Fed’s Interest Rates Hike Decision Signals Stormy Waters Ahead

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interest-rates

Don’t look now, but the smooth waters we’ve seen over the past few years, in terms of market performance, are poised to get rougher in the months ahead.

This distinct possibility may have played a pivotal role in the Fed’s decision not to raise interest rates in September.

Over the past few years, the market has been relatively calm and steady, and a lot of investors have forgotten what real volatility can look like. For example, the market has historically experienced a  “correction” (defined as a drop of 10% or more from any given peak) once every 18 months or so. Yet until recently, the markets had gone four full years without experiencing any corrections. That stability is very easy to become accustomed to, but can prove to be very deceptive.

All of this changed in August, when the market suddenly experienced a severe downturn in just a few days, losing more than 12% of its value from the high reached in May. And volatility returned in a big way, with the market experiencing more than twice the 1% daily gyrations this year, and more than five times the 2% daily gyrations, as of last year. All of these huge daily swings coming in a period of just two weeks.

So what’s going on? It’s actually a combination of factors. First of all, you could say that the market was just “due” for a correction… and that idea certainly has some validity. But there’s more to it than just that. Another major factor cited by many economists is the fact that market volatility may have been artificially suppressed by the Fed’s quantitative easing program (QE) over the past few years. The idea is that when investors know that the Fed is trying to stimulate the economy by keeping interest rates low, they are more willing to assume greater risk than would otherwise be the case, but that all changed late last year, when the Fed phased out their QE policy. The argument is that this “kicked out the artificial support” and left the market to finally stand on its own two feet…which fostered the return of market volatility closer in line with historical norms.

But why would this specifically happen in the month of August? One clear answer could be the situation in China. The Chinese stock market took a plunge over the summer, and in August it became clear that the “Chinese economic miracle” may have run off the rails…at least temporarily. The Chinese government’s official forecast for economic growth this year is around 6.5%, which represents a huge slowdown from the 10-11% of previous years. And many private observers say that the truth could be far worse. Judging from data like freight shipments, energy usage, and auto sales, it is very possible that the true rate of growth could be closer to 2%, or even less than that…perhaps even negative, for the first time in decades.

This has major implications for the world economy. China’s imports of raw materials are critical to the economic health of many emerging market countries. And the growing Chinese economy, now the world’s second largest, has become an important source of profits for many of the world’s major corporations. For example, China is now the world’s largest auto market…30% larger than the U.S. Many people are shocked when they learn that General Motors sells more cars in China than in the U.S. A slowdown in Chinese auto sales is big news for a lot of companies.

All of this has raised the risks in the global economy, which is still fairly weak outside of the U.S. This could be a big reason why the Fed decided not to raise interest rates in September, in spite of the fairly robust state of the U.S. economy. Many commentators have noted that the Fed seemed to be taking a more comprehensive, global outlook in making their rate decisions, and thus decided that the overall world situation was too fragile to risk higher rates at this time. Clearly, the Fed was concerned about some of these issues and wasn’t quite yet ready to take any chances on doing anything that could further destabilize the situation.

These same risks could weigh on the markets in the coming months. In addition, September and October have historically been the worst months, BY FAR, for the markets. Historically speaking, more corrections (and outright bear markets) have started in September and October than any other months of the year.

So when you look at the overall situation, with no more QE to prop things up, weakness in the rest of the world, a potentially significant slowdown in China, and negative seasonality, investors should brace themselves for a lot more market volatility than they’ve seen in quite a long time. Which makes it a good time to review your overall financial plan to consider making any necessary adjustments, in anticipation of more stormy waters ahead!