Rate Hike Offers Little Surprise
Most of the increase appears already baked into stock prices, although opportunities still exist.
In a widely anticipated move, the Federal Reserve on Dec. 14 raised its target for the federal funds rate by 25 basis points, to 0.50%-0.75%. In addition, the central bank cited improving economic conditions that could support an additional 75 basis points of rate increases in 2017.
Low Inflation, Lackluster Business Investment Support Cautious View
As we noted ahead of the Federal Open Market Committee meeting, inflation is still below the committee’s 2% goal and business fixed investment remains below desired levels. We believe these data points support our view that low real interest rates are needed to ensure full utilization of labor and capital for some time. We incorporate a federal funds rate of 2.25% and a 10-year Treasury yield of 3.5% by 2020 into our valuation models. The FOMC appears to agree, predicting only gradual increases in its target and an extended period of low rates by historical standards.
Relatively rate-insensitive names like Citigroup (C) and Wells Fargo (WFC) remain undervalued and attractive, in our view, while the most rate-sensitive banks have risen above our fair value estimates. Also, we like the fact that Citigroup and Wells Fargo are working through manageable performance issues, enabling them to control their destinies in a variety of rate environments. As for the trust banks and the asset managers, rate-dependent names--like BNY Mellon (BK), State Street (STT), and Federated Investors (FII)--have already benefited from the market’s perception of future rate increases as well as regulation, with most of the asset managers rallying strongly since the presidential election on the belief that a Trump administration will curtail a lot of the regulation introduced since the 2008-09 financial crisis. Of the asset managers, we still prefer wide-moat-rated BlackRock (BLK) (the leading provider of exchange-traded funds) and T. Rowe Price (TROW) (which has the best and most consistent performance in the group) for long-term investors, as we believe they are the best positioned to deal with the secular trends affecting the industry, along with Northern Trust (NTRS) among the trust banks. All of these picks are currently trading at or above our fair value estimates.
Life insurers MetLife (MET) and Prudential Financial (PRU) would also see material benefits from higher interest rates. However, the recent runup in their shares in anticipation of higher rates and looser regulation leaves these companies modestly overvalued, in our view. Of the brokers and wealth management firms, we see TD Ameritrade Holding (AMTD) as approximately fairly valued, while the others have already priced in much of the potential benefits from a faster ramp in interest rates and less regulation.
So far, there is little reason to believe that the forces producing low equilibrium rates--advances in technology, demographic trends, and the state of the global leverage cycle--will reverse in short order. We reiterate that although market-based measures of inflation expectations--including longer-dated bond yields--have increased dramatically over the past month, underlying factors driving rates have not changed. In fact, the Federal Reserve sees current policy as accommodative, given the limited inflation pressures showing up in economic data. We’re even more skeptical; without more evidence of an overheating economy, it seems fair to assume the current rate environment is closer to neutral.
We think changing market inflation expectations are more closely linked to expectations of a more aggressive fiscal policy than to the Fed’s stance on rates. Several proposals could have inflationary effects. Increased spending on roads and bridges should stimulate growth and create high-paying jobs for an important segment of the population; a relative lack of construction jobs has been somewhat problematic since the housing bust. Thus, some upward wage pressure could result. As products are increasingly required or encouraged to be produced domestically, consumer prices could rise considerably. A "Made in the USA" label is typically accompanied by higher labor costs. Higher levels of debt resulting from a looser fiscal policy--taxes are likely to be cut under the new administration, while spending cuts could be slower to materialize--are also inflationary.
Case Weakens for Gold as Investment
While the December rate hike was largely expected by the market, the FOMC’s signaling three additional increases next year appear to have come as somewhat of a surprise, causing gold prices to fall. We expect gold to decline to $1,100 per ounce by the end of 2017 as the rising nominal interest rate environment coupled with continued inflation weakness creates an unfriendly environment for gold as an investment.
Longer term, most FOMC members continue to anticipate the fed funds rate to rise to around 3%. Furthermore, despite continued weakness in inflation in the near term, the FOMC continues to expect long-run inflation of about 2%. As a result, we see the case for gold as an investment will remain weak in the longer term. We expect that in the long term, Chinese and Indian jewelry demand will fill the gap left by investment demand. However, the rise of consumer demand will take time, which means significant risk to gold prices in the near term. Our long-term gold price forecast is unchanged at $1,300 per ounce by 2020.
Most gold miners look fairly valued at this time. However, we see opportunities in Eldorado Gold (EGO), Goldcorp (GG), and Kinross Gold (KGC), driven by company-specific issues. For Eldorado, risks to the opening of its Greek operations are an overhang. Goldcorp investors continue to wait to see improvement in the firm’s youngest mines, Cerro Negro and Eleonore. Kinross’ shares have traded off by a larger degree than we expected, given the declining gold price. Nevertheless, we caution investors that the near term will remain rocky. Significant investment flowed into gold over 2016, and the return of these ounces to the supply will create additional downward pressure on prices.
Morningstar.com does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.