It was a busy week in Washington with a highly anticipated midterm election followed by the Federal Reserve meeting. The results of both came in as expected although it seems the markets were not synced to that result. Wednesday’s 2 percent plus rally signaled that there was still uncertainty surrounding the election fallout. On Thursday, the Fed delivered an in-line statement: not raising rates now but signaling that a hike is coming in December due to continued strong economic growth and a tight job market.
The Real Me
Last week I had the good fortune to see former Federal Reserve Chair Janet Yellen speak in Washington D.C. She spoke candidly regarding the criticism of the Fed and the uncertainty of U.S. trade policy, yet she also stood firm in her belief in the Federal funds rate, which should be approximately 3.0 percent. Why 3.0 percent? Interest rates, primarily short-term rates, are composed of two factors: inflation expectations and the “real rate.” When investors loan money, they expect to get a return of inflation plus a return above that, i.e. the real interest rate. Former Chair Yellen discussed how previously she believed that the “real rate” should be approximately 2.0 percent. Due to structural changes in the global economy, primarily slower growth and lower global interest rates, she now believes the real rate of interest should be closer to 1.0 percent. With inflation expectations around 2.0 percent, this would result in a targeted Fed funds rate of 3.0 percent. The chart below shows that even at 3.0 percent, it would still be at the lower end of its historic range, implying three more increases ahead. Yellen did not confirm if the opinions of her former colleagues at the Fed believe the same.
Keep Calm and Shop On
November consumer sentiment was released today. On the surface, one would expect sentiment to decrease due to the decline in stock prices, intensified midterm election rhetoric and rising interest rates. However, due to the strength in the U.S. economy (primarily in the job market), consumers remain upbeat.
What we will be watching is if positive sentiment results in strong consumer spending. As we move into the holiday season, will consumers increase their spending over last year? We remain optimistic that they will, due to rising wages and low unemployment.
Week in Review and Our Takeaways
While the week ended in a thud, the week as a whole posted a nice return. The S&P 500 rallied roughly 2.0 percent as election uncertainty subsided. Now that the mid-terms are in the rear view mirror, investors can shift their focus to economic fundamentals. There will continue to be noise around trade and the Fed, however, we believe economic fundamentals will trump these concerns in the near term, which should support corporate earnings, thus equity prices.