Economic Strength and Raising Interest Rates

PNC Chief Investment Strategist Bill Stone explains why this is the end of an era.

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U.S. Economic ExpansionPNC’s outlook is that 2016 will continue to bring economic expansion for the United States. The economy’s strength was first acknowledged by the Federal Reserve in its December 2015 decision to raise interest rates, a sure signal that we’ve come far from the days of the Great Recession.

The Great Recession

Let’s go back to 2007-2009 for a moment — not to the nitty-gritty of how the crisis unfolded, but to the measures that the Fed took to help enact recovery. The Fed implemented a rare zero-interest rate policy at the height of the financial crisis to ease unemployment and support economic growth. Those extraordinary conditions, deemed “life support” by many, remained in place until late 2015.

Overall, 2015 was marked by continued economic expansion, but equity markets faced uncertainty and challenging dynamics that sent volatility racing. In August, the CBOE Volatility Index® (VIX®) reached heights not seen since 2011, given an imminent rate hike and concerns about global growth. Corporate earnings were overshadowed by the drop in oil prices, which caused a sharp decline in earnings from the energy sector. Other worries included concerns about slowing global growth, the impact of falling oil prices and geopolitical issues, to name a few.

Market volatilityMarket Volatility

Market volatility is a term often used to describe the fluctuation of stock and bond prices.

Many events can lead to volatile market conditions: economic data, market news, world events, political disruptions, unforeseen catastrophic events, expectations about the future, corporate announcements and more. So while the timing and severity of volatility are often unpredictable, everyone investing toward a long-term goal may experience it at one point or another; the 2007-2009 financial crisis and anticipation of a rate hike are just two examples.

Time for growth: expansion period about average

Now, with the economy reaching stronger footing, there is less of a need for concerted support measures. The message the Fed sent in December with its first step toward a normalized monetary policy was powerful; the move from a 0 – 0.25% range to 0.25 – 0.5% indicated an expectation of further improvement. PNC believes the Fed will continue to act slowly and deliberately — raising rates every so often to ultimately reach a “normal” 2.5 – 3% range by 2019.

The expansion that began in July 2009 (using GDP as the indicator) is nearing its seven-year mark. This might seem like a long time for economic expansion but, in historical terms, is actually not long at all. The current period of growth can be viewed as close to average, considering this was a credit-driven crisis (primarily mortgage-centric) to begin with. According to Cornerstone Macro Research, based on the bottoming of the National Association of Home Builders Index, the average length of economic expansion is 19.6 quarters (about five years). The shortest was in 1980 at just 4 quarters and the longest, in 1990, at 40 quarters (10 years). The current expansion is clocking in at 26 quarters.

Impact on Consumers, InvestorsImpact on consumers, investors

Consumer spending continues to improve. Its pace of above 3.5% growth for 2015 was actually the fastest in 11 years, according to Cornerstone. Consumer net worth has surpassed prerecession peaks, aided by several years of solid stock market performance. Confidence in the future outlook is vital to sustainability of spending, too — and thus carries through to economic growth.

Likewise, U.S. housing data is still trending upward. For sales of existing homes specifically, 2015 was the best year since 2006, and more moderate increases are anticipated through 2016. PNC forecasts the housing market will continue to spur economic growth in 2016. Add to the demand for construction: solid job growth, rising wages in some areas, low mortgage rates, and easing access to mortgage credit.

This positive outlook, job gains, wage and income growth — and most notably the Fed’s action — prompted banks across the country, including PNC, to raise their prime rate for the first time in seven years. The prime rate influences rates for many types of short-term personal, small business and mortgage loans.

A small increase has little impact on the traditional 30-year fixed mortgage rate. This is because other factors, such as the rate on the 10-year Treasury bond and expected long-run inflation, come into play with these types of mortgage loans. (People borrowing on shorter-term loans or adjustable-rate mortgages, however, are likely paying a bit more.)

Stocks, which have been on a six-year bull run, continue to push higher and tend to produce significant positive returns over the long term. Historically, the S&P 500 has had positive performance in the 12 months following a rate hike. The outlook for bonds, however, is not as strong; rising interest rates push down bond prices and longer-term interest rates have tended to rise in the wake of the Federal Reserve beginning its tightening cycle.

What about that volatility? Financial markets had already priced in this initial rate increase, which should actually help to lessen volatility in the short-term. But that doesn’t mean there won’t be market shifts from time to time. Markets don’t like uncertainty, and while we can certainly forecast expectations, we don’t know how quickly the Fed will continue to lift the rate. But we remind investors that the reason for raising interest rates is a good one; it marks a return to normal.

Just remember that when market volatility strikes — don’t panic. One of the best ways to achieve your longer-term investing goals is to carefully create a financial strategy and not sway from it. Sticking to your plan can help you ride out market downswings and historically has shown to help preserve assets long-term.

Focus on 2016Focus on 2016

As we consider the markets through 2016, we continue to focus on a few factors of concern to investors:

  • Timing of interest rate hikes
    Following the initial rate increase last December, we expect further adjustments to be gradual (however, there are always uncertainties).
  • Global growth concerns (China, for example.)
    2015 brought a sharp upheaval in China’s stock markets. Data seems to indicate a slowing of growth from recent years, but growth of just under 7% (forecast) is still quite strong.
  • Impact of low oil prices
    Lower gasoline and energy costs are a direct benefit to consumers, putting more money in pockets that can be used to fuel spending, and energy-reliant manufacturers gain from lower expenses. Energy companies saw a sharp drop-off in earnings in 2015, but the large negative impact from the fall in prices appears to be over. Hardest hit are economies largely tied to oil, such as Russia.
  • Divergence in monetary policy
    As the United States moves toward normalization of monetary policy, the Eurozone and Japan are likely to remain on the receiving end of stimulus measures, in our view.
  • Terrorism threats
    Geopolitical issues rattle markets from time to time; there is always the risk of unforeseen events around the world.
  • Wages and inflation expectations
    While the labor market has advanced since the recession, wage growth has only recently developed. Wage growth is imperative to continued improvement, as far as jobs go. Inflation has been kept at bay, and a material increase is not likely in the near term.
    Bill Stone Bill Stone PNC Chief Investment Strategist
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