The Fed hikes rates into mediocrity

The following is a re-post from Russell Investments Blog on June 14, 2017.  See http://blog.russellinvestments.com/the-fed-hikes-rates-into-mediocrity/ for the full text of the posting.

The U.S. Federal Reserve (The Fed) raised interest rates for the fourth time of the expansion at today’s June 14 meeting, taking the U.S. policy rate slightly above 1%. While this decision was widely anticipated by markets, there are several important observations for global investors to bear in mind going forward.

The macro backdrop for today’s decision: Domestic mediocrity offset by global strength

The Fed normally hikes interest rates into economic strength. But following a lackluster showing in the first quarter (1.2% real U.S. GDP growth), the U.S. economy in our view is continuing to underperform expectations. For example, the Citi U.S. Economic Surprise Index—a measure that tracks incoming economic data against consensus estimates—collapsed from +58 in mid-March to -40 in early June. This is a dynamic that we correctly anticipated in our Global Market Outlook. But it has yet to push the Fed off course.

Inflationary pressures have also failed to materialize. Core consumer price inflation slowed markedly in March, April, and May. Again, this is normally a dynamic that would slow the Fed down.

The rate hike justification

So, what gives? Regarding the outlook for both growth and inflation, it appears that the Fed is essentially forecasting that much of the recent slowdown is transitory in nature. There are some elements to this argument that we are receptive to. The inventory drawdown in the first quarter was a large headwind to growth in the first quarter (and is likely to reverse) and a price war in the telecom industry has had a significant impact on the recent inflation statistics (and is likely to fade away over time). But we also see more fundamental reasons for caution. Bank lending to consumers AND businesses has cooled notably in recent months. Automobile sales – one of the timeliest indicators on consumption activity – is tracking three percent below its first quarter average through May. And rental price inflation is starting to moderate after a significant build-out in multifamily homes in recent years.

While domestic economic fundamentals, in our view, have been lackluster, three other forces have aligned to warrant today’s hike.

  • First, the global cycle has strengthened. The slowdown in China, in particular, was a major source of worry for the Fed in 2016. But more recently we have seen a broad-based reacceleration in economic and earnings trends across the emerging market economies. Stronger global growth removed a source of downside risk to the Fed’s domestic U.S. outlook.
  • Second, the unemployment rate at 4.3% is very low by historical standards. Monetary policy acts with a lag in terms of its impact on the real economy. And with the economy by most measures at or near full employment, this was a key catalyst for a hike.
  • Third, financial conditions remain very accommodative. Despite having now raised short-term interest rates four times this cycle, the ten-year Treasury yield is actually lower than it was before the Fed started hiking. Longer-term interest rates on mortgages and business loans are what matter for economic activity, and the Fed has not injected much restraint into the economy through its rate hikes thus far.

The balance sheet unwind: Making monetary policy boring again

In addition to hiking interest rates, the Fed is also talking about starting the process of winding down its balance sheet—its portfolio of asset holdings—later this year. In many ways, this is the opposite of the Fed’s Quantitative Easing (QE) program, where they bought assets to suppress long-term interest rates and stimulate the economy. Now that the Fed is closer to achieving their goals, they want to gradually unwind the balance sheet. The key for investors is that they plan to do this in a passive, predictable, and plodding way:

  • Passive—Rather than selling their Treasuries and Mortgage-Backed Securities (MBS), the Fed will simply stop reinvesting the principal when these assets mature.
  • Predictable— The cessation of reinvestments is expected to be introduced gradually every three months on a pre-specified timeline (rather than turning off the spigot all at once).
  • Plodding – Recent simulations from the Fed staff suggest they are planning to draw down the balance sheet at a much slower pace than that at which they grew it following the crisis.

San Francisco Fed President, John Williams, has even said2 that they have designed the process to be “boring.” Markets can handle boring, and as such we do not expect a major impact from this proposal on fixed income assets.

Market implications: Not a favorable mix for U.S. equity investors

The biggest issue for investors, in our view, is that the Fed is hiking into a mediocre U.S. economy. We don’t see the fundamentals as being strong enough to warrant another hike this year. But the risks to this view are skewed towards the Fed staying on course for another rate increase in September or December. Under this scenario, our analysis of Fed hiking cycles over the last 30 years shows that rate hikes can be quite damaging to valuation multiples. In a normal cycle, this headwind is more than offset by a strong economy and strong corporate earnings. But in a mediocre growth world, there is unlikely to be enough fundamental support from U.S. earnings to warrant chasing the U.S. equity rally. Instead, we continue to look for opportunities in non-U.S. equity markets, where valuations are more attractive, and economic and earnings trends are stronger. Emerging market local currency debt is another area where we see good value.

