Quarterly Investment Commentary
After a relatively quiet second quarter, international headlines moved markets at the start of the third quarter, as Israel invaded Gaza and Russian separatists shot down a commercial airliner in eastern Ukraine. Although stocks staged a comeback during August, September was a challenging month that brought most indices into negative territory for the quarter. The exception was the S&P 500, which posted a gain of about 1%, led by the health care and technology sectors. Small company stocks ended the quarter down 7%. Foreign and emerging market stock markets also struggled in the third quarter, posting losses of about 6% and 3%, respectively.
Bond market returns were slightly positive for the quarter. Market interest rates ended the quarter marginally lower (measured by the 10-year U.S. Treasury yield), continuing the downward trend from the first half of the year.
Economic indicators in the U.S. continue to show signs of improvement, with estimates for second quarter economic output revised higher and consumer confidence growing. Unemployment is gradually trending lower but wage growth has been limited, which has kept inflationary pressures at bay. The Federal Reserve has suggested that it will not need to raise short-term lending rates for a “considerable time.” (Current estimates are for rate increases sometime later in 2015.)
Reflecting improving trends in the U.S. economy, the Federal Reserve continues to wind down its bond-buying program. In contrast, the Federal Reserve’s European counterpart, the European Central Bank (ECB), continued policies geared to stimulate European economies and battle falling prices. However, investors expected even greater measures to combat the Eurozone’s economic woes, and responded negatively to ECB announcements. The ECB’s meager measures reflect the reality that political will for more action remains subdued in influential Eurozone countries, most notably Germany.
The Federal Reserve
Who is this?
A) Your grandmother
B) Someone who likes fancy scarves
C) One of the most powerful women in the world
The Federal Reserve (“The Fed”) is one of the most important financial institutions in the world. It is also one of the least understood. The picture above is of Janet Yellen, Federal Reserve Chairwoman and one of the most powerful women in the world. No, she is not your grandmother, but yes, it appears that she does like fancy scarves. Interestingly, in a recent poll less than 25% of respondents could correctly identify Yellen, with a smaller but still significant percentage thinking that former chairman Alan Greenspan (who retired in 2006) is still at the helm.
A primary objective of our quarterly newsletters is to provide you with education and context to interpret the barrage of financial information that you receive each day. Unfortunately, when it comes to the Fed, this information is often full of complexity and jargon that’s hard to decipher. Since the Fed’s proclamations continue to drive the news cycle and contribute to daily volatility in the markets, we think it is worthwhile to spend time this quarter reviewing some basics about the Fed: How it came to be, what tools it uses, and how its current policies are unprecedented… or not.
First, a short history lesson is in order. The United States experimented with creating a centralized entity responsible for overseeing our banking system early in its history, but by the early 1800s had abandoned the idea. The following 100 years featured private banks who issued their own loans without regulation. Many banks ended up failing or going out of business in a short period of time. Financial panics, economic instability, and recessions were the natural result.
The Panic of 1907 was the eventual catalyst that prompted the creation of the Federal Reserve. Panic quickly spread following one individual’s failed attempt to manipulate the price of a specific stock by borrowing heavily and purchasing shares, which created a run on numerous banks and trust companies. Had it not been for the intervention of J.P. Morgan and other New York bankers who provided liquidity to the market, the crisis likely would have grown much worse. This situation that was sparked by one person’s greed caused the United States to realize it truly needed an institution that could step in during times of crisis to act as a lender of last resort, calm markets, and stem massive withdrawals driven by a sudden lack of confidence in the system. The Fed was born.
A “Dual Mandate”.
The Fed was established to pursue two primary goals, which are often stated as its “dual mandate:”
To maintain maximum employment. This means aiming for a level of unemployment that provides anyone willing to work with gainful employment.
To maintain price stability. This means keeping prices from either rising or falling rapidly. Maintaining stable prices is beneficial because it enables consumers and producers to make decisions without worrying about the purchasing power of their money changing dramatically over the short run.
Achieving these two goals requires careful balancing since there are trade-offs and the objectives often stand in conflict with one another. For instance, if the Fed attempts to help provide capital for businesses to boost hiring (i.e. thus decreasing unemployment) and the plan works, new workers will naturally choose to borrow and spend more money to buy things like houses, cars, and furniture. More demand for these things tends to push their prices higher and inflation can then become a concern.
The total amount of money deployed in the economy is the primary driver for both full employment and price stability. Too little money in the system and there isn’t enough money to hire workers. Too much money in the system and prices rise. So, controlling the supply of money is the Fed’s predominant goal, and “Monetary Policy” is the official term for this. The Fed utilizes three primary tools to influence the supply of money:
Set the interest rate for money that is lent to banks (i.e. the “discount rate”). A lower rate encourages banks to lend and therefore helps to increase the money supply.
Determine the amount of cash that banks must hold in reserve (i.e. “reserve requirements”). Reserve requirements are an important component of helping to ensure that banks do not take too much risk in the loans that they make. However, in practical terms, the Fed rarely changes the reserve requirement, so this tool is not used to make fine tuning adjustments in the money supply.
