Pacific Funds, September 2016

The Federal Reserve (Fed) concluded its September meeting of the Federal Open Market Committee (FOMC). It released updated economic forecasts and left the federal funds target rate unchanged, which increases the case for a rate hike in December. Pacific Funds℠ portfolio managers discuss key points from a fixed income, multi-asset, and equity perspective, as well as potential implications for the remainder of 2016.

Fixed Income
Pacific Asset Management, manager of Pacific FundsSM Fixed-Income Funds

As expected, the Federal Open Market Committee (FOMC) left the federal funds target rate unchanged in the September meeting. Of note:

  • The FOMC decided to maintain the target range at 0.25% to 0.50%.
  • Language changes were minimal, but important, with a hawkish tilt, such as in:
    • September: Growth of economic activity has picked up from the modest pace seen in the first half of this year. In July: Economic activity has been expanding at a moderate rate.
    • September: Labor market conditions will strengthen somewhat further. In July: Labor market indicators will strengthen.
    • September: Near-term risks to the economic outlook appear roughly balanced. In July: Near-term risks to the economic outlook have diminished.
    • New language, which sets up for a rate hike later this year: “The Committee judges that the case for an increase in the federal funds target rate has strengthened, but decided, for the time being, to wait for further evidence of continued progress toward its objectives.”1
  • Members were more divided, and for the first time since December 2014, three members dissented and cast votes in favor of a rate hike. This was in comparison to the July vote where only one member dissented.
  • Economic projections for gross domestic product (GDP) growth in 2016 were lowered to 1.8%, down from 2.0% in June.
  • Median economic projections for GDP growth in 2017–2019 are 2.0%, 2.0%, and 1.8%, respectively.
  • The Fed’s own expectations, measured by the “dot plots,”2 have been reduced, leading to the following projections for potential rate increases over time:
    • One rate hike in 2016, raising the federal funds target rate to 0.75%.
    • Two rate hikes in 2017, raising the federal fund target rate to 1.25%.
    • Three rate hikes in 2018, raising the federal funds target rate to 2.00%.
    • Three rate hikes in 2019, raising the federal funds target rate to 2.75%. 
  • The next meeting is scheduled for November 1-2, 2016.

We continue to maintain our view as expressed in our July update to the FOMC comments, where we stated: “In our opinion, it appears the Fed is setting up a rate hike for December, assuming data is not overly strong for a September rate hike, nor overly weak to remain through the year.”

Additionally, we find it hard to believe the projections calling for rate increases over the next three years would take place with GDP growth of 2.0%, which is expected to move lower. As a result, we would conclude that either projections for economic growth are too conservative, or projections for raising the federal funds target rate are too aggressive for these forecasts to be consistent, unless inflation begins to move higher. We believe that given history, it is most likely that projections for raising the federal funds target rate are too aggressive in the long term.

Pacific Life Fund Advisors LLC, investment adviser to Pacific FundsSM Portfolio Optimization Funds and Pacific FundsSM Diversified Alternatives

The Fed’s decision to remain at current interest rate levels reflects a continued cautious approach. However, language from the FOMC statement now suggests preparation for a December rate hike, especially when considering that three dissenting members are now arguing in favor of a rate hike. The Fed also unsurprisingly continued its trend of reducing its long-term expectation for interest rates reflected in its updated dot plot chart.

  • Key phrase from the FOMC statement: "Near-term risks to the economic outlook appear roughly balanced,” which was the same language the Fed used prior to the last December hike and had been missing until this latest statement.
  • Three dissenting members leaning toward a rate hike, suggesting a growing desire to hike at least once by year-end.
  • The long-term dot plot has seen either a reduction or no change for 19 consecutive quarters.

The declining dot-plot chart indicates long-term rates will likely remain lower for longer, and this could positively impact core and emerging market (EM) bonds. Core bonds move inversely with changes in interest rates, and the shallower rate-hike path indicated by the Fed relieves pressure on an asset class at high historical valuations. For EM bonds, fewer rate hikes reduce the likelihood for the dollar to increase, which may lead to fewer headwinds for the asset class.

U.S. Equity
Rothschild & Co Asset Management US Inc., subadvisor to Pacific FundsSM U.S. Equity Funds

As expected, the Fed maintained its prudent approach, deciding to keep the target range for the federal funds rate unchanged. However, this decision was not taken unanimously, as three of the ten voting members of the FOMC opposed it, preferring to raise the key rate. For these dissenters, a low rate for too long can have adverse effects on financial stability. In addition, the Committee believes that the Fed has basically fulfilled its dual mandate of full employment and price stability, which argue for the continued monetary normalization started in December 2015.

At her press conference, Federal Reserve Board Chair Janet Yellen acknowledged the validity of those arguments. However, several factors have convinced a majority of the Committee members to pursue a very cautious approach:

  • The health of the labor market seems to have been of primary importance. In the last few months, the unemployment rate has not declined despite still robust job creation. This phenomenon might reflect better employment opportunities that have prompted those who were inactive to rejoin the ranks of job seekers.
  • Limited wage growth further solidifies this argument and suggests the existence of still unused capacity.
  • Moreover, Janet Yellen emphasized the asymmetry of the risk profile. Because interest rates are already low, the Fed has little room to ease conditions if growth falters, and it will be easier to respond to faster inflation than to an economic downturn.

The bottom line is that the most likely scenario, while not a certainty, is for the Fed to increase its key rate at the December meeting. Not only will labor market indicators need to improve further, but also economic growth has to rebound from the weak pace of the last three quarters.

On the one hand, this very prudent posture will add additional pressure on other central banks, including the European Central Bank and the Bank of Japan. On the other hand, it should encourage capital flows to emerging countries, although in its recent report, the Bank for International Settlements has once again warned of the financial risks related to the high and increasing debt level in emerging countries.

The Fed’s decision to stay the course was expected; its longer-term game-plan may be more relevant. In the first half of 2016, the most expensive stocks in the S&P 500® index posted large gains even as stocks with compelling valuations declined in value; a future rate hike might dampen investors’ infatuation with dividend stocks, and return the focus to fundamentals.



1Board of Governors of the Federal Reserve System. Press Release, September 21, 2016.

2A dot chart or dot plot is a statistical chart consisting of data points plotted on a fairly simple scale, typically using filled-in circles.  

This commentary reflects the views of the portfolio managers through 9/23/2016. Rothschild & Co Asset Management US Inc.’s, Pacific Asset Management's, and PLFA’s views are subject to change as market and other conditions warrant. No forecasts are guaranteed. This commentary is provided for informational purposes only and is not an endorsement of any security, mutual fund, sector or index. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

Rothschild & Co Asset Management US Inc. is unaffiliated with Pacific Life Insurance Company.

S&P 500® is a registered trademark of Standard & Poor’s Financial Services LLC.

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Pacific Life Fund Advisors LLC (PLFA), a wholly owned subsidiary of Pacific Life Insurance Company, is the investment adviser to Pacific Funds Portfolio Optimization and is responsible for determining the asset allocation mix for each portfolio. PLFA also does business under the name Pacific Asset Management and manages certain portfolios under that name.


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