Lift-Off: Fed Heads for Low Orbit

Goldman Sachs Asset Management -

On December 16, the US Federal Reserve (“Fed”) announced a well-telegraphed 25bps rate hike to 0.25%-0.5%—the first increase in a decade. The policy remains extraordinarily accommodative

This is the first small step toward interest rate normalization since the financial crisis. The statement cited sufficient improvement in the US economy and inflation outlook, but also emphasized continued challenges that are likely to check the pace of this tightening cycle. The following are our initial takeaways from Wednesday’s decision:

  1. We think the Fed’s action amounts to a cautious hike, with a close eye on inflation and financial market developments. The statement stressed that the Fed expects the pace of tightening to be gradual and subsequent moves will depend on incoming data and financial and international conditions. Fed Chair Janet Yellen preserved flexibility around the course of policy, stressing there is no preset course for tightening. Based on current forecasts, we believe the trajectory of interest rates will be shallow. Given the positive trends in the US labor market, we expect the Fed’s main focus in the coming months will be on inflation, financial conditions—particularly dollar strength—and economic growth. Although today’s move was widely anticipated in financial markets, the Fed will want to observe the impact of higher rates on financial markets, households and businesses in the real economy.
  2. We believe the Fed could raise interest rates again in March if inflation rises and financial conditions stabilize. Our current expectation is for an additional three increases in 2016, but the path remains uncertain. The dollar’s strength was among the key factors—along with broader financial conditions and weak external demand—in the Fed’s decision to postpone tightening in both June and September this year.
  3. The US economy has the momentum to support a moderate course of tightening, in our view. However, financial conditions and the inflation trajectory remain sources of significant uncertainty in the path of further rate increases. In the short term, we do not believe this modest policy adjustment is likely to derail a US recovery that has momentum. As a result, we remain pro-cyclical in our investment outlook, with equities remaining our favored asset class at this stage of the cycle (more on this point below in takeaway #4). We see US growth moderating only slightly from 2.4% this year to 2.2% in 2016. We also believe the Fed remains focused on limiting potential market volatility at the outset of this hiking cycle, as the move was well-telegraphed and broadly in line with market consensus.
  4. We are moderately positive on equities and corporate credit. In our view, the decision to raise rates reflects the Fed’s conviction in the economy’s positive trajectory, and so should be broadly favorable for risk assets and investor sentiment, particularly in light of the accompanying dovish guidance. That said, our fundamental, bottom-up stock and corporate bond selection continues to drive our process, rather than headlines or sentiment. We maintain high conviction in the companies in which we invest and believe they have the potential to outperform relative to the broader market.
  5. The Fed’s decision to hike and the prospect of higher US yields should support the dollar around current levels. We think that the dollar’s upside in the near term is probably limited, given 1) the Fed’s action was well-telegraphed and moderate, 2) the dollar has already rallied a long way over the past 18 months, and 3) the lack of aggressive easing by central banks in Europe and Japan to drive increased flows to the US.
  6. In emerging markets, we think commodity prices, Chinese growth and local fundamentals are more important than Fed policy. Markets have had a long time to adjust to the prospect of higher US rates and we believe emerging market assets have largely priced in a modest course of Fed tightening. As a result, we continue to believe emerging market assets will be driven primarily by local fundamentals.