From the performance of the market to begin the year, it appears we now have an indication of what may be coming over the next two weeks. The ECB meets on January 22 and the Greek election is on January 25, and between now and then, investors will increasingly focus on the euro, ECB policy and Greek politics. The Federal Reserve is also keeping an eye on Europe and comments from one official indicate its policy may be influenced by what happens overseas.
U.S. equities opened the week on the down-slope, but they were rescued by comments from a Fed official Wednesday evening. During a speech, Charles Evans, President of the Federal Reserve Bank of Chicago, said that he is worried about low inflation rates and housing, and wants any rate hikes to move slowly. He also said he’d like to push rate hikes out in time, saying, “I don’t think we should be in a hurry to raise rates” and “raising rates would be a catastrophe.” Stocks futures immediately rebounded in the wake of his comments and the U.S. opened higher on Thursday. The S&P 500 Index rallied 1.79 percent in the wake of his comments, and along with other major indexes, reversed all of its losses for 2015.
The comments of Mr. Evans came after the Fed minutes from the last meeting showed officials are concerned about weakness in the global economy, particularly Europe and Japan. The Fed’s focus on economic conditions overseas contrasts with the relative strength of the domestic economy, but this could be a sign that rate hikes will be delayed by a slowdown abroad. Falling energy and commodity prices, for example, will hold inflation low even if the U.S. economy continues to grow at an accelerated pace in 2015. Since Fed officials want higher inflation, they may decide to hold rates lower and longer, in order to create a boost.
Rate hikes could also be delayed by currency markets. The performance of the euro over the past week is a case in point. The currency fell to its lowest levels since 2006 as talk of a quantitative easing program from the European Central Bank (ECB) increased, along with the Fed seemingly endorsing the idea in its minutes by making a reference to “foreign policy responses.” While the Federal Reserve would prefer to see a weaker U.S. dollar because that would lead to higher inflation rates, it would rather not see Europe enter a serious deflationary spiral, which would ultimately lead to an even stronger U.S. dollar. If the U.S. dollar strengthened, the Fed would rather it occur because Europe devalued the euro, rather that via rate hikes.
As the market showed on Thursday, delayed rate hikes are good news for the equity markets. A European quantitative easing program would also be bullish for U.S. equities, but even more so for European stocks. This will benefit funds such as WisdomTree Europe Hedged (HEDJ), which are long European stocks, but short the euro to eliminate currency exposure. We added this fund to one of the portfolios in the ETF Investor Guide last year in anticipation of this situation.
Complicating matters in Europe is the situation in Greece. The anti-austerity Syriza party is ahead in the polls and their victory could lead to unpredictable results. It’s impossible to know if Syriza would switch its stance on the bailout agreements, of which austerity is a part, after winning, or if it didn’t, how the ECB or European Commission would respond. Uncertainty leads to fear because in the absence of information, emotions dominate. Concern over the potential outcomes in Greece is helping to pull the euro sharply lower along with Greek stocks, and weighing on equities in other eurozone nations. This could lead to collateral damage in other markets, including domestic stocks, but this would be a buying opportunity to pick up discounted assets, since the response from the Fed and ECB will be one of strong support for the markets.