Sometimes Economics is Secondary
At times the economic news pales in importance to the headlines, and November 13, 2015 was one of those times. The terrorist attacks in Paris were a clear message that the worldwide battle against radical ideology is going to be with us for many years to come. However, the people of France are vowing not to give in to fear and are continuing on with their daily activities, while respectfully remembering the dead and wounded. We stand with France, and the rest of the civilized world does as well.
During traumatic world events like the Paris attacks, the markets generally react in a similar fashion. Shock creates an initial market reaction. The market absorbs and processes the information and makes adjustments if necessary, and then moves on.
Typically, these effects are transient on the broad scale, but they can produce longer-term upheaval in a particular area. For example, isolated attacks on oil fields and refineries might have a short-term effect until the supply catches up with demand. As a long-term investor, you should focus on long-term, broader effects unrelated to catastrophic events — like interest rates.
Fiscal Policy Normalization is Near
The Federal Reserve has kept interest rates near zero for seven years. It's been so long that investors may have forgotten how fiscal policy and interest rates are supposed to work. The intent was to introduce stimulus to a stagnant economy, but policies that theoretically should produce a booming economy have only resulted in slow economic growth.
At the same time, with interest rates near-zero, saving has been discouraged and stocks have become the only place for investors to make real money. As more money has poured into equities, overvaluation has remained a constant threat. The Fed recognized this threat in their recently released meeting minutes, referring to an increased risk of "a buildup of financial imbalances."
Fed policymakers have been split on the need to raise interest rates for months given the mixed bag of economic data and no sign of inflation anywhere on the horizon. In recent months, the balance has clearly been shifting toward a rise in rates as unemployment reached a 5% target value and the slack in the labor market continues to decrease.
With low inflation mostly attributed to a strong dollar and the collapse of oil prices, the meeting minutes show that the majority of the Fed policymakers are prepared to raise rates in December. Even though the dollar's strength and oil prices are unlikely to change in the short-term, they almost certainly will over the medium-to-longer term, and the Fed simply can't delay that long to normalize policy.
Wait...Higher Interest Rates Are Good News Now?
Stock markets have been reacting to the threat of an interest rate hike as bad news, as they logically should. Higher interest rates make fixed investments more attractive compared to stocks and higher borrowing costs make it more difficult for businesses to use and manage debt.
However, when the Fed's meeting minutes were released, the markets reacted positively. The Dow rose 240 points after the release of the minutes, and all three major indices closed significantly higher for the day. What's the reason for optimism? The key words are "gradually" and "certainty."
The Fed's minutes made it clear that the interest rate hake must be gradual to avoid shocking the markets and that it should take place soon. Even the more reluctant Fed policymakers see the need to normalize policy. Starting with a hike in December avoids the possible need to make a larger and more sudden increase down the road that could cause greater market disruption. Further, it was noted that yet another delay in interest rates "could increase uncertainty in financial markets and unduly magnify the perceived importance" when rates do eventually increase, and that a delay could "erode (the Fed's) credibility."
In reality, rates are so low -- and the markets are so distorted -- that a gradual rise in interest rates is unlikely to have a dramatic effect on the markets and economy in general. The Fed has given the markets a cautious roadmap, which is exactly what they needed to hear. Markets fear uncertainty as least as much as they do higher interest rates.
The terrorism battle continues. As of this writing, swift action has been taken against the masterminds and accomplices of the Paris attacks, and there have been no follow-up attacks there. Meanwhile, in connection with the Paris attacks, the Belgian capital Brussels is on the highest level of alert with concerns of an "imminent attack." A separate attack on a hotel in Mali killed 20, but at this point it is not clear that there is any connection to European terrorist efforts.
When terrorist attacks do occur, resist the urge to immediately take action with respect to your finances. Even the stock market impact from the 9/11 attacks -- that were direct hits on Wall Street and the financial mechanisms of the US -- were reversed within a month on all the major exchanges. Thus, you should take the time to evaluate any effects on your holdings and the amount of time that the effect is likely to last.
Keep in mind that such effects are not always bad. After 9/11, some technology and defense-related companies saw their shares increase significantly. Oil is another useful example. When supply is disrupted by an attack, prices will go up and profits are likely to do so as well for those companies unaffected by the disruption. How long will it take the market to normalize? That is a case-by-case evaluation that you must make before deciding to take any action.
Interest rate changes pose a different sort of challenge, but the response should be similar. Don't take rash action, but evaluate your holdings for how interest rates will affect them, and how large the effect might be based on the amount of the change.
Again, the effects are not always bad. If banks are prevalent in your portfolio, higher interest rates should be a positive as they translate to more income for financial institutions. (If you had a portfolio weighted too heavily in financial institutions during a period of near-zero interest rates, you probably should have been making adjustments some time ago.)
To borrow a phrase first used by the British monarchy during World War II, “keep calm and carry on.” Absorb the effect on the market, and then evaluate the individual changes in your holdings before you act. Don’t overreact to a short-term spike in the market either way.