Stocks drop over 2% on Fed rate hike fears

The broker said the stock was “poised to move.” Silly me, I thought he meant up. – Randy Thurman, CFP, CPA and noted author and one of the nation’s most trusted investment advisors

In a week marked by few quarterly earnings reports and even fewer pieces of economic data, stocks plummeted more than 2% on Friday following hawkish comments by a Federal Reserve voting member. The stock market also may have been unnerved by a report that North Korea had successfully carried out a nuclear test. Stocks had been up slightly through Thursday but Boston Fed President Eric Rosengren in a speech on the last trading day of the week said that low interest rates could cause the U.S. economy to overheat. He called for a rate hike in September and a gradual approach to raising rates in the future. Known in the past for his dovish views on interest rates, this change in thinking caught the market by surprise and came at a time when other Fed officials have also been clamoring for a rate hike. Recent economic data, though, has been mixed at best as evidenced by the recent weaker-than-expected employment report for August and the disappointing ISM services sector report this week. Even with the recent talk of a rate hike, the fed funds futures market still places the odds of such a move at about 30%. But comments earlier in the week by both the European Central Bank (ECB) and the Bank of Japan (BOJ) seemed to imply that both central banks may be taking their foot off the gas pedal. The ECB did not extend the deadline for its bond-buying program and held key interest rates unchanged, although it’s difficult to push rates much lower than they already are. Part of the reason for the sell-off in stocks last week might have been due to investors losing confidence in the effectiveness of monetary policy to improve economic growth. But if the economy is on solid footing as some Federal Reserve officials assert, then the markets should not fear an interest rate hike but embrace one.

Last Week

In a light week for economic data, the ISM non-manufacturing index or services sector index in August was weaker than expected and expanded at the slowest pace in six years. Measures for business activity and orders were also weak and fell by the biggest percentage since the recession in 2008. Both economic reports should give the Federal Reserve pause when deciding to raise interest rates at their meeting later this month. Weekly jobless claims dropped and the total number of claims is consistent with a healthy job market. Oil prices also closed higher last week as the Energy Information Administration (EIA) reported that weekly crude inventories showed a large drawdown.

For the week, the Dow Jones Industrial Average fell 2.4% to close at 18,085 while the S&P 500 Index also dropped 2.4% to close at 2,127. The Nasdaq Composite Index declined 2.4% to close at 5,125.

This Week

Both the August producer price index (PPI) and consumer price index (CPI) are expected to edge only slightly higher and show that inflation remains benign. Retail sales for August are forecast to fall by 0.1% after being flat in July and industrial production is also expected to decline slightly. The preliminary Michigan consumer sentiment index in September should be slightly higher than the previous month as the labor market remains strong and wages have risen modestly.

Two Federal Reserve officials will voice their opinion on the U.S. economy and monetary policy on Monday and the Bank of England meets to review its policy on interest rates, which are expected to remain unchanged.

Of the six companies that are scheduled to release quarterly earnings this week, Oracle is the only prominent one among them.

Portfolio Strategy

One of the best-performing asset classes this year has been small-cap stocks, especially small-cap value stocks, which are up over 11% on average for the year. Typically, small-cap stocks have higher growth prospects that large-cap stocks and do not pay a dividend as earnings are reinvested back in the company to fuel future growth. With investors expecting the Federal Reserve to raise interest rates, those dividends may not be as attractive on a relative basis. Any interest rate hike would also increase the value of the U.S. dollar, which hurts large U.S. companies that export their goods overseas as their products are more expensive and less competitive. Most small-cap companies, on the other hand, are primarily focused on the U.S. domestic market and are not affected by the strong dollar nearly as much. Currently, growth projections for small-cap companies look more promising than those for large-cap companies. Just as large-cap value funds have significantly outperformed large-cap growth funds this year, small-cap value funds have trounced the performance of small-cap growth funds. The best way for investors to participate in this asset class is through a low-cast, broad-based exchange-traded fund that is well-diversified and includes all of the major industry sectors.