As 2016 began and 2015 ended, global financial markets faced plenty of uncertainty in the wake of the first rate hike by the Federal Reserve (Fed) in nearly nine years. Although the rate hike was well anticipated and priced in by many market participants, the Fed’s move forced markets to focus on imbalances in the global economy and financial markets that had been simmering for years. The fears about how (and when, if ever) those imbalances would be resolved led to an extreme bout of financial market volatility over the first few months of 2016. Those imbalances included:

·         The strong U.S. dollar

·         A global oil glut and the financial stresses on countries and companies affected by the drop in oil prices

·         The slowdown in the Chinese economy, and fears of a “hard landing” as it transitions from an export-led manufacturing economy to a consumer-led domestically focused economy

·         Central banks outside the Fed pursuing easier monetary policy via negative interest rates and additional quantitative easing

·         Rising fears of widespread global deflation and recession

UNTANGLING IMBALANCES: FED PLAN

At the center of these issues was the Fed’s plan—set out in the December 2015 Summary of Economic Projections—to raise rates four times (by a total of 100 basis points) in 2016.

The Fed’s plan to follow up its 25 basis point (0.25%) rate hike in December 2015 with four additional hikes this year didn’t cause the global imbalances noted above, as those built up over the more than eight years of zero interest rates, quantitative easing, slow global economic growth, etc. However, the prospect of the global economy and financial markets successfully working through those imbalances while the Fed was raising rates at that promised pace seemed too much for many asset classes to bear in the first six weeks of 2016. The seemingly intractable imbalances only added to the financial stresses; by mid-February 2016, the S&P 500 was down 10.5% year to date and 14.2% from its May 2015 peak, spreads on high-yield debt to Treasuries widened out considerably, and the price of oil hovered in the mid-$20s per barrel (down more than 30% from the start of 2016 and 75% from mid-2014 peaks). By that time, financial markets were pricing in near 100% odds of a recession occurring this year. Here at LPL Research, we placed the odds of a recession at 25–30% (up from 10–15% at the start of the year), with most of the increase due to the increased likelihood of a policy mistake here or abroad. The economic data itself, based on the Leading Economic Indicators (LEI), still only suggest only a 10–15% chance of a recession in the next few years [Figure 1].

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