Buy and sell government securities (i.e. “open market operations”). This is the tool that the Fed employs most often, and the Fed usually focuses on buying and selling short-term government securities in order to affect shortterm interest rates. If the Fed buys short-term bonds, then short-term bond prices rise and short-term interest rates decline. If the Fed sells short-term bonds, then short-term bond prices go down and short-term interest rates rise. (The subject of the inverse relationship between bond prices and interest rates is a topic which we have covered in past newsletters, but be sure to let us know if you would like a refresher on this.)
In the wake of the extreme financial market decline of 2008 – 2009, the Fed utilized its usual tools to reduce short-term interest rates to near 0% to help stimulate the economy. With concern that the Great Recession (as it has come to be called) would still deepen, the Fed determined that it needed to take additional action to encourage borrowing and thereby increase money supply. They decided that in addition to reducing shortterm interest rates, they would also reduce longer-term interest rates (impacting home mortgages, business equipment financing, etc.). In order to do this, they expanded their bond purchases to include longer-term Treasury securities as well as mortgage-backed securities issued by government-sponsored agencies (like Fannie Mae or Freddie Mac). The chart at left shows these large-scale asset purchases starting in 2009 and demonstrates how dramatically the increase in Fed assets has been over the last 5 years.
Many have expressed concern that the Fed has overstepped its reach by buying longer-term securities. While it is true that the scale of the Fed’s long-term bond purchases is unprecedented, it is important to observe that this is not the first time that the Fed has adjusted its usual methods or taken an unconventional approach. There are two other times where the Fed took unconventional action.
The Great Depression. The Fed’s initial response to the financial collapse of the 1930’s was weak and ineffective, in part because they were not able to utilize all of the tools available today. This led to many structural changes that greatly expanded the Fed’s ability to buy and sell securities. In 1933 the US eliminated the Gold Standard and established the Federal Open Market Committee via the Banking Act of 1933. These changes greatly expanded the role of the Fed and resulted in unprecedented open-market purchases that increased the supply of money by nearly 150% over the following decade.
Stagflation. During the 1970s, oil shortages occurred simultaneously with a period of stagnant economic growth and created the perfect storm to drive prices higher during a recession (i.e. when prices would otherwise have naturally been declining). This was a situation that the Federal Reserve had not faced before, and was difficult to manage without going outside the box. In order to combat inflation, Fed chairman Paul Volcker raised interest rates to a peak of 20% in 1981, which was considered incredibly high given that the Federal Reserve has very rarely targeted rates in excess of 10%. Volcker’s actions garnered stiff political attacks and widespread protests.
Our purpose in providing these historical examples is not to argue for the correctness of the Fed’s current methods, but simply to observe that the Fed’s approach has changed over time in order to account for changes in the financial markets. Its basic objectives, however, remain unchanged.
Following the Great Recession six years ago, we often see various individuals and firms preaching absolute clarity for the future of the economy and the direction of the Fed. This can include statements with regard to hyperinflation (e.g. “The Fed has pumped way too much money into the economy”) or interest rates (“It will be just like 1980. Rates have to rise by 10%.”). These sorts of statements have a tendency to drive investors to extremes. For instance, those concerned with hyperinflation may have heavily weight their portfolios toward commodities such as gold and silver since these investments sometimes do well in inflationary environments. Those who believe that interest rates will rise meteorically may have held their fixed income portfolios entirely in cash for many years rather than owning bonds. In short, acting on extreme convictions has led to some extreme portfolio positions.
It is important to consider the facts. Based on historical results, commodity investments have the potential to drop nearly 70%. (The S&P Goldman Sachs Commodity Index declined 68% from 7/1/2008—2/28/2009). So, those who try to avoid the risk of hyperinflation may actually put themselves directly in front of an equally risky situation: the potential massive loss of investment value. On the other side, in the no-risk portfolio, those who have held cash for the last six years have missed out on 29% cumulative returns on bonds (as measured by the Barclays US Aggregate Bond Index) while waiting for rate increases.
To be clear, acting on conviction and tilting a portfolio slightly toward something that helps one to sleep better at night is perfectly rational. What we intend to convey here is simply that when one takes an extreme position based on an expectation of a perfect understanding for what will occur in the future, the risk of being wrong can be very costly, potentially even more costly than what one was trying to avoid in the first place.
From our perspective, only two things are clear regarding the Fed’s future actions:
1) As the economy improves, the Fed will likely raise short-term rates; and
2) The Fed will eventually sell the assets that it has purchased during the last five years.
Less clear are the timing and precise impact of the Fed’s specific actions. Analysts may parse each word that the Fed uses to try to decipher their potential actions, but regardless of what many “Fed watchers” and “experts” say, no one really knows the exact path that the Fed will take, including the Federal Reserve itself. In fact, the Fed has been quite clear that the action they take and the timing of these actions will depend greatly on future conditions, which are subject to near-constant change.
Given inherent variability in the economy, attempting to predict the timing of Fed actions is not a sound investment strategy. As always, we do not try to time markets or design investment strategies around unpredictable things that are outside of our control. Instead, we focus on what we can control, implementing a well-balanced portfolio that holds a broad array of investments to balance the various economic conditions and Fed decisions that may come our way.
While the future isn’t clear, we still believe it is worthwhile to understand the forces that affect the market and to comprehend the environment in which we all invest. We hope that you have learned something about the Fed and that next time you see Janet Yellen in the news, you will have a better understanding for what she is thinking about.