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Yellen Tips Her Hand - Higher Rates Likely

| August 29, 2016
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MPCA Weekly Market Update

Equity markets traded down slightly last week after Federal Reserve Chairwoman Janet Yellen signaled that the central bank will gradually raise short-term interest rates in the coming weeks or months ahead. A week ago, Bloomberg calculated the odds of a Fed interest rate hike by December of 51.1%. Those same odds closed at 62.9% on Friday. Fed Chair Yellen started Friday off with a bullish economic assessment, quickly followed by Vice Chair Stanley Fisher mentioning a possible September hike, which sent the equity markets down slightly. All told, while higher rates mean more expensive borrowing, having the Fed Chair confirm a strengthening economy is a long-term positive for equities.

Odds of higher interest rates traditionally send the financial sector higher, banking names in particular, and this week was no exception. The S&P 500 Financial Index was up 0.37% while the S&P 500 Banking Index was up over 1%. This year there have been two pronounced themes in equity markets that continued this week. The first has been smaller caps outperforming larger caps, the second value names outperforming growth names. This week the larger cap S&P 500 Index had a -0.7% return while the mid- and small-cap S&P 1000 had a 0.0% return. If these macro trends hold for 2016 it will be the first time that small- and mid-caps beat large-caps since 2012, and the first time value beats growth since 2013.

In spite of hopes for a second half rebound, the US economy is not exactly crushing it at the moment. Q2 US GDP was revised modestly lower, to an annual rate of 1.1% from an initial 1.2% reading. The US trade deficit shrank in July to $59.0 billion from $63.3 billion in June. There was good news in the durable goods orders, which were surprisingly strong, rising 4.4% in July versus a consensus estimate for a 3.7% rise. Core capital goods orders rose a robust 1.6%.

Sales of new homes surged 12.4% in July to the highest level since October 2007, and 31% compared with a year ago. However, sales of existing homes, which outnumber new home sales by a factor of eight, fell 3.2% in July, muddying the outlook for the overall housing sector. Scarcity of affordable inventory is stifling existing home sales, the National Association of Realtors reports.

Sadly, the week saw another tragic event on the world stage, as a strong earthquake struck a mountainous region of central Italy on Wednesday, killing more than 250 and leaving many more homeless. Innumerable buildings in the region were destroyed, and continued aftershocks have hampered rescue efforts.

In other news on the Continent, a poll of more than 7,000 Germany businesses saw a decline in confidence among those surveyed. The Ifo index fell to 106.2 in August versus 108.3 a month earlier, the steepest fall in more than four years. The weakening German sentiment was blamed on a delayed reaction to the UK’s June Brexit vote.

That explanation seems questionable, however, as UK Consumer sentiment rebounded strongly in August, more than reversing the post-Brexit shock from July, jumping to 109.8 from 106.6. The rise was the largest in over three years. UK GDP for Q2 was left unrevised at +0.6% quarter-over-quarter, but business investment was unexpectedly revised much higher. It had been assumed that businesses would take a wait-and-see approach ahead of the late-June Brexit vote. Instead, investment rose 0.5% on the quarter versus an initial -0.6% reading.

Coming Up This Week:

  • Today:The US reports personal income and spending, as well as the core personal consumption expenditures price index, the Fed’s preferred inflation measure
  • Tuesday: The Eurozone economic sentiment index
  • Wednesday:The harmonized index of consumer prices for the Eurozone
  • Thursday: Global manufacturing purchasing managers’ indices
  • Friday: The US August employment report

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