetary ammunition should economic conditions deteriorate in the future. Likewise, the Fed will want to make certain that once the rate increases do commence, it does not have to reverse course mid-stream. That means that Fed leaders will need the utmost conviction that the economic recovery is sustainable before administering the initial rate increase, so that rate hikes will not need to be retracted in the near term. Not only would a reversal in monetary policy diminish the credibility of the Fed’s decision-making ability, but it would also create a significantly challenging environment for financial markets.
Monetary policy by its very nature is a balancing act with the Fed overseeing a dual mandate: maintaining stable prices and pursuing full employment. The Fed targets a two-percent inflation rate to help shield consumers from losing too much purchasing power should inflation trend higher and to avoid economic stagnation should inflation slump to precariously low levels. Lately, not only has the Fed fallen short of meeting its inflation target, but the world is also confronting disinflationary forces, such as the large drop in energy prices over the past several months. Such an environment makes it difficult for some market participants to anticipate that the Fed will raise interest rates.
The chart below illustrates the Fed’s median estimate of interest-rate increases vs. the market's estimate of interest rates out to 2017. The gap between the Federal Open Market Committee's (FOMC) projection for the fed funds rate in 2017 and fed funds futures is about 160 basis points. Part of this gap reflects a difference of views about actual growth, potential growth, and the equilibrium real interest rate, but a significant portion reflects a divergence of expectations about inflation forecasts. Typically, by the time the Fed can see evidence of a widespread trend of rising prices, inflationary pressures within the economy are already building. Since inflation is a lagging economic indicator, the Fed historically has acted preemptively to avert inflation risks, allowing it to change interest rates at a measured pace. We expect the Fed to follow a gradual path as it begins raising rates—increasing rates no more than two 25-basis-point increments this year.
Chart 1: Estimates of Interest Rate Increases in the U.S.
Source: Federal Reserve Board, Bloomberg, 2/26/15
The second part of the Fed’s dual mandate, seeking full employment, requires it to acknowledge that the labor market can occasionally overheat, and at other times cool off. Lately, it has been ablaze with over one million jobs created in the last three months alone. Such impressive job growth leads us to believe that Fed officials can "check the box" on full employment. It also suggests that they want (and even expect) tighter financial conditions once the rate increases are underway. Indeed, that’s how monetary policy works. The Fed’s ultimate objective is to find the right balance of policy that is supportive of the domestic economy but does not lead to overly speculative markets or asset bubbles.
For now, as we await the finale of the ZIRP, we recommend that investors remain slightly underweight U.S. Treasury securities as improving economic data and the eventual rise in interest rates will tend to push bond prices lower. Meanwhile, we continue to see value in U.S. large-cap stocks and developed-market equities for the foreseeable future.
Darrell L. Cronk is the president of Wells Fargo Investment Institute (WFII), an organization that provides world-class global manager research and investment strategy advice to Wells Fargo’s Wealth, Brokerage, and Retirement (WBR) division. Mr. Cronk also serves as chief investment officer for WBR, which is comprised of Wells Fargo Private Bank, Wells Fargo Advisors, Wells Fargo Institutional Retirement, and Abbot Downing businesses, accounting for more than $1.6 trillion* in assets under administration. In his role as chief investment officer, he leads global investment strategy including equity, fixed income, real assets, and alternative investments.
Mr. Cronk is frequently featured in the media including The Wall Street Journal, The New York Times, TheStreet, Dow Jones MarketWatch, Barron’s, the Associated Press, and Reuters, and makes regular appearances on Bloomberg, CNBC, and Fox Business News. He has authored numerous investment-related articles and regularly speaks at investment-industry conferences.
With more than 20 years of experience in financial services, Mr. Cronk most recently served as deputy chief investment officer for Wells Fargo Private Bank. He has held a variety of positions at Wells Fargo, including regional chief investment officer, senior director of investments, regional investment manager, senior investment manager, equity analyst, and senior financial consultant. He began his career as a senior credit analyst for Norwest Bank, a Wells Fargo predecessor.
Mr. Cronk earned a Bachelor of Science in Finance from Iowa State University, a Master in Finance from Boston University, and is a CFA® charterholder. He is based in New York City.
*As of Sept. 30, 2014
All investing involves some degree of risk, whether it is associated with market volatility, purchasing power or a specific security. Stocks offer long-term growth potential, but may fluctuate more and provide less current income than other investments.
Investing in fixed income securities involves certain risks such as market risk if sold prior to maturity and credit risk especially if investing in high yield bonds, which have lower ratings and are subject to greater volatility. All fixed income investments may be worth less than original cost upon redemption or maturity. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline of the value of your investment.
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