For the last several years, a combination of near zero interest rates and increased liquidity from quantitative easing has helped to suppress market volatility. Now, more than nine years into this economic expansion, the Fed is well along its path toward normalization. The fed funds rate has risen by 2.0%, and is not far away from the Fed’s estimate of the long-term neutral level – around 3.0%. This suggests we may be approaching the latter stages of this economic cycle, as rate hikes beyond the neutral level contributes to tighter financial conditions, which is often viewed as the culprit of an ensuing recession. Historically, these upward moves in rates, as the Fed attempts to prevent late-cycle overheating, have been accompanied by heightened market volatility (as illustrated above). While interest rates may not have moved into restrictive territory yet, an uptick in volatility from exceptionally lower levels should not be unexpected as we look ahead – particularly given the Fed’s telegraphed path for short-term rates.
Despite the fact that heightened volatility may be ahead, it may be 2020 before the fed funds rate truly moves into “restrictive” territory, and thereby the current economic expansion may have more room to run. Traditionally, equity markets have performed well in the latter stages of a business cycle, thus de-risking in anticipation of increased volatility or a potential recession has not typically been an effective strategy. As shown in our accompanying piece, pulling out of the market at the wrong time and missing just a few days of strong performance could drastically reduce portfolio returns. The bottom line is that volatility is a normal part of the market cycle, and while unnerving, it often presents opportunities for long-term investors with a disciplined investment plan.
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Plante Moran Financial Advisors (PMFA) publishes this update to convey general information about market conditions and not for the purpose of providing investment advice. Investment in any of the companies or sectors mentioned herein may not be appropriate for you. You should consult a representative from PMFA for investment advice regarding your own situation.