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The Fed Proves it Still Holds Sway

| February 21, 2017
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Four weeks in a row now the US equity markets have climbed. Last week, the S&P 500 added 1.5% - marking its fifth gain in the first seven weeks of 2017. In fact, the US equity markets have yet to log a daily decline in excess of 1% in 2017 (please don’t expect this to be the norm). Over that time, the benchmark index is up 5.0%, even as uncertainty starts to swirl regarding the tax and regulatory changes that were attributed to so much of the market’s positive move since the election.

To be clear, the market has not climbed solely on the prospects of tax policy changes and reduced regulatory burdens– but these certainly have played a major part (strong Q4 earnings reports have played their part as well). With the “devil in the details,” Congress and the White House are now hashing out what exactly these plans will look like. According to one source, the delayed efforts to repeal and replace Obamacare are in turn holding up any other efforts in the realm of tax reform.

It is this uncertainty that led Janet Yellen to temper her comments regarding future interest rate increases for this year. As she made her semiannual appearance before Congress on Tuesday and Wednesday, she expressed that the Fed wanted greater clarity on the time, scope, and composition of any fiscal changes before making assumptions on the growth outlook for the economy. This was despite her remarks that both inflation and the labor market are close to targets.

Speaking of inflation, the headline inflation number (CPI) has been steadily rising since the second half of 2016, and the January CPI report released last week confirmed this trend. Headline inflation increased 0.6% in January, the strongest monthly gain in almost four years, resulting in a 2.5% increase year-over-year. Much of this was from a sharp increase in oil prices, with the energy index rising 4.0% in January. Next week, we’ll get the Personal Consumption Expenditures (aka, PCE deflator) – which is the Fed’s preferred inflation measure. If the PCE confirms what is being seen in the CPI, pressure will increase on the Fed to increase rates sooner rather than later.

All in all, Yellen’s testimony to Congress – particularly her note that the risks of waiting too long to raise rates outweighed the risks of a premature hike – led investors to speculate that the Fed is more likely to raise rates during the upcoming March meeting than previously thought. This sent Treasury prices down slightly over the course of the week. The market implied probability of a March hike now stands at 34%, which is up moderately from 28% a week prior.

Shifting back to equities, a stronger risk appetite, stronger economic data, and some significant M&A news pushed global equities to record highs over the course of last week, ahead of this holiday shortened week. Consumer data points remained strong as retail sales advanced 0.4% versus consensus of 0.1%, and U.S. housing starts exceeded expectations. With earnings season nearing completion, S&P 500 earnings are on pace to grow by 5% for the 4th quarter of 2016. To date, information technology and financials grew earnings by 11.2% and 9.1% in the 4th quarter, while energy remained a drag with earnings down by 9.3%. However, energy earnings are expected to recover and be incremental to S&P 500 profits in 2017.

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