Markets Under Pressure on Concerns over Federal Reserve Policy and Potential Government Shutdown

By: Craig Fehr, CFA December 20, 2018

Stock market building with Amercan flags in front and Wall Street street sign overlapping photo.

Stocks extended Wednesday's (Dec. 19) decline, with the S&P 500 falling more than 1% and the Nasdaq flirting with a bear market (down 20% from its peak) on Thursday (Dec. 20). Headlines about a potential government shutdown added to investors' anxieties about the Federal Reserve (Fed) raising rates and slowing global growth. Consider the following takeaways from these recent events:

  • Fed "dovish," but not "dovish" enough - As was widely expected, on Dec. 19, the Fed increased its federal funds rate by 0.25% to a new range of 2.25% - 2.50%. The committee now projects two rate hikes in 2019 versus the three it was projecting in its September meeting. While officials continued to express a positive view on the economy, they slightly lowered their projections for GDP growth and inflation. While the market was already expecting slightly fewer rate hikes next year, we believe stocks sold off after this announcement because the Fed did not strike a significantly more passive (dovish) tone in response to recent market volatility and the moderation in some economic readings.

    In our opinion, this market reaction is a reminder that Fed policy will remain a key driver of equity markets in 2019 as the Fed negotiates the balance between higher rates, inflation and a healthy but slower-growing economy. It's clear that markets were hoping for the Fed to outline a more passive approach, including ratcheting down its forecast for 2019 rate hikes even further. It should not be lost, however, that the Fed acknowledged the health of the economy and signaled it will let the incoming data be its guide. More moderate economic growth, in combination with still-low inflation (helped by the drop in oil prices), justifies in our view a data-dependent approach instead of a previously predetermined course to future rate hikes.
  • Potential government shutdown a short-term disruption - Fears of a government shutdown resurfaced after U.S. House of Representatives Speaker Paul Ryan announced that President Trump would not sign a temporary government funding resolution. Government funding expires at midnight Friday (Dec. 21), and if an agreement is not reached, this would affect about a quarter of federal spending. It’s important to note that we have seen government shutdowns before, and their impact tends to be short-term in nature.

Balancing tailwinds and risks

In our view, tailwinds and risks have become more balanced as we have advanced in this market cycle, but the fundamentals are still sufficiently healthy to support this bull market heading into next year. While we acknowledge the risks, we think that market expectations have fallen faster than the economic backdrop suggests. The recent market volatility might be unnerving, but it’s still part of investing. We don't think you should make changes to your long-term strategy based on short-term fluctuations, but instead use this volatility as an opportunity to review your strategy with your financial advisor and ensure it’s properly aligned with your goals and risk tolerance.

Adding fixed-income investments if appropriate could help reduce swings in the value of portfolios when stocks drop because they tend to decline less or even rise. Higher short-term rates make short-term bonds more attractive within a properly laddered bond portfolio, in our view.

In addition, as the yield curve (the difference between long- and short-term rates) has narrowed, short-term bond yields are closer to long-term bond yields while potentially having less interest rate risk. At the same time, this may be an opportunity to add to equities if the recent volatility has left you underweight in equities relative to your objectives. While you should expect further swings in the stock market, also keep in mind the opportunities created by short-term pullbacks.

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