The Fed’s Latest Move

The Fed raised rates again. Still, there may be some opportunities in bonds.

After just two rate hikes in nearly a decade, the Fed raised rates again at the March meeting. Citing moderate growth in economic activity, solid job gains, and increased inflation, the Fed pushed its key borrowing rate up 25 basis points higher. The federal funds rate target range is now 0.75%-1.00%.

The economy by all appearances has made really good progress: Job gains have been quite solid, and the unemployment rate is now in line with the Fed’s estimate of normal long-term levels. Meanwhile, inflation continues to rise toward the Fed’s target of 2% a year.

What was less certain entering the meeting was how much the Fed’s expectations for the path of future rate hikes had changed. When we look at the survey of Fed officials rate forecasts, known as the “dot plot,” there was little change. The median expectation was still for two additional quarter-point hikes in 2017, and three in 2018, though there was a slightly higher expectation for 2019.

The Fed also indicated a willingness to let inflation rise slightly above the bank’s 2% target. Overall, it appears to be pretty consistent with market expectations going into the meeting.

This year’s rate hikes are already built into bond yields. And while retail investors may worry that a rising rate environment is bad for bonds, they should keep in mind that the Federal Reserve doesn’t control the entire yield curve: Changes in the federal funds rate most directly affect the short end of the curve, or shorter maturity bonds. When the Fed raises rates, it pushes up yields on short-term bonds. But yields on 10-year bonds, for example, can be affected by a whole host of other factors, including risk sentiment, expectations for inflation and economic growth, and investors’ demand for longer-maturity securities.

Put simply, the long end of the yield curve doesn’t always move in sync with the short end, so the Fed’s rate increase may not cause prices to fall on longer-term bonds. What’s more, longer bonds can provide yield as well as protection in the event of a flight to quality that causes stocks and other, riskier assets to underperform.

We think the key is to owning bonds is having a flexible mandate whereby you can obtain attractive yields from various segments of the bond universe.  This may include government bonds, corporates, preferred securities, floating rate securities and inflation protected bonds, to name a few.  This reduces the pure interest rate sensitivity of your overall portfolio.

Source: Fidelity Viewpoints

 

No Great Surprise – Fed Rate Remains Steady

Why the delay? In a nutshell, the recent economic news has been OK, but not quite good enough. The August jobs report, for instance, saw an addition of 151,000 new jobs. Decent, but not anything like the 200,000-plus jobs that the economy has been generating over the past few years. Inflation remains stubbornly low. And global concerns such as China’s wobbling economy and the continued uncertainty from Brexit no doubt played a role in the Fed’s thinking. As Brainard put it earlier this month, we may be in an economy of a “new normal,” where growth continues but never really accelerates.

Given these circumstances, it appears that the Fed believes the benefits of a rate hike are outweighed by the risks for now. Pushing rates up to around 1% or so would give the Fed a little more leeway if it needs to respond to an economic downturn by lowering rates. But doing so in an economy that is only growing at a mediocre pace could have the clearly undesirable outcome of causing such a downturn.

Besides, relative to the European Central Bank and the Bank of Japan, the Fed does have at least a few more tools in the toolbox. It could cut rates back to near-zero – the others already are below zero. It could offer guidance that rates will stay in place for some time.  Or it could embark on a new round of quantitative easing, here again something the European and Japanese central banks already have in place (although an expected boost in the ECB’s quantitative easing did not materialize when it met September 8).

We still believe that U.S. interest rates are likely to go up in December. The August 2016 small business survey from the National Federation of Independent Business (NFIB) showed that finding qualified workers to fill open positions was one of their biggest problems, a potential indication that wage inflation is about to begin stirring. This could move the Fed to raise rates before 2016 comes to a close. Looking ahead, we do believe two more hikes in 2017 are possible, which could put rates to around 1.25% by the end of next year.

