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Market Perspective for 5/19/16

Yesterday the Federal Reserve suggested that it was considering raising interest rates.   It cited employment strength (the unemployment rate is below 5%) and the recent surprisingly strong consumer price index report, which showed CPI running north of 2%.  One Fed governor already dissented in March in favor of hiking rates, and more are said to be in favor now.  This has the market in a state of concern right now.  Everyone recalls the environment after the previous hike (December 16th, 2015) to the announcement that the Fed was on hold (February 11th, 2016).  It was not very good for risk assets.  Some are going to say that the Fed was floating a trial balloon for June, seeing what kind of a pushback they’d get from the stock market, bond market, and perhaps most importantly, the People’s Bank of China.  Why the PBOC?  Because the Chinese currency is more or less tied to the dollar, and if we tighten, they are forced to tighten.  If anything, they would prefer us to ease right now, given the difficulty they are certainly having reaching their GDP forecasts.  They could break the peg and devalue the yuan, but that could trigger a trade war and make everybody a loser. It is my guess that over the next week the market will decide that the Fed really can’t afford to risk raising rates in June, and the markets will trade much like they did prior to the meeting in terms of price level and industry leadership.  Expect market leadership to come from defensive, dividend oriented securities. Of course, I could be wrong and in the alternative scenario the market begins to price in a June or July rate hike and perhaps another in December.  In that case, market leadership would swing toward financials (which benefit from higher rates), technology and health care (both are rate neutral).  The dollar should also be a winner.  In this scenario the list of losers would be long – foreign currencies, commodities (most definitely including gold), emerging markets, utilities, and REITs.   Expect anything economically sensitive to be a loss leader as the broad market trades lower. It seems to me the right thing to do is to get a little more defensive, just in case.

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