Morgan Stanley
  • Wealth Management
  • Dec 3, 2018

Optimism Over Fed Policy May Not Last

Despite a softer tone, the Federal Reserve may hike rates several more times in the next year.

Lisa Shalett Wealth Management Head of Investment & Portfolio Strategies

Markets rallied last Wednesday when Federal  Reserve Chair Jerome Powell made comments that some investors interpreted as signaling that the Fed won’t raise interest rates as many times next year as expected.

The S&P 500 surged more than 2%, returning to positive territory for the year to date. It had slipped into the red in October, and again in November, during sharp, but relatively brief selloffs.

While Powell’s more moderate stance may be a plus for markets, I think investors need to keep it in perspective. Below are three reasons the shift in commentary isn’t a game changer:

  • Morgan Stanley Research’s analysts never thought the Fed would hike three times next year. That’s what previous Fed guidance had indicated, but our official Research department call is for one hike in December and two more in 2019. The firm’s view hasn’t changed. Powell’s comments may have signaled that a pause could be coming, but they were actually more nuanced than the market’s bullish interpretation.
  • The Fed is no longer the only driver of markets. Other factors may be more influential lately. Tilting negative are interrelated factors, such as slowing global growth, trade tensions and geopolitics. Meanwhile, tax cuts and fiscal stimulus have counteracted those influences.
  • It’s not the official fed rate that investors seem most worried about. While the Fed controls the very short-term fed funds rate, investors are focused on the 10-year Treasury rate. That benchmark bond rate has risen, not just because of higher inflation, but also because U.S. economic growth has normalized—i.e., its strength and stability don’t depend on Fed stimulus. The 10-year Treasury rate, however, does reflect higher corporate borrowing costs and tighter financial conditions. And stock analysts also use it to calculate the current value of a stock by discounting future profits against the rate of return for this low-risk bond. As a result, when that rate rises, stocks often fall.

Even though stocks typically benefit from a dovish Fed, investors should remain cautious. Rather than focusing solely on Fed policy, investors need to watch issues like trade, fiscal policy, deficits and oil prices to understand where the market may head next.

Risk Considerations

Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision. 

Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.

Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate.

Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.

Rebalancing does not protect against a loss in declining financial markets.  There may be a potential tax implication with a rebalancing strategy.  Investors should consult with their tax advisor before implementing such a strategy.

Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies.  Technology stocks may be especially volatile.

International investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economies.

Investing in foreign emerging markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks.

Investing in commodities entails significant risks. Commodity prices may be affected by a variety of factors at any time, including but not limited to, (i) changes in supply and demand relationships, (ii) governmental programs and policies, (iii) national and international political and economic events, war and terrorist events, (iv) changes in interest and exchange rates, (v) trading activities in commodities and related contracts, (vi) pestilence, technological change and weather, and (vii) the price volatility of a commodity. In addition, the commodities markets are subject to temporary distortions or other disruptions due to various factors, including lack of liquidity, participation of speculators and government intervention.

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