As a part of our investment strategy team, I know we will be taking a close look at the potential implications of rising rates in our upcoming Global Market Outlook quarterly update, which I hope you’ll read. Generally speaking, any U.S. rate increases will likely exert upward pressure on the dollar and draw capital to dollar assets. That could act as a headwind on the emerging markets whose cyclical positions have actually improved thus far in 2016. Oil too could feel the impact, given its inverse correlation with the dollar.

Overall, we continue to believe that current conditions lend support to the potential power of a multi-asset strategy. With the expensiveness of U.S. equities, it may be particularly useful to consider a globally diversified approach in today’s markets.

This information is reprinted from Russell Investments Blog.  You may visit here for original content and appropriate disclosures.  (http://blog.russell.com/fed-rate-remains-steady/)

 

2016 Begins With A Global Market Shock From China

[The following update was provided by Russell Investments.]

Back in August of 2015, Russell Investments’ team of global investment strategists said the mid-year global market volatility sparked by economic news in China reflected
“volatility consistent with the long grinding global recovery.” We wrote at the time: As far
as China is concerned, we belong to the “growing pains” camp rather than ascribing to
the “sky is falling” view.

As the first week of January 2016 wrapped up, China’s Shanghai Composite Index had
lost 10% for the week, marking its steepest decline since the week of August 21. This
sparked volatility globally, such as in the U.S. market, where the Russell 1000® Index
declined 6.7% for the week. Similarly, the Stoxx Europe 600 dropped 6.7% and Japan’s
Nikkei 225 Index fell 7%.

Looking through all this market noise, our strategists believe the volatility in Chinese
markets over the past week was due to market idiosyncrasies and does not reflect a shift
in the fundamentals of the Chinese economy.

As stated in the team’s recently released 2016 Annual Global Market Outlook, and
despite the recent sell-off, “we are witnessing a convincing program of market reform —
recently acknowledged by the International Monetary Fund with its inclusion of China’s
official currency in the international Special Drawing Rights (SDRs) currency basket.
Further, the transition from an economy driven by fixed investment to one driven by
consumption and services also appears to be on track.”

Specifically, our strategists do not see the economic and related events that unfolded in
China during the first week of 2016—including the disappointing Caixin China
manufacturing Purchasing Managers’ Index (PMI) for December—as negative enough to
sway their ‘soft landing’ assessment for China in 2016. However, given the magnitude of
growth in China’s market over 2015, the team expects to continue seeing air pockets on
the downside.

Three primary factors trigger “air pockets on the downside”

Russell Investments’ strategists noted the following three factors regarding China as converging during the first week of 2016 to trigger the week’s market sell-off:

1. Yuan devaluation: On Monday, China devalued its currency by placing the official reference rate at a four-year low. Accordingly, both onshore and offshore yuan markets weakened and raised concerns of weaker than previously thought domestic growth. Yuan devaluation continued over the week.

2. Regulatory uncertainty: In 2015, Chinese authorities put a ban on investors who owned stakes of over 5% from selling their shares on the secondary market.  This ban was due to expire on Jan. 8, 2016, causing some investor concern.  Following Monday’s sell off, Chinese authorities announced that this was no longer the case and the selling restriction was to be kept in place. Later in the week, regulators announced new rules: major shareholders of listed companies are restricted to selling a maximum of 1% of their holdings in a single entity via the competitive-bidding process every three months and are required to give 15 days’ notice in advance of a sale.

3. Disappointing Purchasing Managers’ Index (PMI) report: The Caixin China manufacturing PMI came in at 48.2, which was below the expectation of 49.0.  Meanwhile, the non-manufacturing (services) PMI came in at 50.2, also below the expectation of 52.3.

Looking ahead

With global markets very jittery, Russell Investments’ strategists are keeping a close eye
on daily currency fixings. We are also focused on Chinese trade data as well as the
fourth-quarter 2015 gross domestic product report on 19 January.

Despite global market volatility and the large sell-off in the Chinese market during the
first week of 2016, our team continues to hold a neutral view on Chinese equities for both A-shares and H-shares.  We are inclined to look through market volatility at this
stage and focus on China’s underlying economic fundamentals, which in our view, remain intact.

However, investment professionals across Russell Investments are closely monitoring
the situation in China and the knock-on effect to all asset classes. The consensus
agrees that underlying fundamentals of the Chinese economy are relatively sound and
the week’s market moves globally weren’t sufficient to shift our overarching views.

