December 14, 2015
Markets may have priced in their expectations for a 25-bp rate liftoff this coming Wednesday afternoon. However, they may be subject to additional pre-positioning before policymakers raise the nation’s borrowing costs for the first time since June 2006. In doing so, they will provide their outlook for 2016 and present some sense of the odds for the subsequent path of rate normalization.
Last week’s tumultuous trading left the S&P 500 with its worst weekly action since last August. We saw an 11% collapse in energy prices fuel investors’ fears among high-yield energy debt trades. This extended into the fund bond arena, set off by the surprise closure of Third Avenue’s relatively small, $788 million “Focused Credit Fund” as redemption requests met with illiquid markets. Put another way – people couldn’t get their own money out of the fund. That is scary for most investors.
Prices for safety-linked US debt moved sharply higher. On Friday, yields on benchmark 10-year treasuries fell to 2.139% from 2.305% the previous week. The US dollar also took a step back from recent gains. The strengthening dollar and slowing fundamental growth sent oil prices lower again this morning after Iran promised to raise crude exports. Benchmark Brent prices fell 2.9% to $36.85 and US WTI crude fell 2.2%, beneath the $35 level at $34.85, giving further reason for last week’s capex (read capital expenditures – or investment) cuts by energy majors Chevron (CVX) and ConocoPhillips (COP). This raised uncertainty surrounding energy firms’ debt obligations at the far end of the credit risk spectrum (can/will they pay the bills). Gold traded 0.4% lower at $1,070.10 and copper 0.7% lower at $210.10, unable to extend Friday’s sharp 2.1% increase as commodity prices failed to find secure bottoms from which to move higher.
Friday’s economic data on retail sales and consumer sentiment failed to offset the oncoming train of expected rate hikes from the Fed. Core retail sales came in above estimates during November, lifting expectations for real consumption in the final quarter. Consumer sentiment rebounded to a four-month high. Between the now and the then of the FOMC decision, little is likely to alter FOMC’s data-driven policy move. According to CME Group data, chances of a Wednesday rate increase sit at 79% despite market turmoil. The decision may fail to surprise; however, policymakers’ ability to manage expectations may be tested as members’ forecasts for unemployment, interest rates, and other data provide clues for subsequent rates hikes. In short, most anticipate the still “data dependent” Fed will try to achieve a dovish rate launch, with announcement of one-and-then-see what the economy may bring.
As resilient as the advance out of the August lows has been, there have been many red flags. We have seen lots of negative structural developments that keep us cautious as we struggle to participate in a seasonal year-end bullish bias while respecting the risk associated with the narrow, poor participation rally in stocks. Due to these concerns, we maintain a cautious stance on markets. Risk factors include the upcoming Fed rate decision, high relative P/E to earnings growth, lackluster performance in “risky” assets (small-caps, commodities and emerging markets), and continued poor breadth in the stock market. In addition, credit markets, specifically the “high yield” markets are cause for concern. It is unknown whether these are isolated credit events affecting a few hedge funds and mutual funds, or whether this is a greater, systemic problem waiting to work its way through financial markets.
Our models are weighted to respect price levels. Generally when we see an environment like this we get whipsawed as volatility increases and the markets prepare to enter a potential change in trend. We have to remain disciplined and adhere to our strategy more than ever in a market dominated by high frequency traders that can take the averages down double digits rather swiftly. Therefore, we will continue our disciplined approach to risk management and keep exposure at a minimum until the models indicate conditions have improved.
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