Stocks don’t seem to be spooked by wars or pestilence. But the mere suggestion that the Federal Reserve could raise rates sooner than expected strikes fear in the hearts of investors.
Last week, we saw a departure from the resilience we’ve seen in the stock market in recent months. Stocks sold off significantly, with the S&P 500 and Dow giving up more than 2.5%. This sharp selloff is cause for some head scratching. After all, in recent weeks, stocks have shrugged off the downing of a commercial jet, an escalating conflict in the Middle East, the collapse of Portugal’s largest bank and the deadliest strain of the Ebola virus seen to date.
It seems that fears over the Fed have driven this selloff. It all started last Wednesday with the second-quarter GDP report, which showed a stronger-than-expected 4% growth rate. The headline GDP number began to stoke fears that the Fed might raise the federal funds rate sooner. Later that day, the FOMC statement was released. Despite references to slack in the labor market, many market observers seemed to conclude that this was a hawkish turn for the Fed given its acknowledgement of higher inflation. By then, stock investors had begun fretting.
But worries soon ballooned to a full-on panic following Thursday’s release of the employment cost index, which, at a 0.7% rise, beat expectations and the previous quarter’s reading. Why the freak out? Well, with the unemployment rate tumbling over the past year, investors had been soothed by all the metrics the FOMC cited that indicated slack in the job market. Chief among them was wage growth, which had remained subdued despite the overall drop in joblessness, that is, until the release of the ECI.
While the ECI was just one data point, driven primarily by an increase in benefits, it triggered a flight response from investors. That’s because many of them think of the FOMC as the “guardians of the galaxy.” Any hint that this policy could be altered was enough to scare investors, who are already suffering from a bout of skepticism.
Fortunately, Friday’s employment report granted a small reprieve. The unemployment rate inched up while non-farm payrolls continued their six-month streak of 200,000-plus new jobs. Still, it was no blowout report. The percentage of long-term unemployed—another metric the Fed watches closely—did not improve further after a big decrease in June. Most importantly, we saw a continuation of modest wage growth. This was important because it refuted the ECI number and helped calm concerns.
A Fit Over the Fed
Fact is, stocks were down big. If the Fed’s comments last May triggered a taper tantrum, then perhaps this was a “tightening tizzy.” Like the market’s response to talk of unwinding QE, the fear of higher interest rates may continue to impact stocks. Many market observers are asking whether this is the beginning of the long-awaited correction.
From where we sit, it’s less likely that last week’s selloff will result in a full-blown correction. But if it does, then investors need to take a step back. While a fear of rising rates is impacting stocks right now, our expectation is that actual rate hikes will have a more negative impact on bonds than stocks. We also expect that, at some point, stock investors will get a lot more comfortable with the idea of rate hikes starting sooner. Why? Because it means that the economy is strengthening. And that’s typically a tailwind for stocks.
“While a fear of rising rates is impacting stocks right now, our expectation is that actual rate hikes will have a more negative impact on bonds than stocks.”
To be sure, stocks are vulnerable right now given that valuations are stretched (albeit lower than they were a week ago) and investors have their doubts. But the economy is clearly on the mend and second-quarter earnings have been better than expected. What’s more, while we wouldn’t be surprised if rate hikes begin a bit sooner than expected, we think the Fed’s tightening cycle will progress at a thoughtful pace. That pace will be dictated by macro conditions and ultimately settle at a lower rate than the accustomed target set by the Fed in recent years.
In this environment, investors need to be wary of areas of vulnerability. But, at the same time, they can’t shy away from asset classes necessary to meet longer-term goals.
Kristina Hooper, CFP, CAIA, CIMA, ChFC, is US head of investment and client strategies for Allianz Global Investors. She has a B.A. from Wellesley College, a J.D. from Pace Law and an M.B.A. in finance from NYU, where she was a teaching fellow in macroeconomics.
The Standard & Poor’s 500 Composite Index (S&P 500) is an unmanaged index that is generally representative of the U.S. stock market.
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