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Dow & S&P near all-time highs

December 19, 2016

by Brad Houle, CFA
Executive Vice President
Ferguson Wellman Capital Management

Market Summary

The stock market was slightly positive on last week up around .20 percent taking a break from the strong move upwards following the election in November. Both the S&P 500 and the Dow Jones Industrial Average are within striking distance of all-time highs. The 10-year Treasury bond sold-off this week with the yield rising from 2.47 percent to 2.55 percent as treasury prices and yields move inversely to each other.

Shifting Gears from Monetary to Fiscal Policy

On Wednesday, the Federal Reserve increased short-term interest rates by .25 percent. This marks the second time that the Federal Reserve has been able to increase short-term interest rates since the Great Recession. This raises the federal funds rate to a target range of .5 percent to .75 percent. The Fed wants to “normalize” short-term interest rates because we will at some point have another recession and they would like to have the ability to stimulate the economy by lowering rates, if necessary. The message from the Federal Reserve on Wednesday was to expect three rate hikes in 2017 that is supported by a strong labor market and an uptick in inflation toward 2 percent.

Despite the best efforts of the Fed through monetary policy, the economy has grown very slowly since the Great Recession. In order to keep the economy growing, there is a coming shift from monetary policy to fiscal policy. Monetary policy is financial engineering that the Federal Reserve and other central banks in the world have been using in an attempt to stimulate the economy. Monetary policy comes in many flavors: quantitative easing, “Operation Twist” and zero interest rate policy. The effectiveness of monetary policy has run its course and the shift is now to fiscal policy, which encompasses tax cuts and deficit spending to continue to stimulate the economy. The change in the government fiscal policy is expected to become a large part of the Trump administration’s economic policy.

The Driver of Recent Market Activity

Fiscal policy moves that have been discussed by the Trump administration include tax cuts for business and individuals, a rollback of regulation and spending on infrastructure. These changes will take time to become law and even longer to induce faster economic growth. Recent growth in market activity is based upon the expectation of faster economic growth due to fiscal policy. As part of this expectation, there has been a notable uptick in small business and CEO confidence. Increased confidence is thought to lead to greater capital spending, which is a positive for economic growth and increased worker productivity.

Since the election, the stock market is up around 6 percent and the 10-year Treasury has increased in yield from 1.85 percent on Election Day to 2.55 percent as of Friday. As mentioned before, the stock market reaction is based on the expectation of faster growth in the economy. The selloff in the bond market is based upon the expectation of larger deficits and higher inflation due to the change in economic policy.

Our Takeaways from the Week

– The Fed move this week was anticipated and signals increased economic growth and eventually more resources to implement monetary policy when it is needed in the future
– Bond market sells off amid speculation that the U.S. will see larger deficits

  
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