How Interest Rates Are Driven By Inflation Data

How Interest Rates Are Driven By Inflation Data

The Federal Reserve Board last week signaled that it expects to raise short-term interest rates at a slower pace than it intended to at the end of last year, citing concerns about global economic growth and stock market volatility. The Fed now sees just two quarter-point rate hikes this year, down from four in December.

oilprice_sidebar

With this shift, the Fed and investors are now largely “on the same page” in terms of their outlook for future monetary policy decisions. For the past several months, the markets had been predicting fewer than four rate hikes in 2016 (in some cases, far fewer). The resolution of this issue gives the markets important clarity that should allow investors to focus more of their attention on corporate earnings and other fundamental drivers of stock valuations.

The Fed’s decision about when to raise rates again and by how much will be driven largely by inflation data. We expect the inflation rate to begin rising during the next three months.

  • Continued strong job growth will eventually generate sustained wage inflation.
  • In addition, oil prices have begun to stabilize and rise from their historic lows (see the chart). Higher oil prices, and ultimately higher gasoline prices, will lead to less downward pressure on inflation as we move through 2016.

 

Equity

Emphasizing U.S. stocks. Our equity strategy continues to significantly emphasize the U.S. market over international markets, due to relatively strong domestic economic growth and because of structural challenges facing Europe and Asia. Central banks in both of those regions are attempting to generate stronger growth through aggressive monetary policy, but it remains unclear if their strategies will accomplish that goal.

grwothof100Our overweight position in U.S. stocks has benefited performance. The S&P 500 is up 2.19% during the past six months, while international markets are down 4.05% (see the chart).

Balancing growth and value. We recently eliminated our overweight position in growth stocks relative to value stocks. Many growth shares appear to be overvalued and have become more volatile. Meanwhile, the energy sector—which represents a significant portion of the value stock universe—has become more attractive, for two key reasons: Stabilizing oil prices, and the resultant reduction of the risk that oil companies will default on their debts due to rock-bottom oil prices. Oil companies’ revenues, profits and stock prices will ultimately rise in response to positive developments in the energy sector.

Our decision to adopt a more balanced position between the growth and value sectors has benefited performance, as value (S&P 500 Value index is up 0.36%) has outpaced growth (S&P 500 Growth index is down 2.03%) year-to-date (thru 3/15/16).

Focusing on dividends. We have maintained an overweight position in stocks of dividend-paying U.S. companies throughout 2016. Companies that pay dividends to shareholders tend to be relatively large, established and financially stable. This strategy has helped reduce overall volatility relative to broad-based global benchmarks. For example, weekly returns for the Horizon Active Asset Allocation Fund have a standard deviation of 2.75% year-to-date, versus 3.35% for the MSCI ACWI Ex US index of developed markets and 3.91% for the MSCI Emerging Markets index (thru 3/15/16). (see chart)

 

Fixed Income

Staying duration neutral. Our current fixed income strategy is duration neutral due to lingering uncertainty about the direction of interest rates and Fed monetary policy. There are few compelling reasons to either extend or shorten duration until the Fed shows a willingness to take more decisive action. That said, we anticipate adopting a shorter duration strategy if the Fed does indeed raise rates later in the year as expected, in order to mitigate losses in a rising-rate environment.

Remaining credit neutral. We also have adopted a neutral position in terms of the credit quality of our fixed-income holdings, due to conflicting signals about the overall health of the economy and corporate earnings. We are closely watching developments in the energy sector. If oil continues to stabilize, we will look to invest in corporate bonds from the sector that offer attractive yields relative to other segments of the bond market.

Emphasizing international fixed income. Finally, our fixed income strategy is overweight international bonds. Foreign central banks’ policy moves to reduce interest rates have pushed up bond prices in many of those markets, and our overweight position has benefited performance as a result.

 

Categories: Market Notes
X