Analysis Overview – The Fed is likely to cut interest rates in 2016 and this article discusses the factors for this view and the investment strategy in the current scenario.
The Big Slump – When the fed increased rates in December 2015, there were economists talking about at least four rate increases in 2016. However, global economic activity has weakened so significantly that a rate cut is likely instead of rate hike.
No Doubt On Economic Activity Weakness – The GDPNow indicator reading as of March 28, 2016 estimates 1Q16 GDP growth of just 0.6% for the United States. The composite global PMI for February 2016 stands at 50.6 with the PMI slumping in the last two months. China’s non-manufacturing PMI has declined from 54.4 to 52.7 in the last two months with manufacturing PMI at 49.0. All these data clearly indicate that the global economy has witnessed sharp deceleration in growth.
What Is Yellen Saying – The following statements by Yellen on the global economy and the US economy puts things into perspective. I judge the tone as cautiously optimistic, but I am of the view that US economic activity is weaker than reflected in Yellen’s comments.
Readings on the U.S. economy since the turn of the year have been somewhat mixed... In particular, foreign economic growth now seems likely to be weaker this year than previously expected, and earnings expectations have declined. By themselves, these developments would tend to restrain U.S. economic activity...All told; the Committee continues to expect moderate economic growth over the medium term accompanied by further labour market improvement...
The Most Important Comment – "If economic conditions were to strengthen considerably more than currently expected, the FOMC could readily raise its target range for the federal funds rate to stabilize the economy. By contrast, if the expansion was to falter or if inflation was to remain stubbornly low, the FOMC would be able to provide only a modest degree of additional stimulus by cutting the federal funds rate back to near zero."
My View – Yellen is setting stage for potential rate cut in the second half of 2016 or even earlier (depending on how rapidly global growth continues to decelerate. I also believe that a strong US dollar is hurting the “Net Exports” component of GDP and Yellen would ideally want the dollar to weaken. A dovish outlook will help in weakening the dollar and dollar weakness can accelerate on potential rate cut.
Investment Strategy – It is important to remain invested in relatively risk free assets and I am bullish on Gold (GLD), US Treasuries (VGSH) and investment grade corporate bonds (VCIT). I believe that the S&P 500 (SPY) is likely to correct in the next 3-6 months and fresh exposure to the index can be avoided. While individual stocks still offer value using bottom-up investing strategy, a big exposure to any stock is not advisable at this point of time. While global economic weakness or potential recession can be negative for risky asset classes, central banks pursuing renewed expansionary monetary policies can trigger rally after correction.