Having Found One Reason After Another to Postpone The Inevitable, the Fed Finally Announced an Increase In Short-Term Interest Rates. But What Will Really Drive the Economy and Markets Going Forward?

Well, it finally happened. On December 16th, after seven years of finding reasons to maintain short-term interest rates at very low levels, the U.S. Federal Reserve (Fed) ran out of excuses and announced it would raise its target for the federal-funds rate by 0.25%. The fed-funds rate only applies to overnight loans for certain large institutions, but it commonly influences other short-term interest rates in the United States and abroad.

While opinions surrounding the Fed’s intentions have dominated the financial news, I believe the decision was more a result of economic conditions — rather than a driver of any upcoming changes in the near term. The Fed has stated for quite some time that its policies are data-dependent. Accordingly, modest economic growth and reasonable employment numbers in the U.S. set the stage for the eventual increase in the fed-funds rate.

What’s really important going forward is not the Fed’s recent decision — which was widely conveyed ahead of time — but the course of several issues that will play out globally. These issues include the type and duration of monetary policies that will be pursued by the world’s central bankers, and the trends in commodity prices, currency values, credit spreads and longer-term interest rates.

ECONOMY

Economic conditions across regions have been mixed during the past year. In the United States, the economy has continued its path of resilience since the end of the Global Financial Crisis (GFC) — albeit with very modest growth in gross domestic product and only slight increases in wages. Additionally, the U.S. has ended its program of bond purchases (a.k.a.,“quantitative easing”), and has potentially embarked on a path of measured interest-rate increases.

In Europe and Japan, economic progress has generally lagged that of the United States — although signs of improvement have become evident. Moreover, unlike in the U.S., the European Central Bank and the Bank of Japan are still engaging in quantitative easing and are keeping short-term interest rates at very low (or even negative) levels.

Among emerging markets, economic conditions have varied widely. But the headlines have focused mainly on the negatives, and have created the impression of near-universal gloom. On the ground, however, we’re still finding well-run companies whose stocks are selling at reasonable valuations — particularly in India, Mexico, the Philippines, South Korea and Taiwan.

The reasons for the negative headlines regarding emerging markets, and many developed markets for that matter, mostly have had to do with the economic slowdown in China and the related fall in commodity prices. As China has slowed the building of its infrastructure, there have been ripple effects because the Chinese have been demanding less than the hoped-for amounts of commodities such as oil, iron, copper and chemicals. Naturally, emerging-market commodity producers like Brazil, Russia and Venezuela are among the countries that have been hit the hardest by the slowdown. But other countries, such as India and the Philippines, are large importers of energy resources and have been receiving a huge boost from lower prices.

While China’s slowdown is painful for Chinese workers and for the country’s trading partners, the slowdown is not necessarily irrational. China incurred massive debts to develop its infrastructure and has become a major exporter of manufactured goods. Now it’s time for China to focus more on balancing its economy with increased domestic demand from Chinese consumers.

In the United States — aside from states dependent on oil, gas and coal production — the decline in energy prices is a windfall, as it leaves more money in peoples’ pockets. But this hasn’t yet been much of an enhancement to economic growth because the pace of consumer spending has actually slowed since last autumn. So rather than spending their low gas price windfall, people are taking the opportunity to save and pay off debt. This could be a new mindset among consumers and a partial return to the philosophy of previous generations who viewed debt as dangerous.

Another condition in the U.S. has been the continued strength of the dollar, which has been affecting economies around the globe. While the higher value of the dollar has been exerting a braking force on the U.S. economy, so far the resilience of the economy has been sufficient to generate moderate growth. Further, the strong dollar has allowed the relatively weak currencies of Europe and Japan to provide a boost to those economies. Now that the Chinese yuan has decoupled from the dollar, China will also get a boost from dollar strength. While a strong-dollar policy may temporarily seem to be a medicine with no side effects, this policy must be administered with extreme care to avoid the deleterious consequences of a trade war. But for now, so far so good.

