article 12-16-2015

The Fed Raises Rates—Why U.S. Stocks Still Look Pretty Good

The Fed raised rates (finally), with an expectedly modest 25 basis point increase—read why Portfolio Manager Charlie Dreifus continues to believe that the move will help U.S. equities, especially in an increasingly uncertain global economy.

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The Fed has followed through on previous signals and raised rates 25 basis points, marking the first increase on the part of the U.S. central bank in a decade.

I believe that the move signals 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.

Still, the increase comes against a backdrop of great uncertainty, so there are some factors that complicate the Fed’s decision, chief among them increasing concerns about weak commodity demand across much of the globe, including but not limited to oil. Related to this is OPEC’s recent announcement that that it would ignore its production limits and keep oil flowing. This news comes before Iran has fully returned to the market and the possible removal of sanctions against Russia—two moves that would dump even more product on the market.

This tepid outlook for commodities in a far from robust world economy thus poses dilemmas for the globe’s central bankers who are trying to bring about inflation. So the real impact of the hike is very likely to be de minimis because the rest of the world is holding steady.

One effect of the hike could therefore be a more expensive dollar—everything else being equal—which could further depress commodity prices and potentially raise again the specter of deflation. And with the eurozone version of QE already in effect and rates near zero, there simply aren’t any monetary tools left to stoke global demand in the face of steeper commodity price declines. By comparison, the U.S. is in appreciably better shape.

The appetite for junk bonds and leveraged loans has also waned. In some cases Wall Street banks can be left funding what others will not. There is no mistaking what is happening in the credit markets—there is more selectivity regarding credit quality—even if this has not yet been fully reflected in the equity market. Certainly some have started to question the health and liquidity of the corporate debt market.

This anxiety is disconcerting because the economy does not seem to be arguing for higher rates outside the Energy sector. China’s decision to loosen its peg to the U.S. dollar, which followed a bearish period for the yuan, only adds to the worldwide uncertainty.

Having said all this, the Fed seems to believe that rising wages means that inflation in the U.S. has bottomed. If we don’t see more evidence of steady wage growth, especially if paired with falling commodity prices, then the Fed has to think about whether or not they made a mistake and if subsequent increases need to be postponed indefinitely.

I expect the economy to improve in the aftermath of this hike, primarily because it reduces uncertainty and indecision, at least here in the U.S. An example is potential home buyers who will now expect mortgage rates to rise.

In such an uncertain period, of course, the question is, what are equity investors to do? First and foremost, one needs to know one’s risk tolerance. Then one needs to look at the alternatives to equities and to see if there is a viable choice. The T.I.N.A. principle, the idea that There Is No Alternative to equities, is somewhat tired, but still alive in our view.

So while the increase might initially spook some investors, I think there will soon be a realization that U.S. stocks still look fairly attractive, especially in a global context. For most investors with longer-term horizons, equities remain the preferred option, though perhaps marginally less so than a few months prior.

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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