By increasing the overnight Fed funds target to a range of 0.25% to 0.50% on Dec. 16 the Federal Reserve has finally kicked off the "normalization" of interest rates and monetary policy. The Fed’s decision, however, belatedly follows developments in the global financial and commodity markets that have actually been normalizing for many years now.
Crude oil, gold, and the foreign exchange value of the U.S. dollar were among the earliest asset classes to commence the normalization process. On a monthly settlement basis since January 2009, crude oil peaked at a price of $113.93 in April 2011, followed closely by the bottom for the U.S. dollar index at 80.5 in July 2011 and then gold's peak at $1,829.30 in August 2011. In the grains, the price per bushel of corn then crested at $3.3295 in July 2012.
Notably, the postfinancial crisis price peaks in oil and gold and the bottom for the dollar all occurred well before the Fed announced its third round of quantitative easing (QE3) in September 2012, the May 2013 Bernanke taper-tantrum, the year-end 2014 conclusion of QE3, and now the December 2015 liftoff for the Fed funds. These observations collectively illustrate what can often be the extreme forward-looking nature of the relatively speculative commodity and foreign exchange markets.
The speculative-grade debt market, which has recently attracted a tremendous amount of investor attention and angst, was the next asset class to begin a preemptive policy normalization correction in valuation. This type of corporate debt peaked in April 2013, just before the Bernanke taper-tantrum, when the iShares High-Yield Corporate Bond ETF stalled at a price of $93.85. More recently, investment-grade corporate bonds have established, at minimum, an interim top as of January 2015 (iShares Investment-Grade Corporate Bond ETF price of $123.89), as have large-capitalization equities per the 2,107.39 price peak for S&P 500 Index in May 2015.
It quickly becomes apparent that the asset classes that have been undergoing price corrections for longer periods of time are the same ones registering the largest percentage declines in prices. Staggering cumulative declines in crude oil (-63.4%), corn (-50.1%), gold (-41.8%), and even the ascent of the U.S. dollar index (+22.4%) make the year-to-date index price corrections (as of November) in stocks (-1.3%), investment-grade bonds (-6.4%), and even speculative-grade bonds (-13.4%) look quite acceptable.
Investors now face a central question regarding the prospective performance of multiple asset classes in 2016: How much further do these various policy normalization-driven valuation corrections have to run? Our McGraw Hill Financial colleagues at Bentek Energy currently foresee the price of crude averaging about $46 per barrel in 2016, so the bottom for commodities may be close at hand.
The outlook for stocks and bonds, which have only more recently initiated valuation corrections, is less clear. The performance of financial assets will be partially determined by consumer price inflation, and by extension how quickly and how far the commodity pendulum swings in the opposite direction once prices have bottomed for good.
As the Fed initiates the first policy reversal seen in more than a decade, it all boils down to a basic question. Will the Fed successfully engineer a soft landing for the U.S. economy and an encore performance of the not-too-hot but not-too-cold "Goldilocks" economy, or could we be destined to repeat the unintended deflationary consequences of the prior tightening cycle in 2004-2006?
At the moment, Global Markets Intelligence (GMI) Research believes that the financial asset policy normalization-driven valuation correction will continue at least until the 10-year Treasury note reaches a yield of 2.5%. Recognizing that the 15-year average of the price-to-earnings (P/E) ratio for the S&P 500 Index is 16x forward earnings, we believe that stocks will continue to oscillate within a 15x- to 17x-valuation range for the foreseeable future.