MARKETS

In my last message to shareholders, I expressed my view that the third-quarter declines in stock markets around the world were mostly temporary “air pockets” rather than the start of major moves into bear territory. And in the fourth quarter, most stock indices did in fact rebound off their lows.

The S&P 500® Index rose 7.04% for the quarter to finish the year with a 1.38% gain. The Russell 2000® Index of small-company stocks increased 3.59% for the quarter and lost -4.41% for the year. As for international stocks, the MSCI World Ex-U.S.A. Index gained 3.91% for the quarter and fell -3.04% for the year.

Meanwhile, high-quality bond returns were little-changed overall. The intermediate-term Barclays Capital U.S. Aggregate Bond Index declined -0.57% for the quarter and rose 0.55% for the year. Similarly, the long-term Barclays U.S. 20+ Year Treasury Bond Index lost -1.38% for the quarter and -1.59% for the year.

So what’s the likely scenario for markets going forward? As usual, I think stock markets will take their cue from economic developments around the globe.

The U.S. seems poised to continue along its path of slow but steady expansion in spite of the Fed’s slight move toward monetary tightening. It seems to be a reasonable hope that U.S. economic strength — plus continuing monetary easing in Europe and Japan — will help lift those economies from their continuing post-GFC slump.

Most emerging-country stock markets, on the other hand, have been tainted by both weaker Chinese growth and the declines in oil and other commodity prices. But there are pockets of opportunity in these markets because some companies will be relatively unaffected by China and will actually benefit from lower energy costs.

My base assumption is that most financial markets will hold up reasonably well. But we should also be aware of several canaries in the coal mine that may serve as signals of more-significant challenges ahead.

One such signal could be further deterioration in oil and other commodity prices. While most of the world benefits from cheap prices, commodity producers suffer as revenues decline. The magnitudes of the declines already experienced have led to incidents of civil unrest. I worry that a further drop in oil prices — or even a continuation of current price levels — could spark increased aggression from Russia and greater troubles in the Middle East, including more suffering for refugees.

A second signal could be the proliferation of losses among low-grade (“junk”) bonds, many of which were issued by troubled energy companies whose problems could get even worse if oil and gas prices stay low. We’ve already seen one major mutual fund forced to suspend shareholder redemption requests due to lack of liquidity in the fund’s bond investments.

Beyond junk bonds and energy-related problems, we’re also seeing a general widening of credit spreads due to fears that credit woes will spread beyond the oil patch. This means that the differences in yields on lower-rated bonds versus higher-rated bonds are expanding across the quality spectrum, which is a condition that often precedes an economic recession.

Investors should also consider that securities firms are holding smaller bond inventories than several years ago. This results from the firms’ efforts to meet today’s more-stringent capital requirements and to reduce trading operations, which have become less lucrative and subject to increased regulatory scrutiny. Smaller inventories have led to more volatility in bond prices because securities firms are less able to trade for their own accounts — a practice that in previous years often helped to support prices during periods of lower liquidity. Currently, low liquidity seems to be exacerbating the wider credit spreads discussed above.

A third signal could be a more-extreme movement toward deflation. Actual deflation would amplify debt-related problems as, in effect, debt must be repaid in more expensive currency. It’s worth keeping in mind that excessive indebtedness was one cause of the GFC. Since the GFC ended, there’s been more debt shuffling than actual debt reduction — as consumer debt has been replaced with government debt. By some estimates, $57 trillion worth of debt has been added around the world since 2007. As the amount of global debt rises, the threat of deflation increases.

Again, I’m not predicting any of the negative scenarios described above. I’m simply paying attention to the canaries in the coal mine to make sure that they’re still singing. The main reason I remain relatively optimistic is because most of the challenges I see today have to do with pockets of illiquidity, rather than widespread insolvency. With the carnage of the GFC in the recent past, however, investors would do well to keep their eyes peeled for any distant smoke on the horizon.

