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Dow, S&P 500 post gains despite Fed rate hike

The pessimist complains about the wind; the optimist expects it to change; the realist adjusts the sails. -William Arthur Ward, motivational author and speaker

It was a foregone conclusion last week that the Federal Reserve would raise interest rates but investors feared that the language of the Fed’s statement and comments by Fed Chair Janet Yellen could roil financial markets. As it turned out, the Federal Open Market Committee (FOMC) did raise the federal funds rate by 25 basis points as widely thought but the accompanying statement was far less hawkish than expected. As a result, the bond market rallied and all of the major stock averages posted gains for the week with the biggest gains occurring on Wednesday, the day of the announcement. After the interest rate hike, the target range for federal funds is now between 0.75% and 1% and the Fed forecast of two additional rate hikes this year was in keeping with its original forecast. In her comments, Yellen said that the economy had made solid progress toward its goals of full employment and price stability and that further gradual rate hikes would be appropriate. The emphasis in her remarks was on the word gradual as the federal funds rate is expected to be at only 1.4% at the end of this year and at 2.1% at the end of 2018. The yield on the 10-year Treasury actually fell on the news of the rate increase and ended the week at 2.50%. As a means of comparison, yields overseas are far less attractive as the 10-year German Bund yields 0.43%, the Japanese 10-year yields 0.07% and the 10-year in the United Kingdom yields 1.25%. Investors must keep in mind that bonds form a global market and this yield differential should increase demand for U.S. fixed income investments, driving up the price and lowering the yield. Interest rate sensitive stocks also performed well last week as lower bond yields make their dividend payouts more attractive to investors. Sectors such as utilities and telecommunications whose stocks have above-average dividend yields were among the best performers while financial stocks took a breather since they benefit from higher rates and a steeper yield curve. The biggest wild card that affects future U.S. economic growth, inflation, interest rates and the financial markets is still President Trump’s pro-growth policies. Until this uncertainty is resolved, the stock market is likely to trade in a narrow range.

Last Week

The producer price index (PPI) was higher than expected in February and has risen 2.2% in the last 12 months while the consumer price index (CPI) came in as expected and has increased 2.7% over the last year. Home builder confidence soared to its highest level in 12 years as President Trump has sought to reduce many burdensome regulations. Retail sales rose only slightly in February as consumer spending may have been affected by delays in tax refund payments. Housing starts rose more than expected in February and the Philly Fed Index, a measure of regional manufacturing activity, topped forecasts in March.

The biggest surprise in the economic data last week was the release of the leading economic indicators in February. The index rose 0.6% to reach its highest level in more than a decade. This bodes well for the U.S. economy as prospects are bright for tax reform, deregulation and increased fiscal spending, but lately Congress has been bogged down with other issues and has been slow to act on these pro-growth initiatives.

For the week, the Dow Jones Industrial Average edged up 0.1% to close at 20,914 while the S&P 500 Index rose 0.2% to close at 2,378. The Nasdaq Composite Index gained 0.7% to close at 5,901.

This Week

It promises to be a quiet week for economic data. February durable goods orders are expected to increase modestly but less than the previous month while February new and existing home sales should be consistent with the numbers that were reported in January and confirm a steadily improving housing sector.

Among the most notable companies scheduled to report quarterly earnings this week are Cintas, Lennar, Nike, General Mills, FedEx, Accenture, Micron Technology and ConAgra.

Portfolio Strategy

Prior to the Federal Reserve meeting last week, it might have been easy for fixed income investors to bail on their bond holdings. The odds of an interest rate increase were well over 90% and interest rates, which move inversely to bond prices, had risen to levels not seen in a few years. After a particularly strong jobs report in February and a decline in the unemployment rate to 4.7%, it was expected that any comments by Fed Chair Janet Yellen would definitely be more hawkish. Instead, she did a masterful job of lowering investors’ expectations for continued interest rate hikes, emphasizing a gradual approach based only on the economic data as it presents itself. She predicted only two more hikes this year as some economic measures have been soft recently. The Atlanta Federal Reserve now expects that first quarter gross domestic product (GDP) will be only 1.2% and tepid wage growth could help keep a lid on inflation. Oil prices, which are a key component of headline inflation, also have fallen sharply on concerns over excess supply. While President Trump’s pro-growth policies sound good on paper, there could be plenty of disappointment both in the scope of these policies and the timeline of their eventual implementation. For these reasons, investors should maintain their fixed income positions in order to stabilize their portfolio, reduce the overall risk and provide a dependable source of income. Corporate bonds, which can benefit from an improving economy, would be preferred over government securities and short-to-intermediate bond maturities would be preferred over longer-term issues.

The next edition of the Weekly Market Commentary will not be until April 3rd as I will be on vacation for ten days beginning March 24th.