- The Issue
- The Outlook
- The Rest of the World
- Investment Strategy Tips for Investors
- The Fine Print
The Fed and Capital Markets – What's the Buzz
The U.S. economy is undergoing a shift from extreme monetary accommodation toward a neutral monetary policy. As the Fed unwinds a record level of monetary easing, uncertainty about how the economy and capital markets will react to higher interest rates has increased market volatility.
In response to the financial crisis of 2007/08, the Fed began buying Treasury bonds and mortgage-backed securities in 2009. The Quantitative Easing (QE) program ended in October 2014 with approximately $3 trillion on the Fed's balance sheet. Quantitative Easing lowered long-term bond term yields which provided support to the economy and capital markets. Since the end of QE, the Federal Reserve has continued to hold the Fed Funds rate at a target range of 0% - 0.25%, a historically low level. Surprisingly to some economists, long-term yields have likewise stayed historically low.
As the Federal Reserve Board of Governors debates the timing of the first rate hike, their uncertainty has exacerbated investor concerns about the future of interest rates and their impact on capital markets. As the Fed's program of historically low Fed Funds Rate ends, bond yields are expected to adjust up, and stocks could adjust down. While interest rates across all maturities are expected to remain low relative to historical levels for some time, the relative importance of early shifts is significant. With the Federal Reserve Fed Funds target range from 0% to 0.25%, the first increase in the Fed Funds Rate to 0.25% represents a shift up of more than 100%. The markets have never had to adjust to a change of this magnitude.
Further, unlike previous rising Fed Funds Rate cycles, this time the Fed is not responding to inflationary pressures. Throughout 2015, the Fed's chosen inflation indicator, the personal consumption expenditures index, has been below its target level of 2% with little evidence that the economy is overheating. The Fed has chosen a 2% target because a higher inflation rate is costly in economic terms, while a lower inflation rate risks the Fed's monetary levers used to stimulate growth, becoming ineffective in a recession. With respect to inflation and interest rates, "not too hot, not too cold" is the Fed's objective.
Investors can take comfort that without inflationary pressures, the Fed can take its time increasing the Federal Funds Rate while keeping a close eye on the economy. Historically, as the economy approaches full capacity, inflation trends up and triggers the Fed to increase interest rates to slow consumption and take the inflationary pressure out of the economy. As a result of slowing consumption, corporate earnings then slow, and an equity market correction follows.
Today, while the stance of monetary policy is shifting toward normalization, there is a long way to go before policy becomes normal, and even farther before it becomes restrictive. In conclusion, there is little evidence that the U.S. economy is at high risk of entering a high inflationary environment in the next 12 to 24 months. Therefore, the Fed should have time to act slowly, allowing the U.S. economy and capital markets time to adjust to modestly higher interest rates. This suggests that bond and equity market returns will be positive, but more moderated than past cycles, particularly for bonds, which are ending a 29-year cycle of downward trending interest rates.
The Rest of the World
International economies are early- to mid-cycle in their recoveries. Global monetary policies remain extremely accommodative with the European Central Bank and China recently announcing new accommodative policy measures. China's economic stabilization is key to growth in Europe and Asia as many nations in these regions depend on robust trade for economic growth.
Investment Strategy Tips for Investors
- Recognize that short and even medium term equity market volatility is normal and expected.
- Ensure that assets invested in traditional equities have time horizons of at least 5 years.
- Consider cash outflows for the next 12-24 months. Investors in the innovation sector have high risk exposure through their employment income and/or company ownership, and need access to liquidity when the times are tough. Estimate monthly living expenses, unforeseen medical or tax bills, and option or stock purchase plans. Don't neglect to consider the impact of exercising incentive stock options which can result in an Alternative Minimum Tax bill the following April. Keep cash reserves in low volatility portfolios, such as a mix of high quality tax-exempt bonds and liquid alternative hedge funds.
- Include multiple sources of imperfectly correlated strategies in your portfolio. Recognize that even the most respected professional investors are hotly debating where capital markets are going. Having multiple sources of imperfectly correlating strategies in your portfolio is good hedge against this uncertainty. Investors are advised to invest in a mix of bonds, domestic and international equities, and alternative investments.
- Keep an allocation to high quality tax exempt bonds. These investments can provide liquidity, attractive after-tax income, and stability to the portfolios of wealthy investors.
- Watch fees and taxes. In a market that is anticipated to return moderate returns for balanced portfolios, these factors are headwinds that can significantly lower the growth of investor wealth. Costs of investing could include advisory fees, custody fees, fund or ETF fees, commissions, loads, trading and miscellaneous fees. Investment returns should be reported net of all fees. Ask for a fee audit to confirm the total fees being paid v. benefits received.
- Take time to invest new cash into riskier assets. Develop an investment program that takes 3 to 6 months to deploy cash into domestic or international equity target allocations. Accelerate the program during a market downturn. (Not as much time is needed to invest cash into lower volatility assets such as bonds and low volatility hedge funds.) Avoiding steep drawdowns in the initial period of an investment program will enable growth to compound faster.
- Add or increase allocations to strategies beyond bonds that are designed to moderate equity downturns. These include both Limited Partner and liquid alternative hedge funds. For example, equity long/short strategies have outperformed the S&P 500 during periods of traditional equity market downturns. Note: the due diligence on alternative investments is far more complex than for traditional equities or bonds. Plus, for hedge funds to add value, their role in an investment portfolio, tax inefficiency and liquidity constraints need to be considered.
- Look for market sectors that may offer compelling opportunities to outperform. Based on 10-year total returns, developed international and emerging market equities appear to be opportunistic places to invest, but the catalysts that will trigger outperformance are not yet evident. Overweighting these asset classes now could be an early move.
- Call your advisor to discuss strategies to fit your needs. Market cycles and personal life stage investing needs can sometimes seem difficult to reconcile to form an action plan. Call your advisor to discuss strategies that may be relevant to your specific needs and circumstances.
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