The Federal Reserve meets in two weeks and has gone to lengths to prepare markets for the possibility that the meeting could result in the second rate hike of this cycle. As recently as August 12, the fed funds futures market was ascribing just a 16 percent chance of that happening. By the end of August, however, through its various statements, and reinforced by evidence of firming economic activity, the Fed had succeeded in raising those expectations to a 36 percent probability.

But last week, two important economic reports that were softer than expected have taken some of the wind from the Fed’s sails. First, the ISM report on manufacturing activity in August showed a contraction for the first time since February. That was followed by the August employment report that showed 151,000 new jobs had been created, rather than the expected 180,000, and that the year-over-year increase in average hourly earnings had fallen to 2.4 percent from 2.6 percent in July. While these two reports don’t indicate that the economy is in trouble, they do suggest that the Fed doesn’t need to be in a hurry. Investors seem to agree, but remain wary. The futures market currently ascribes a 32 percent chance of a rate hike in two weeks. And while that is lower than it was one week ago, it is still elevated from where it was in mid-August.

Economic Data Firms and Fears of Overseas Instability Subside

This episode is reminiscent of market expectations regarding the Fed back in early June. On May 18  fed fund futures were indicating a 32 percent chance of a rate hike at the Fed’s June meeting on the 14th and 15th. However, by June 3 those expectations had fallen to just 4 percent following the surprisingly weak May jobs report. This time, however, the economy is on firmer ground than it was in the spring.

In addition, concerns about both economic and political stability overseas have receded. Although the August jobs total was below expectations, it was still strong enough in the eyes of the Fed to continue to absorb the remaining slack in the labor market. And investors have gotten the message.

On June 2, the day before the May Jobs report, the yield on the two-year Treasury note was 0.89 percent. Following the report the yield began a descent that bottomed out at 0.56 percent on July 5, helped along by the UK’s Brexit vote. Since then it has climbed back to a yield of 0.79 percent as of last Friday, having given back just four basis points following last week’s softer data. In addition, not only have the near-term expectations of another rate hike remained elevated, the expectations of a rate hike by December have climbed back to 59 percent, exactly where they were following the May jobs report, and well above the 8 percent probability of July 5 when the two-year note yield bottomed. This is not to say that the Fed will raise rates in September. But, it has succeeded in raising the market’s awareness that a rate hike is likely coming, sooner or later.

Earnings and the Economy Show Signs of a Strong Finish

The S&P 500 is now higher by 6.7 percent on the year, with most of that return coming in the third quarter as the index has climbed 3.9 percent. Small cap stocks have done even better as evidenced by the 8.7 percent climb in the Russell 2000 index so far this quarter. The ascent has been accompanied by a rotation into the more economically sensitive sectors of the index, at the expense of the more defensive groups. Telecom, technology and financials have surged, while utilities and consumer staples have declined.

Perceptions of improving economic activity, which led to a rebound in corporate profit growth, have been the primary catalyst. According to Factset, analysts now expect earnings to grow by 5.5 percent in the fourth quarter after a decline of 2.1 percent in the third. Somewhat firmer data from China, and so far the resilient UK economy, belying expectations of a near-term recession, have helped. The dollar has stabilized after climbing sharply following the Brexit vote, allowing the MSCI Emerging Markets index to rise 8.1 percent since June 30.

Particularly noteworthy has been the recent strength in financial stocks, which have been battered by slow growth, low interest rates and increased regulatory oversight. The XLF financial sector ETF has risen 7.5 percent this quarter. More importantly, it rose 1.9 percent last week. Financials, especially banks and insurers, are especially sensitive to prevailing interest rates. Last week’s softer economic data, which failed to derail the rally in financials, is an encouraging sign that the economy is firming and that the market has gotten the Fed’s message.

Important Disclosures:   
The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Ameriprise Financial associates or affiliates. Actual investments or investment decisions made by Ameriprise Financial and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances.
The MSCI Emerging Markets Index captures large and mid-cap representation across 23 Emerging Markets (EM) countries. With 837 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
The Russell 2000® Index is a market-capitalization-weighted index made up of the 2,000 smallest US companies in the Russell 3000.
The XLF financial sector ETF includes a wide array of diversified financial service firms with business lines ranging from investment management to commercial banking and REITs.
FactSet is a multinational financial data and software company. The company provides financial information and analytic software for investment professionals.
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