article 11-16-2015

Does A Rate Hike = Normal?

The Fed looks more and more likely to be gift-wrapping a December rate increase—see why Portfolio Manager Charlie Dreifus continues to believe that the move would be good for equities, mostly by offering a sign that the economy is fully recovered.

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I continue to believe that a 25 basis point rate hike by the Fed is likely to happen in December. Rather than hurting the economy, it would more than likely improve it.

As I have argued before, a rate increase would show that the U.S. economy is off life support and on the road to normalcy. It could also cause previously delayed economic activity to kick in that may itself lead to some inflation.

There will be one more jobs report in early December before the Fed's final meeting in 2015. Remember—both realized and expected progress are key metrics in the Fed 's decision. One thing looks sure to me—the first hike will be framed in dovish language, meaning there will be no threat of further immediate hikes.

The Fed's desire to see inflation rise to the 2% level has received a great deal of attention. The fact that the CPI (the Consumer Price Index, which is not the preferred measure the Fed uses to calibrate inflation), excluding energy, rose 1.9% for the twelve months ended September 30 has not received a similar amount of attention. Once the energy price decline anniversaries, the energy component will no longer be down.

In all likelihood the U.S. economy will strengthen in 2016 because of (among other things) a federal budget deal with greater government spending in an election year, the lag of lower energy prices kicking in, the absence of a West Coast port strike, and a strong housing market, which has led to higher rates of household formation.

Consumer confidence has stabilized as a result of higher stock prices, lower gasoline prices, and, perhaps most importantly, reduced Washington turmoil.

As we saw with the third-quarter GDP report, inventories (-1.4%) were a significant reason for sluggish overall economic performance, specifically in the industrial sector. So much is made of China's sluggish growth (for them) that the fact is lost that total exports to China represent only 0.7% of U.S. GDP.

The S&P 500 Index had its fifth-best October since 1928, advancing 8.3%. Breadth, however, was narrow. For example, in the Consumer Discretionary sector the advance by the largest market cap quintile was nearly 12 times that of the smallest quintile, and names such as Amazon, Expedia, and Netflix accounted for a large chunk of the gain.

Despite the market's advance—or perhaps because of it—there appears to be even more angst about its overall direction. Everyone seems to be thinking about events that could upset the market and cause it to decline. Many worry that a recession will be that event.

Yet something has to cause a recession. Without a financial crisis, the Fed tightening to cut off too-high inflation, or an external shock, it is unlikely a recession is on the immediate or near-term horizon.

With weak economic conditions, the real economy is not absorbing the created money. As Marshallian K has taught us, the money goes elsewhere — i.e., into financial assets.

With skeptical sentiment dominant, most investors are underperforming. Yet what if the market continues to surprise on the upside and ultimately drags along the holdouts?

It will all end poorly, and from higher price levels. We may even see some of this before year end in an attempt to catch up and window dress.

Rising bond spreads imply that investors are more nervous regarding the outlook (that is, the creditworthiness) of a sector or issuer. Essentially, it indicates that stress is building and creates disadvantages for lower-quality companies.

I still expect that scenario to play out, despite the recent narrowing of spreads. Investors chasing yield caused much of that reduction.

Strategas Research Partners recently asked, "Are common stocks the Cinderella asset class in an era of difficult-to-achieve return assumptions?" They could be, which bring us back to their concept of T.I.N.A.—"There Is No Alternative" to equities.

In answer to the question of what to do with one's investable assets, my answer, unsurprisingly, is to ask investors to consider a risk-conscious investment approach.

Important Disclosure Information

Charlie Dreifus is a Portfolio Manager and Principal of Royce & Associates, LLC, investment adviser to The Royce funds. Mr. Dreifus's thoughts and opinions expressed in this piece are solely his own and may differ from those of other Royce investment professionals, or the firm as a whole. There can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future. 

The S&P 500 is an index of U.S. large-cap stocks selected by Standard & Poor's based on market size, liquidity, and industry grouping, among other factors. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money

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