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Fed Tightens the Screws, Government Shutdown Looms

  • Equities have sold off as the Federal Reserve hiked rates for the fourth time this year

  • Possible government shutdown looms, but government dysfunction is nothing new.

  • We remain cautiously optimistic. Economic and company fundamentals remain strong

In 2018, tax reform legislation was implemented, corporate earnings grew to nearly 20% and the unemployment rate is near a 50-year low, with more job openings than people looking for jobs, and U.S. GDP growth could top 3% for the first time in a decade. With that backdrop, broad stock market indices are on pace to finish the year in negative territory and well off their intra year peaks. With just a few trading days remaining in the year, this month marks the worst December for the Dow Jones Industrial Average since 1931, when the United States was in depression. This is leaving many investors scratching their heads in disbelief.

The main culprit for the declines this week is the Federal Reserve. Equity markets have been declining since the Fed decided to raise rates a fourth time in 2018 and the seventh time in two years. The Fed tried to be dovish in making their last move upward, by signaling fewer hikes in 2019. However, investors had expected a much more dovish tone, and risk assets sold off because the chance of a policy mistake increased. Current inflation is below the Fed’s target and has been trending downward in the fourth quarter, and unemployment is extremely low. While the economy is humming along, the Fed even agreed there do not seem to be any asset bubbles. This leaves many questioning why the Fed continues to push rates higher when the economy is widely expected to slow in 2019 and 2020. Looking to Fed Funds futures, the market is pricing in over a 50% probability that the Fed will not hike rates at all in 2019, but the probability that there will be more is driving equities lower.

In addition to the Fed raising short-term rates, a government shutdown looks increasingly likely. President Trump is threatening to veto any spending bill that does not include border security. However, government shutdowns are nothing new. This would mark the 21st time since 1976 that there has been a government shutdown. Shutdowns have ranged from 1- 21 days, so they tend to be relatively short -term in nature. Also, the potential shutdown is limited in scope this time around, as it impacts about 25% of government agencies, and non-essential federal workers. These workers will eventually be paid in full. Markets tend to trade down on news of a shutdown, but recover quickly, often recovering more than twice as much as they lost.

Other concerns that have been hanging on investors’ minds have been slower economic growth, weaker earnings growth, and tariffs. We covered these topics in greater detail in our 2019 outlook. In summary, earnings growth is expected to slow with the U.S. economy, but both are still expected to be healthy. The economy and corporate earnings were propelled by tax cuts and growth is declining to sustainable levels. Tariffs are a risk but have yet to impact prices of goods on a broad scale. This impact has been limited to certain industries and products.

We do not mean to dismiss these investor concerns, but merely put them in perspective. The Fed continuing to raise rates is our biggest concern right now, but we think the Fed will be more cautious in 2019. We believe there is a chance for a pause to reassess actions, and there could be one rate hike in 2019 rather than two as the Fed had currently indicated. If there is a government shutdown, we think it will be short-lived, and with limited impact. We will continue following developments out of Washington and are watching for any signs that the shutdown will be prolonged. Tariffs are hard to predict, and this could be a longer-term issue. Both the United States and China will want to come to a trade agreement, but neither will want to concede much ground.

Overall, we are cautiously optimistic. Valuations in equities were near 15-year highs in some indexes and have come down over the past quarter. Valuations are closer to their 15-year averages now. Small capitalization stocks and value stocks are a lot cheaper than their long-term averages. There are many uncertainties in the market, but economic and company fundamentals remain strong.


This report is created by Cetera Investment Management LLC


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