With sincere thanks for your continued investment and for your trust,

Sam Stewart

RISKS AND DISCLOSURES

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CFA® is a trademark owned by CFA Institute.

Wasatch Advisors is the investment advisor to Wasatch Funds.

Information in this document regarding market or economic trends, or the factors influencing historical or future performance, reflects the opinions of management as of the date of this document. These statements should not be relied upon for any other purpose. Past performance is no guarantee of future results, and there is no guarantee that the market forecasts discussed will be realized.

DEFINITIONS

A credit rating is an assessment of the credit worthiness of individuals and corporations. It is based upon the history of borrowing and repayment, as well as the availability of assets and extent of liabilities. Ratings are issued by S&P or Moody’s and typically range from AAA (highest) to D (lowest). The credit quality of the investments in the Fund’s portfolio does not apply to the safety or stability of the Fund. Ratings and portfolio credit quality may change over time. Unrated securities do not necessarily indicate low quality. The Fund itself has not been rated by an independent rating agency. For information on the rating agency’s methodology visit: http://www.standardandpoors.com/home/en/us and http://www.moodys.com.

A credit spread is the difference in yield between two bonds of similar maturity but different credit quality. For example, if the 10-year Treasury note is trading at a yield of 6% and a 10-year corporate bond is trading at a yield of 8%, the corporate bond is said to offer a spread over the Treasury of two percentage points.

The federal-funds rate is the interest rate at which private depository institutions (mostly banks) lend balances (federal funds) at the Federal Reserve to other depository institutions, usually overnight. It is the interest rate banks charge each other for loans.

The financial crisis of 2007-09, also known as the Global Financial Crisis and 2008 financial crisis, is considered by many economists to have been the worst financial crisis since the Great Depression of the 1930s.

Gross domestic product (GDP) is a basic measure of a country’s economic performance, and is the market value of all final goods and services made within the borders of a country in a year.

Quantitative easing is a government monetary policy used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.

Valuation is the process of determining the current worth of an asset or company.

The S&P 500 Index includes 500 of the United States’ largest stocks from a broad variety of industries. The Index is unmanaged, but is a commonly used measure of common stock total-return performance.

The MSCI World Ex-U.S.A. Index captures large and mid cap representation across 22 of 23 Developed Markets (DM) countries — excluding the United States. With 1,004 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.

Source: MSCI. The MSCI information may only be used for your internal use, may not be reproduced or redisseminated in any form and may not be used as a basis for or a component of any financial instruments or products or indices. None of the MSCI information is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. Historical data and analysis should not be taken as an indication or guarantee of any future performance analysis, forecast or prediction. The MSCI information is provided on an “as is” basis and the user of this information assumes the entire risk of any use made of this information. MSCI, each of its affiliates and each other person involved in or related to compiling, computing or creating any MSCI information (collectively, the “MSCI Parties”) expressly disclaims all warranties (including, without limitation, any warranties or originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential (including, without limitation, lost profits) or any other damages. (www.msci.com)

The Russell 2000 Index is an unmanaged total-return index of the smallest 2,000 companies in the Russell 3000 Index, as ranked by total market capitalization. The Russell 2000 is widely used in the industry to measure the performance of small-company stocks. Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell indices. Russell® is a trademark of Russell Investment Group.

The Barclays Capital U.S. Aggregate Bond Index covers the U.S. investment grade fixed rate bond market, including government and corporate securities, agency mortgage pass-through securities, and asset-backed securities.

The Barclays U.S. 20+ Year Treasury Bond Index measures the performance of U.S. Treasury securities that have remaining maturities of 20 or more years.

You cannot invest directly in these or any indices.

© 2016 Wasatch Funds. All rights reserved. Wasatch Funds are distributed by ALPS Distributors, Inc. WAS003970 Exp: 4/30/2016

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