The next time the Fed speaks, investors should pay attention
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Financial markets focused on two big stories last week: the result of the French elections and the Trump tax plan. Meanwhile, the biggest news of the week from the markets' perspective was seemingly lost in the shuffle.

The markets were ebullient following the news that Emmanuel Macron will face Marine Le Pen in the second round of the French elections. Macron is the clear favorite of investors, as he is a staunch advocate of France remaining in the European Union. In stark contrast, a Le Pen victory would all but assure the collapse of the EU, as the institution couldn't survive the exodus of both the second and third largest economies.

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Immediately following the first round of elections the probability of a Macron win stood at nearly 90 percent. The race has tightened and polls now have the odds at less than 60 percent. A Le Pen victory would likely be greeted by major equity market sell-offs across the globe, and we all know how incorrect political polls can be.

 

The Trump tax plan would slash the corporate tax rate from 35 percent to 15 percent. Repatriated earnings from companies would be taxed at even a lower rate. On the personal side, the current seven tax brackets would be collapsed into three, lower brackets — 35 percent, 25 percent, and 10 percent. If passed in the proposed form, we would see higher corporate earnings and greater disposable income. All of that is good news for investors, so why was the plan greeted in a lukewarm fashion by the markets?

What many people may not realize is that some tax reform is already baked into asset prices. Additionally, the chances the plan will be passed in its current form is virtually nil. The markets are forward looking, and have been anticipating tax reform since Trump's surprise election. That is, the tax plan was as expected, even if the final version of tax reform — assuming it is enacted at all — may not develop as anticipated.

So what was the important news the markets ignored? Federal Reserve Vice Chairman Stanley Fischer announced that despite relatively weak recent economic reports, the nation’s central bank is still on track for two more 25 basis point rate hikes in 2017.

It is ironic that markets ignored Fischer’s pronouncement. Recently, relatively benign remarks by regional Fed governors moved markets. For instance, last September, Fed Governor Lael Brainard said she was concerned about the impact that global difficulties will have on the U.S. economy and cautioned against moving too soon on rate hikes. The equity markets soared following her comments.

It appears that the markets have moved on from their Fed obsession, but history would caution against that. The stock markets flourish in falling rate environments and struggle in rising rate environments. In Invest With the Fed, Gerald Jensen of Creighton University, Luis Garcia-Feijoo of Florida Atlantic University, and I found that the S&P 500 returned on average 15.2 percent annually when interest rates were falling and only 5.9 percent when rates were rising.

As interest rates rise, investors should expect to realize lower equity returns. High price-to-earnings ratios can be justified at lower market interest rates, but as rates rise, bonds become more attractive vis-a-vis stocks. When the Fed talks, investors are wise to listen.

Robert R. Johnson, PhD, CFA, is president and chief executive officer of the American College of Financial Services. He is co-author of Strategic Value Investing, Invest with the Fed, and Investment Banking for Dummies.


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