S&P 500 closes flat as Fed leaves interest rates unchanged

You can become, to an enormous degree, the person you want to be. – Warren Buffett

Although there was a plethora of newsworthy items and economic data last week, the major stock averages barely budged and ended the week at almost the same levels where they began. The S&P 500 Index rose only two points and traded in a very tight range for the entire week. The most important news event was the two-day Federal Open Market Committee (FOMC) meeting and the results were mostly as expected. In a unanimous decision among its members, the Fed left interest rates unchanged and was fairly confident that it would raise the federal funds rate only one more time, most likely in December. It also announced that it would begin to gradually reduce its $4.5 trillion Treasury and mortgage-backed security portfolio in October, which is only a week away. Further out, the Fed forecast three rate hikes in 2018 and two in 2019 and lowered its long-range target to 2.8% from 3.0%. It also lowered its inflation outlook and forecast GDP growth of 2% on a longer term basis. The odds of a rate hike in December immediately rose to over 60% after the meeting concluded, but the Fed seemed to ignore weak inflation that remains below its 2% target. The war of words with North Korea also escalated last week as President Trump threatened to “totally destroy” the rogue nation if the U.S. is threatened and proceeded to slap more sanctions on them. The North Korean Minister of Foreign Affairs responded by saying that they might test a hydrogen bomb in the Pacific Ocean. Secretary of State Rex Tillerson struck a more conciliatory tone in saying that the U.S. seeks a “peaceful solution” to the North Korean crisis. Based on the market’s reaction to last week’s rhetoric, investors don’t seem too concerned, at least for now. One beneficiary of these increased tensions between the two countries has been aerospace and defense stocks, which have risen over 20% this year and have been one of the best performing sectors of the market. Mergers and acquisitions have also helped their performance as defense giant Northrop Grumman announced last week that it is buying rocket maker Orbital ATK, just two weeks after United Technologies agreed to buy Rockwell Collins.

Last Week

U.S. import prices recorded their biggest gain in seven months due mostly to higher oil prices, but import prices have risen only 2.1% over the past 12 months. Housing data was mixed in August as housing starts slipped and existing home sales hit their lowest level in 12 months as there simply are not enough homes for sale. Housing permits to build new homes, though, surged to their second highest level since 2007. August leading economic indicators rose more than expected and weekly jobless claims fell 23,000 to 259,000, far less than feared due to the effects of people being temporarily put out of work by hurricanes in Florida and Texas.

For the week, the Dow Jones Industrial Average rose 0.4% to close at 22,349 while the S&P 500 Index edged up 0.1% to close at 2,502. The Nasdaq Composite Index slipped 0.3% to close at 6,426.

This Week

August new home sales should be strong and exceed the number reported in July while durable goods orders in August are expected to increase slightly after plunging last month. The final reading for second quarter GDP is forecast to be 3%, the same as the previous reading. The September Chicago Purchasing Manager’s Index (PMI) is expected to show strong expansion and the September University of Michigan sentiment index should show that consumers remain very confident about economic and job prospects.

Federal Reserve Chair Janet Yellen will speak before the National Association for Business Economics on Tuesday.

The most prominent companies on the earnings calendar this week include Carnival, Nike, Darden Restaurants, Micron Technology, Accenture and Con Agra Brands.

 Portfolio Strategy

The Federal Reserve’s plan to begin to reduce the Treasury and mortgage-backed securities on its balance sheet should not have much impact on interest rates. The Fed will start by letting $10 billion in securities mature each month for the rest of this year and then increase that amount to $50 billion a month next year. The yield on the 10-year Treasury is currently 2.25% and it could rise to 2.50% by year end if the economy strengthens and inflation increases. Unwinding the balance sheet to the tune of $10 billion a month is just a drop in the bucket and should have only a minimal effect on interest rates. Global forces are also at work that should help keep Treasury yields low. Both the European Central Bank (ECB) and the Bank of Japan (BOJ) have easy monetary policies in place and yields that are far lower than those in the U.S. As a means of comparison, the equivalent yield of the 10-year Treasury in Germany is 0.45%, in the United Kingdom 1.36%, in France 0.73% and in Japan 0.02%. The attractiveness of U.S. yields, despite being at historical low levels, should create demand for these securities, increasing the price of these bonds while depressing the yield. (Bond prices move inversely to yields.) The scarcity of bonds in the world with attractive yields should help mitigate any material increase in U.S. interest rates as global investors will be drawn to our markets. The yield on the 10-year Treasury could rise to 3% next year, though, as the Fed increases the amount of its monthly tapering and the ECB also starts to reduce its own asset purchase plan and quantitative easing program.