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Posted by on Mar 17, 2017 in Crossing Wall Street, Market Insight

Crossing Wall Street Review – March 17, 2017

Crossing Wall Street Review – March 17, 2017

By Eddy Elfenbein, editor of  Crossing Wall Street and portfolio manager of the AdvisorShares Focused Equity ETF (NYSE Arca: CWS)

This week’s Fed rate increase was hardly a surprise. Officials at the Fed have gotten quite good at telegraphing their moves to Wall Street. So the big news wasn’t this week, as the expectation for what was in the pipeline was formed over the last few weeks.

Despite the news’s being well planned, the reception was unexpected. Stocks rallied on the higher rates, but the long end of the bond market rallied as well. In other words, long-term rates went down on the news that short-term rates went up. Gold also rallied. That’s not what the playbook says.

The best way to square this circle is to believe that Wall Street expects higher rates, but perhaps not as quickly as they assumed. Wall Street had been very optimistic about the economy, not just regarding stocks’ going up, but regarding which sectors this was going to happen in (tech, cyclicals). That’s what the Trump Trade was all about. But in her press conference, Janet Yellen was very cautious, “We haven’t changed the outlook. We think we’re moving on the same course we’ve been on.” I think the Fed’s view is that Wall Street simply hasn’t been listening to them. The Fed sees gradual growth, but the Trump Trade was predicated on rip-roaring growth. In that battle, my money’s on the Fed largely because they’re the ones who make the money.

Along with the Fed’s policy statement, its members also updated their economic forecasts. I should add that the Fed is notoriously bad at forecasting. I mean, even for economists, they’re really, really bad. Still, their outlook—the famous blue dots—tells us where they think the economy is going.

For this year, the Fed expects two more rate increases. Not too long ago, I thought that prediction was far too optimistic. Now it looks quite reasonable. The Fed sees another three rate hikes coming next year as well. In fact, the median is only one vote away from seeing four rate increases next year. If that’s accurate, it would bring the range for Fed funds to 2.25% to 2.5% in months.

The Fed sees inflation holding at 2%. That means that real short-term interest rates will remain negative for nearly two more years. There are few factors that are as bullish for stock investors as negative real rates. Effectively, the Fed is giving us no alternative but to invest in stocks. While much of the bull rally has been helped by share buybacks, there’s been real investment as well. It’s taken a while to wind its way to the real economy, but it’s there.

What happens next? The Fed meets again in May, and it’s doubtful they’ll raise rates. After that, the Fed gets together in mid-June, and another rate hike is very possible. The futures market currently thinks the odds are roughly 50-50. Right now, I’d say it’s 70-30 in favor of another rate increase.

But there are a lot of moving parts to this forecast. The keys to watch are inflation and the labor market. Last Friday, the government reported that the economy created 235,000 net new jobs. That’s a strong number. The unemployment rate dipped to 4.7%. Over the last year, average hourly earnings are up 2.8%. That’s not much, but at least it’s 0.6% ahead of core inflation. During much of the period from 2011 to 2014, wages basically stayed in line with core inflation. This means that workers saw no real wage increase. Now they are seeing one, even though it’s small.

Inflation is still not a threat. On Wednesday morning, ahead of the Fed’s announcement, the government reported that consumer prices rose 0.1% last month. That’s what economists had been expecting. The “core rate,” which excludes food and energy prices, rose by 0.2%, which also matched expectations. So while the labor market has been expanding, there’s been only modest inflation pressure. That helps explain the Fed’s cautious approach.

All of this will have an impact on the stock market. I think it’s very likely we’ll see better relative performance from defensive areas of the market. This includes areas like healthcare and consumer staples. When traders see a better economy, these areas tend to get left behind. I still hold to my belief that stocks may face a modest pullback soon. Say 5% to 7%. Nothing too serious, but enough to scare off some momentum traders. We have nothing to fear. In fact, it may give us some good buying opportunities.

The information, statements, views, and opinions included in this publication are based on sources (both internal and external sources) considered to be reliable, but no representation or warranty, express or implied, is made as to their accuracy, completeness or correctness. Such information, statements, views and opinions are expressed as of the date of publication, are subject to change without further notice and do not constitute a solicitation for the purchase or sale of any investment referenced in the publication.