Bottom line – what does this mean for investors?

Russell Investments’ strategists do not expect China’s ongoing economic growing pains
to cause a global recession. However, the week’s global market volatility is a reminder to
investors that with stretched valuations and questionable growth, market risks remain
heightened.

Especially in periods of market volatility, it is important to remember that markets rise and fall, particularly over the short term. If you’re a long-term investor, it’s best to avoid knee-jerk reactions at the risk of ‘locking in your losses’—because you don’t truly feel the pain of market declines until you sell investments at a low. Sometimes, short-term volatility provides good buying opportunities.

As always, Russell Investments is continually monitoring its funds and seeks to help
clients manage risks through diversification and dynamic portfolio management by
looking to take advantage of any opportunities arising from market volatility.

Fed keeps interest rates near zero a little longer

OK, so we’ll wait a little longer for the U.S. Federal Reserve (the Fed) to finally raise interest rates. As you know, Janet Yellen and the Federal Open Market Committee held interest rates at near-zero at their last meeting. In hindsight, the delay wasn’t all that surprising: The U.S. equity market decline in August and ongoing volatility—prompted in large part by worries about China and the emerging markets, plus continued concerns about stubbornly low domestic inflation rates—made caution a good choice for the time being.

One thing that’s clear as a result of today’s announcement: We certainly know what the Fed is thinking. Yellen and others at the Fed have been exceptionally transparent about what will drive them to hike rates. Even though September was widely seen as a potential time for rate “lift-off,” minutes from the Fed’s July meeting made it obvious that it was not a done deal. Rather, the choice about a rate increase would depend on economic data. That’s a good thing. We still remember what happened in 1994 when the Fed surprised markets with a rate hike that didn’t seem to be based on available data: it sent bonds and equities tumbling.

In any event, despite the Fed’s caution we remain optimistic about the outlook for the U.S. economy. The U.S. is a large, relatively closed economy, which means it is impacted less by the China slowdown than, say, commodities-intensive Australia. Cheap oil is certainly helping to drive down inflation (and hammering energy producers) but we see that as largely transitory, and lower energy prices act as a tailwind for the consumer. Recent U.S. economic data reports have remained solid; vehicle sales in August were the strongest since 2005 and, as the U.S. Bureau of Labor Statistics notes, the unemployment rate has fallen all the way from 10% during the Great Recession crisis to 5.1% today.

As such, the Fed is still likely to move on raising interest rates this year. They just need a bit more time to assess the recent market volatility in financial markets and feel absolutely confident that the economy is still chugging along. The initial hike will be modest – probably 25 basis points in December. But this is likely to be an extremely gradual rate-hiking cycle which is a positive for both the U.S. economy and financial markets. After seven years of essentially zero interest rates, we’re entering a new world.

We suggest that this may be a good time to re-assess your goals and objectives and have a conversation with your adviser.

Global markets hit a rough patch

 

The selloff in markets around the world appears to have a variety of catalysts. The two factors that many investors have fixated on are a slowdown in China and the timing of the US Federal Reserve’s rate-hiking cycle.

Policymakers in China have implemented extraordinary measures to try to put a floor under equity markets, while cushioning a slowdown in economic growth. China’s slowdown, an oversupply in crude oil and a strong US dollar have driven commodity prices to multiyear lows, challenging nations that are dependent on oil revenues. Meanwhile, as the Federal Reserve approaches its first rate increase, the markets have become increasingly concerned about the potential ripple effects — particularly in currency markets — with memories of 2013’s “taper tantrum” still fresh. Emerging markets broadly have been under pressure of late with weakness in export markets, recessions in Russia and Brazil and political uncertainty in Turkey.

Middling growth in the US and continental Europe, combined with the latest market turmoil and deflationary forces from China’s devaluation, suggest the US Federal Reserve and the Bank of England may not be able to begin their policy normalization processes as soon as had been expected. This would be yet another sign that the global economy has not completely healed following the global financial crisis and still relies on continuing central bank stimulus.

