Key Points
• Fed balance sheet normalization and ongoing rate hikes have some investors nervous, but we doubt Fed policy will disrupt economic growth or the equity bull market.
• Several risks loom on the horizon that investors should consider, but we believe equity prices are more likely than not to rise over the coming year.
Investors focused their attention last week on the Jackson Hole Economic Policy Symposium, signs that tax reform were looking more likely and increasing signals that the government could face a shutdown over the debt ceiling and spending debates. For the week, stock prices advanced after two weeks of declines, with the S&P 500 Index rising 0.8%.1 Materials, health care and
income-oriented sectors led the way while consumer staples lost ground.1
Weekly Top Themes
Somewhat surprisingly, Federal Reserve Chair Janet Yellen did not talk about monetary policy at last week’s Jackson Hole meeting. This probably indicates that she and other Fed officials are comfortable with the market’s expectations for policy—that is that the Fed will make a balance sheet normalization announcement in September and will likely hike interest rates in December.
Some investors feel that normalizing the Fed’s balance sheet while continuing to increase rates would, in effect, result in a “double tightening” that could be too restrictive for the U.S. economy. We doubt this will be the case. The Fed will likely remain slow and deliberative. Rates are rising from what are still extremely low levels, and it would take several more increases before rates approach a neutral level.
It would also take a significant reduction in the size of the Fed’s balance sheet for market liquidity to become an issue. In other words, we think the central bank will follow a path similar to the last 18+ months: slowly tightening policy as growth improves so as not to damage the ongoing expansion.
Weekly Top Themes
The flash August Purchasing Managers Indexes showed mixed results, but were solid overall. The Services PMI, which reflects business activity, was above expectations and reached its strongest reading since April 2015.2 In contrast, Manufacturing PMI dropped, although only modestly.2
Earnings growth is likely to cool over the coming year. Corporate earnings results from the first half of 2017 were quite strong, but it is important to remember that year-over-year comparisons are based on a weak 2016. We expect earnings growth to slow to the mid-single-digit range by next year, which could drag on investment sentiment.