December 17, 2015 | By Scott Minerd, Global CIO
The Federal Reserve made history Dec. 16, finally raising the fed funds target range by 25 basis points to 0.25-0.50 percent after seven years at the zero bound. We anticipate a gradual pace of tightening, though not quite as gradual as the market is currently pricing in. We expect three 25 basis point hikes in 2016 and another three in 2017, with the next hike likely to occur at the March 2016 Federal Open Market Committee meeting. Our analysis suggests the terminal rate in this cycle will be in the range of 2.5–3.0 percent, below the Fed’s estimate of 3.5 percent, which should help to keep 10-year Treasury yields under 3 percent.
If history is a guide, equities typically experience an initial pullback of 5–10 percent in the months following the first rate hike in a tightening cycle. Historically, though, the S&P has ultimately performed well during recent tightening cycles, returning a cumulative 15 percent, on average, in the first two years of the last three tightening cycles. That being said, current valuations temper our return expectations—the ratio of U.S. equity market cap to GDP is near its historical peak, buoyed by historically low rates.
Source: Bloomberg, Haver Analytics. Data as of 11.19.2015, based on the last three tightening cycles beginning in February 1994, June 1999, and June 2004. ©2015, Guggenheim Partners.
Fixed-income investors should also benefit—leveraged loans stand out as having delivered strong returns with much less volatility than the S&P 500 and Treasuries, on average, during previous periods when short-term rates were rising. Leveraged loans returned 5.8 percent on average in the first year of the last three Fed hiking cycles, higher than the S&P’s 4.9 percent. We believe the recent selloff in high-yield credit presents an attractive buying opportunity that will ultimately prove rewarding for patient investors.
Source: Haver Analytics, Federal Reserve, Guggenheim Partners. Data as of 9.30.15. ©2015, Guggenheim Partners.
The ratio of stock market capitalization to GDP can give an indication of whether a market is undervalued or overvalued.
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