Market outlook: Eyes on the Fed

Although unlikely in June, focus remains on the Fed's next rate hike and how global markets will respond.

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In recent remarks, Chair Yellen appears to have taken a June rate hike off the table, but the Fed has signaled that further tightening may happen in the not-too-distant future. Speculation has centered on when it will happen and what it may mean for the economy and investors. Dirk Hofschire, senior vice president of asset allocation research, shares his perspective in his monthly market update with Lars Schuster, institutional portfolio manager for Strategic Advisers, Inc., a Fidelity Investments company.

Q: What's been going on in the markets over the past month?

HOFSCHIRE:We’ve been in a trading range over the past several weeks. At the beginning of the year, the markets really fell out of bed. We haven't had enough bad economic data to justify that, so the markets turned upward in February and March. But we haven't had good enough economic data recently to keep the rally going.

It’s been back and forth within a pretty limited range. I think here in the United States, what we still have is a business cycle that is maturing but it's a sustainable expansion. The big focus, I think, going forward is turned back to the Federal Reserve, and, in particular, when the Fed is going to hike next and whether the global markets can withstand that.

Q: We’re in a more mature part of the business cycle, which essentially means that the U.S. is growing, but does that really even matter anymore? As you said, it seems that all eyes are focused on the Federal Reserve and interest rates?

HOFSCHIRE: You're right. I think the cycle does feel different this time. We've had these extraordinary monetary policies for so long—quantitative easing and zero interest rates. Some countries outside the U.S. now have negative interest rates, and it did take seven years for the Federal Reserve to get to that first rate hike last December. So, it does feel different.

I think when you look below the surface, though, there are some similar patterns to previous cycles that are still important for the analysis. Part of it is that it took the economy a long time to crawl out of the deep hole after 2008.

But as the economy has continued to improve, labor markets have gotten better, and the Fed has shifted, as is normal, to a tightening stance. It may have started as early as 2013, if you think about them first talking about ending their quantitative easing.

As wages continue to accelerate here, I think this is going to push the U.S. economy closer to the late cycle. And that starts to look very much like patterns we’ve seen in the past. Things have moved slowly in this cycle but they're starting to look very similar to what the Fed has looked for during previous periods of monetary tightening.

The one thing I think is really different this time, though, is how weak and deflationary the rest of the world is. So, if you look outside the United States, China has had a very slow rate of growth, relative to its own recent history, and much of the world is growing very slowly. Also, commodity prices have gone down, so we haven't seen much inflation. All of this has made the Fed, I think, much more cautious than usual at this point in the cycle.

Q: What does that really mean from an outlook or investment-implication standpoint?

HOFSCHIRE: I think the Federal Reserve would like to be able to keep raising rates and get back to a more normalized policy stance with higher interest rates. When it looks around the world in places like Europe and Japan that have gone negative with their rates and used even more extraordinary policies, I think the early returns for markets, for investors, and even for economies are that there may be declining returns to those policies and some limits to what monetary policies, in and of themselves, can do.

The real question here is: Can the global economy withstand the Fed tightening cycle? I think we're going to get a glimpse of whether it can in the next few months. We could see another period of volatility like we've seen over the past year, but our base case is that the global economy is strong enough to muddle through it and that global stabilization should ultimately be relatively supportive for the equity markets and for asset prices in general.

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