market perspectives

Last week’s equity market carnage was blamed on a combination of collapsing energy prices, tepid economic data, and growing concerns over liquidity in the high yield bond market. The recent spate of terrorist attacks has further heightened investor anxiety, and with the Fed about to raise interest rates for the first time in nearly 10 years, are there any reasons for optimism?

We believe the path to higher asset prices has clearly narrowed, but our base case is still positive. Of all the concerns noted above, we believe the most significant determinant of market performance in 2016 will be the Fed and its ability to coax interest rates higher without spooking investors. Indeed, the Fed must successfully “thread the needle” by raising interest rates at a gradual pace in order to create the tools necessary to combat the next downturn (whenever that may be) and to avoid the possibility of higher inflation down the road. At the same time, if the Fed raises rates too fast, investors will become concerned about the economy’s ability to sustain its modest growth rate. The Fed’s six-year experiment of ZIRP (zero interest rate policy) is finally about to end and investors are rightly concerned about the way forward.

Nevertheless, history is on our side. We have cited a number of studies showing how stock market performance tends to hold up well during the initial stages of Fed tightening, particularly when starting from very low levels like we are witnessing now. In addition, comparisons of “fast” versus “slow” tightening cycles indicate that investors exhibit a marked preference for the slow version…the Fed has been very clear in its intention to move at a gradual pace. Based on past history, the time to worry about Fed tightening is in the latter stages of the cycle, when rates are higher and the economy looks like it might be overheating. We currently appear to be a long way from those conditions. 

As the world’s largest and most liquid reserve currency, higher U.S. interest rates could have an important impact on other economies. Higher interest rates tend to be a magnet for currency flows, drawing more funds toward the U.S. and pushing the value of the dollar higher (especially as other central banks move in the opposite direction). The stronger dollar will increase the cost of servicing dollar-denominated debt from foreign borrowers and mute the benefits of falling energy prices on commodity-consuming countries (since most commodities are priced in dollars). However, currency trends are impacted by a variety of factors. A continued rise in the dollar (after its sharp gains over the last year) is hardly a foregone conclusion.

While recent weakness in stock prices is likely to sow fears of doubt and uncertainty in the outlook, we believe the fundamental economic backdrop remains largely supportive for asset prices. The goalposts have narrowed and the risks have risen. However, if the Fed can thread the needle as it begins its rate-tightening cycle, odds are high for a positive outcome.

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Important Disclosures

The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice.

Certain statements contained herein may constitute projections, forecasts, and other forward-looking statements. Certain information has been provided by third-party sources and, although believed to be reliable, it has not been independently verified and its accuracy or completeness cannot be guaranteed.

Any opinions, projections, forecasts, and forward-looking statements presented herein are valid as on the date of this document and are subject to change.

All investing is subject to risk, including the possible loss of the money you invest. When interest rates rise, bond prices fall. Past performance is no guarantee of future performance.

Past performance is no guarantee of future performance. 

This material is available to advisory and sub-advised clients of City National Rochdale, LLC, a Registered Investment Advisor and a wholly owned subsidiary of City National Bank.