Currency devaluations

China’s devaluation of the renminbi earlier this month was small in size, roughly 4.5 percent, but large in symbolism. Many market participants took the move as a sign that conventional methods of supporting China’s export-dependent domestic economy (and financial markets) had run their course and that more-drastic measures were needed. This concern is likely overblown, as currency devaluation is just another means of stimulating growth. Nonetheless, with recent interventions in equity markets and the currency devaluation failing to stem the tide, Chinese policymakers are implementing more traditional measures. On 25 August, the Chinese central bank lowered the reserve requirement ratio by 0.50 percentage point and cut the one-year lending rate by 0.25 percentage point.

Despite the tendency of countries to seek weaker currencies to boost their export sectors and to stave off deflationary pressures, China’s move caught the market unprepared. China’s attempts to stabilize its markets through intervention and trading halts have proved largely ineffective. The real economy continues to be weak, with manufacturing surveys showing a contraction in that all-important sector. While China is seeking to rebalance its economic drivers from fixed investment to consumption — a process that could take years, if not a decade — it needs to maintain its export sector so as to create the conditions where jobs and consumer confidence support that transition. That’s a tall order in the best of times and very difficult amid intense market volatility.

Commodity prices

Commodities have performed poorly against this macro backdrop, heavily weighing on the energy, materials and industrial sectors as well as on commodity-exporting nations. Sluggish global growth and a strong US dollar are major contributing factors. We are now at an inflection point: Growth could get a boost from lower input costs or world growth could flatten out as profits begin to fall.

It’s worth noting that commodity prices have caused recessions in the past, but it has usually been a result of rising prices restraining growth. Low oil prices have historically led to higher global growth, so the recent drop could help cushion any slowdown. So could a delay in the Federal Reserve’s long-awaited first interest rate hike.

Emerging markets

Several important cyclical factors that lent support to emerging market debt in the years leading up to and through the global financial crisis have shifted more recently to become headwinds. Slower global growth (and a reduction in global trade), weaker commodity prices and a gradual shift toward a less accommodative Fed policy have been weighing on several emerging market economies. This dynamic accentuates the already notable degree of fundamental differentiation between emerging market issuers.

These cyclical factors have contributed to credit deterioration in some countries, while others are making relatively good progress in adjusting to new economic realities. We expect a discriminating market to reward issuers making progress toward reforms aimed at restoring macro balances, while ultimately punishing those that fail to capitalize on opportunities to implement improved policy. As always, careful selectivity, with an emphasis on bottom-up country allocation will be critical over the long term.

Investment implications

Turning to the equity perspective, the recent jump in market volatility is not without precedent. Since 1980, the S&P 500 Index has fallen in excess of 5% in a week 28 times. The index has recovered those losses within four weeks more than 70% of the time. That said, we’ve not had a 10% correction in the S&P 500 for nearly four years, so the volatility we’re seeing now looks far worse compared to the unusually low levels of equity market volatility we’ve experienced in recent years. We feel it’s important not to overreact to what might be a return to a normal environment. This sell-off has created more reasonable equity valuations. With lower commodity prices, minimal wage pressure and low inflation, many companies should be able to generate mid-single digit earnings per share growth, which may provide compelling buying opportunities.

We feel the persistence of a global environment of slow growth, low inflation and easy monetary policy will continue to be reasonably supportive for risk assets, although bouts of volatility are to be expected. Overall, near-term volatility does not impact the way we invest. Thus we are approaching the current market environment in the context of our discipline as long-term investors, taking advantage of price volatility to buy attractively valued companies and making investment decisions based on our confidence in the long-term prospects of the individual securities in our portfolios.

Markets React to Latest FOMC Meeting

The Federal Open Market Committee (FOMC), as expected, did not make any changes to policy, such as raising interest rates from current rock-bottom levels.  However, the tone of the statement was a bit more neutral towards the subject, compared to the accommodative language seen in recent years.

 Much of the discussion surrounded whether or not the FOMC would remove the key word ‘patient’ from the official statement.  As was the case a decade ago when Chairman Greenspan did this, the change implies a rate hike could be appropriate at any upcoming time the committee chooses.  Of course, there’s a lot of nuanced semantics here and the Fed remains careful to avoid a misinterpretation or misstep.

April was downplayed as a possible jumping off point for rates, but this entire process as of late has been data-dependent, so it could be June or a bit later.  They’ve acknowledged the ‘moderating’ of conditions recently, and weakness in housing, but also the strength in labor growth and potential tailwind from lower oil prices.  

