With the election headwinds helping the stock market in the final weeks of 2016, we would not have been surprised to see the markets pause while President Trump began his first “100 days” in office. However, investors were handsomely rewarded for staying invested as the S&P 500 was up over 6% in the first quarter and the Dow Jones Industrial eclipsed the 20,000 and 21,000 marks1. The gains of the first quarter were more broadly seen across most of the equity sectors, in contrast to the last quarter of 2016 where financial related stocks reaped most of the reward.
Also different this quarter were bond yield movements. Although the Fed did increase interest rates in March2, most bond yields stayed even or dropped slightly allowing bonds to have modest gains. The Barclays Aggregate Bond index was up 0.82% for the quarter1. This helped most investors see nice gains on their statements. The Fed has indicated that future rate hikes are imminent, so how will this impact the economy and ultimately, your portfolio?
The Fed has a goal of keeping inflation steady and unemployment in check. They also try to avoid recessions and keep economic growth positive, but not wildly out of control. When they change the fed funds rate, they are doing so with these goals in mind. Sometimes a recession is unavoidable and one of the indicators that helps predict recessions is an inverted yield curve. An inverted yield curve happens when we see short term rates (like the Fed Funds rate) go higher than longer term treasuries. As the chart shows, an inverted yield curve is often followed by a recession.
This makes sense, because we often see the Fed raise rates when the economy is growing at a healthy clip. The more overheated economic growth becomes, the faster the Fed reacts by increasing rates to subdue the growth. Before too long, we could easily end up with short term rates surpassing long term rates and shortly thereafter, economic growth is slowed too much and we dip into a recession. So how close are we to an inverted yield curve? Not really close, as it turns out. The Fed has several more rate increases before we are at risk of having an inverted situation if rising rates are to be the cause.
We still have concerns over increased volatility that is eventually going to work its way back into the markets. However, we still think any corrections will be short lived and stocks will be the superior investment for the next few years.
1 Thomson Financial