Investing Without the Solace of Central Bank Support

Last week, stocks and bonds in Europe and the United States came under pressure, although U.S. markets were able to finish with a slight gain thanks to a massive rally on Friday. The tech-heavy Nasdaq Composite Index added 0.29% to close the week at 5,142, while the Dow Jones Industrial Average advanced 0.27% to 17,847 and the S&P 500 Index inched up 0.05% to 2,091. Meanwhile, the yield on the 10-year Treasury rose from 2.22% to 2.27%, as its price fell.

Early in the week, investors were disappointed by a hawkish tone from the Federal Reserve (Fed) and, even more so, modest action by the European Central Bank (ECB). The market’s response reinforced two very important lessons for the coming year: Going forward, central banks will be less effective in pushing asset prices higher, and financial conditions outside the U.S. will continue to affect domestic markets.

A Goldilocks Jobs Report

The biggest negative catalyst for the markets was disappointment with the ECB’s modest efforts to extend quantitative easing. But investors also took note of comments by Chairwoman Janet Yellen, who said she expects inflation to move to 2% over the next few years and remarked on the solid pace of household spending. Investors interpreted these comments to mean the Fed might raise interest rates more aggressively than the market expects.

European stocks ended the week sharply lower, as did European bonds, but U.S. stocks were able to rebound on Friday. Investors reacted positively to a “not-too- hot, not-too-cold” jobs report, allowing U.S. equities, and to a lesser extent bonds, to recoup their losses.

The United States created more than 200,000 net new jobs in November while the unemployment rate remained steady, at a low 5%. However, other signs pointed to a less robust economy. Growth in hourly earnings moderated and there is continued divergence between the manufacturing sector and the rest of the economy. Last week’s November reading of the ISM Manufacturing Survey unexpectedly fell to 48.6, the lowest level since 2009, suggesting a contraction in the manufacturing sector.

The bottom line: The jobs report was strong enough to support the notion that the Fed will begin to hike rates this month, but not robust enough to compel the central bankers to embark on a more aggressive course, mitigating the fears from earlier in the week.

A Fraying Safety Net

Last week’s market action reinforced two important themes that are likely to be very relevant in the coming years. First, central banks will not provide the same level of market support that they have in recent years past. While we take the Fed at its word that this cycle will be gradual, even a gentle tightening cycle will create some pressure on already high earnings multiples.

In addition, to the extent monetary tightening is accompanied by a stronger dollar and/or tighter credit market conditions, we could expect to see additional pressure on stocks. This suggests investors adopt a more selective approach, emphasizing areas of the market that can either withstand, or even benefit, from a gradual rise in rates. One example is the financial sector. Rising rates create opportunity for financial stocks, particularly banks, to improve their margins.

The second lesson: Conditions outside the United States will continue to drive, or even dominate, U.S. markets. We have witnessed this multiple times this year: The impact of low European rates on the U.S. yield curve, rising volatility driven by China and, most recently, the U.S. market’s violent reaction to a somewhat disappointing ECB easing.

The last example may be the most relevant, creating a sort of circle of cause and effect. The degree of monetary easing, or lack thereof, in Europe and Japan will have an impact on the dollar, as well as U.S. interest rates. In turn, the pace of the dollar’s ascent will help determine U.S. earnings, inflation — and to some extent, Fed policy.


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