In case you were wondering, the FOMC is the monetary policy-making body of the Federal Reserve System. It is composed of 12 members–the seven members of the Board of Governors and five of the 12 Reserve Bank presidents.

The FOMC schedules eight meetings per year, one about every six weeks or so. The Committee may also hold unscheduled meetings as necessary to review economic and financial developments. It issues a policy statement following each regular meeting that summarizes the Committee’s economic outlook and the policy decision at that meeting. Four times per year the Chairman holds a press briefing after the FOMC meeting to present the committee’s current economic projections and to provide additional context for policy decisions.

 

 

Does a new market high signal that it is too late to invest?

As we close out the first half of 2014, the U.S. equity market (represented by Russell 1000® Index) is positioned near an all-time high.  Market highs are often seen as times to rejoice, but there appears to be as much trepidation as enthusiasm this time around, leading many investors to delay committing additional assets to their investment portfolios until the “inevitable” market correction occurs.

It may be that the last two bear markets (March 2000 – September 2002 and October 2007 – March 2009) are weighing heavily on investors’ psyches. While there is no magic elixir to help people forget those difficult experiences and feel better about investing today, maybe addressing a few common concerns can help ease the apprehension.

Buying near the market high

Timing investment purchases sounds great on paper, but is very difficult to accomplish in reality. When times are good, investors can be concerned about buying in too late. When times are bad, investors tend to hesitate due to fears of things getting worse.You can always find excuses not to invest, but generally markets tend to move in an upward direction over a moderate period of time.

For instance, as shown in the chart below, the U.S. equity market (represented by the Russell 1000®Index) hit 432 new daily market highs between the beginning of 1995 through May 27, 2014. You could argue that hitting a high almost doesn’t feel special anymore. But, when you consider that the market had a cumulative return of over 600% during that period – the equivalent of a 9.9% return per year – it doesn’t look so shabby. In fact, it’s in line with longer-term averages for U.S. large cap equities. We can’t predict the future, but reasonable expectations are that this pattern could continue over the long term.
Russell 1000 Index

Source: Russell Investments. Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

Worries about valuation levels

Astute investors recognize that price levels alone are not a good indicator of relative market attractiveness. The relative cost an investor pays for each dollar of earnings, book value or cash flow also impact future market returns.  When current valuation measures are lower than past norms,history suggests that future market returns may be higher than historical averages. When valuation measures are higher than historical averages, it suggests that future returns may be lower than long-term averages.

Today’s price-to-earnings (P/E), price-to-book (P/B) and price-to-cash-flow (PCF) for the Russell 1000® Index suggest that valuations are slightly higher than average, but relatively close to historical norms. These results could suggest that future returns may be tempered, but do not foretell a looming market correction.
Russell 1000 index valuations

Source: Russell Investments. Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

Concerns about the economy

Although markets don’t move in lock-step with economies, markets tend to be heavily influenced by current and anticipated economic conditions. Last year’s strong global equity returns were heavily influenced by the anticipation of positive global economic growth in 2014. This year is anticipated to be the first year since 2010 where positive growth will be experienced across Europe, Japan, the United States and the emerging markets. Delivery on that growth expectation will help to justify 2013’s strong results and hopefully enable markets to keep moving forward.
Imf projected growth

Source: IMF.org

The bottom line

Is the market overvalued? Is it too late to invest? Is a correction coming?

If you are asking these types of questions, consider the following:

  • Although U.S. equity markets (represented by the Russell 1000® Index) are at or near all-time highs, that doesn’t necessarily indicate they’ve peaked. Since January 1995, the U.S. equity market has seen 432 new daily highs and has eventually moved higher after each one.
  • Market valuations are a good indicator to help set future return expectations. At today’s levels, markets appear to be slightly more expensive than historical averages. This does not suggest a correction, but helps establish a reasonable expectation for more modest positive results.
  • The global economic recovery continues to move forward. 2014 is the first year since 2010 where there is an expectation for positive growth across all the major economic regions. Positive economic growth tends to bode well for capital market results.

Source: Russell Investments

 

 

The Fed begins taper but stresses easy policy

The Federal Reserve Open Market Committee completed their final meeting of 2013 on Wednesday, and while some economists called for the closely-watched tapering decision to be put off until 2014, a $10 billion/month program was announced.  No doubt, you are probably as tired of hearing about tapering as we are, so this provides a bit of closure to the question, although there is still a long road ahead.  Probabilities for this happening had risen over the past week, although there were plenty of well-regarded economists who called for it to begin in January or March of next year.

Why the change?  The economy continues to be growing at a ‘moderate’ pace, according to the committee.  Since October, better labor numbers and improved capital expenditures added a few points to GDP, while flattened housing figures offset that somewhat.  Also, inflation remains quite low and below the committee’s target.

The Fed might also have been weighing whether or not to lower the unemployment target from 6.5% down to 5.5-6.0%, which it did not end up doing.  The minutes from the October meeting alluded to discussion about the topic.  The second component of today’s news release was an acknowledgement by the committee that it could ‘likely be appropriate’ to keep rates at zero ‘well past the time’ that this target is hit—which came as somewhat of a surprise.

The Fed has dual mandates of maximum employment and price stability.  Unemployment is still higher than desired (far below ‘maximum employment’) and inflation is not yet problematic as measured by their conventional metrics.  Therefore, despite the tapering of the stimulus, there is still ample stimulus as they continue to operate on the side of accommodation as opposed to pulling off the gas too early and risking a sputtering of the engine.

At the same time, QE is a dramatic emergency measure, and one could argue whether this policy continues to be as appropriate several years after the depth of the financial crisis.  Naturally, the longer this goes on and the more positive and sustainable the underlying economic data looks, the greater the counter-argument against stimulus.

We bring this back full-circle to what this means for us in an asset allocation context.  Risk assets traded higher on the news, which reflects the stronger underlying economic conditions, while bond rates ticked upward.

  • Fixed income:  Continued stimulus and easy policy means lower bond yields for longer (although the rate ‘spring’ has been getting increasingly compressed and tapering only releases some of the tension).  As economic growth improves, it is fair to expect higher rates.  This could be quite damaging to conventional fixed income portfolios depending on how quickly rates rise.
  • Equities:  As economic growth continues, this translates to both improved company revenues/earnings as well as a positive feedback loop as consumers feel increasingly comfortable about forward-looking prospects.  When this occurs they increase their own spending.  It would not be surprising to see continued strength vs. fixed income while accepting the occasional bouts of volatility we expect from this asset class.

Why Investors Should Ignore Economists

By Morgan Korn | Daily Ticker

 

Ben Bernanke, chairman of the Federal Reserve and inarguably one of the most important economists today, has publicly chided his fellow economic brethren for their inability to correctly forecast the future.  “Economics is a highly sophisticated field of thought that is superb at explaining to policymakers precisely why the choices they made in the past were wrong,” he told Princeton University graduates this May. “About the future, not so much.”

This week Bernanke and other central bankers will convene in Jackson Hole, Wyo., for their annual summer retreat. They’ll speculate, they’ll pontificate and they’ll ruminate about how to fix the sluggish U.S. economy and boost job growth. Solutions and proposals will be shared and debated. But very few of this year’s attendees will accurately predict how the U.S. or global economy will perform next year.

For these reasons investors are better off tuning out the economic noise, says Barry Ritholtz, CIO of The Ritholtz Group.  “Economists distract investors from what’s important,” he tells The Daily Ticker.

Ritholtz points to the monthly nonfarm payrolls number as a perfect example of what he’s talking about — a data point that is closely tracked by investors, economists and policymakers. An upside surprise in the jobs report could lead to a 100-point spike in the Dow Jones Industrial Average. Yet a number that misses the consensus estimate could send U.S. markets plunging. Ritholtz says these diversions confuse investors and cause them to take their eye off the [investing] ball.  “The jobs report is overrated… it’s meaningless,” he says. “All we care about are the long-term trends: is the economy creating jobs? Are wages going up or are wages flat? What does this mean relative to inflation?”

Ritholtz lists 10 reasons why economists should not be taken too seriously in a recent Washington Post editorial. There are exceptions to every rule, and Ritholtz does name a handful of economists that he says are getting it right.  When it comes to grading the Federal Open Market Committee (FOMC), Ritholtz does not hold back:

“The Fed overly relies on models,” he argues. “They’re kind of winging it. I think they’re doing the best they can do. They don’t have a cooperative Congress. They’re in uncharted waters. They’re flinging stuff against the barn wall to see what sticks.”