Q3'2017 FFG Newsletter
We view interest rates as the primary influencer of the stock market and therefore we want to focus this newsletter in on the policies of the largest manipulator of domestic (and global) interest rates: The Federal Reserve (“FED”). This stance of rates driving stock prices has been posited by the FED’s very own Ben Bernanke in a 2004 paper he co-authored titled: “What Explains the Stock Market’s Reaction to Federal Reserve Policy?”. Analyzing what’s in store for interest rates will help us form our outlook for managing your money these next few years. To give you the conclusion at the onset, the FED has started to (albeit incredibly slowly) scale back its highly accommodative monetary policy which has been the primary driver of stock market growth over the last decade. As the FED continues down this path in the midst of very high stock prices (based on many reputable long-term valuation measures[i]), we are trimming our return expectations on stocks and bonds over the next five or so years and shifting more of our focus to protecting against downside risk. This may take some time to benefit our investors, but given our belief that no one can make accurate short-term predictions of stock prices, we feel that risk mitigation is the primary action we can take to add value for our clients over the long-term. We are here to discuss if you have follow up questions pertaining to this newsletter. We realize FED policy is a very complex topic that often requires a deeper dive than we can accomplish in a short market update. Don’t hesitate to give us a call.
What is the FED’s Objective and How Can They Achieve It?
Congress’s mandate for the FED is to promote maximum employment, stable prices, and moderate long-term interest rates. Why? The consensus is that these conditions lead to a healthy economy less exposed to boom and bust cycles. To accomplish these objectives, the FED has three monetary policy tools at its disposal:
(1) Setting the FED Funds Rate (FFR): The overnight borrowing rate banks charge to lend their excess deposits at the FED to other commercial banks.
(2) Setting Commercial Banking Reserve Requirements: This is the portion of customer deposits that banks must hold in cash (i.e. not available for lending). The FED can further manipulate banking reserves by paying interest on reserves to commercial banks or opting out of paying interest. The more interest the FED pays, the more reserves banks will be willing to hold back from lending.
(3) Manipulating the Money Supply with Open Market Operations: The FED can buy treasury and agency (Fannie & Freddy) securities from commercial banks on the open market to increase money supply or sell securities from their portfolio on the open market to decrease money supply.
How is the FED Using These Tools?
(1) FFR - From the onset of the 2008 recession through the end of 2014, the FED kept the FED Funds Rate (“FFR”) at 0.00%.[ii] This overnight bank borrowing rate is now in the 1.00%-1.25% range after four quarter point increases in the last two calendar years.[iii] FED officials have also telegraphed their plans to hike the FFR further, with a goal of around 2.50% by the end of 2018.[iv]
- The 2008-2014 ZIRP (“Zero Interest Rate Policy”) period was intended to boost lending in the economy to pull it out of the 2008 recession more quickly. The FED’s recent rate increases have signaled that the FED believes the economy is healthy enough now to start winding down it’s highly stimulative ZIRP stance.
(2) Reserve Requirements - In the midst of the 2008 recession, the FED was authorized via the Emergency Economic Stabilization Act of 2008 to start paying interest on commercial bank reserves held at the FED.[v] In doing so, commercial banks were incentivized to hold back more deposits in reserves (vs. lending them out) to shore up the banking system which somewhat contradicted the first policy effort above (boosting lending). Total US Commercial Bank reserves held at the FED hit a peak in August of 2014.
(3) Money Supply and Open Market Operations - After 2008, in order to inject liquidity (cash) into the economy, the US government started “quantitative easing” (aka “QE”) through QE 1, 2, and 3. This process involved the Federal Reserve buying vast sums of financial assets, primarily mortgage backed securities and treasury bonds. When the FED purchased these assets, cash went into the banking system with their intention being to keep interest rates low while boosting liquidity in the hope that banks would do more lending… more lending, so the government thought, was the best way to jump-start our post-recession economic recovery.
Now ~$4 TRILLION dollars later, the FED is considering “trimming” its portfolio of treasuries and mortgage-backed securities as the economy appears to be back on good footing enabling the government to unwind these QE programs, the largest monetary stimulus packages ever put in place.
Why Recent FED Comments on Balance Sheet Trimming and FFR Increases Haven’t Crashed Markets
The FED knows that if they sold $4T of mortgages and treasury bonds at once, it would flood (and crash) the financial market, rates would skyrocket, and thus stocks would probably tank as well. In other words, there is a lot at stake and all the incentive in the world to do this slowly and transparently. The initial figure thrown around has been a $10B/mo sell-off or 0.20% of the FED’s portfolio / month with planned increases in the amount of selling capping out at $50B/month within a few years.[vi] Just to put that in perspective, it would take the government nearly 6 years to get their portfolio back down to $1T (closer to “normal” pre-2008 recession levels) from $4.5T if they were to sell $50 billion/mo in these assets starting today.
How Does This Affect Our Investment Management Process Going Forward?
We at FFG are in the camp that rates WILL continue to rise over the next couple years because of these FED policies and a growing domestic and global economy. We don’t know precisely how soon, but eventually rate increases will pose a problem for stocks as investors will see current valuations only make sense in a very low interest rate environment. Higher rates will also increase the % of the Federal Budget allocated toward non-productive interest payments on our $20 trillion debt which will be a drag on GDP. For instance, a 1% increase in the weighted average borrowing rate of our Federal Government would result in a $200B increase in annual interest expense on our debt.
With the FED’s public message being geared toward interest rate increasing policies, we have a fairly tepid outlook for stocks (and bonds) in the 5 years ahead of us particularly in light of the above average gains we have enjoyed in our US stock market over the last 8 years. These returns appear particularly outsized when compared to returns seen in Developed Asia, Emerging Markets, and Europe in the last decade which have been far inferior to our domestic equity markets. Because of these headwinds (mean-reverting return pressures and increases in interest rates) we continue to overweight real assets (gold, real estate, other commodities) and we are taking deliberate steps to rebalance our portfolios in such a way to reduce our “home country” stock bias that has been in full affect the last several years and from which we have benefited greatly.
/s/ Fiduciary Financial Group
[i] Market Cap-to-GDP, Schiller P/E 10, Crestmont P/E, Q Ratio, S&P 500 Composite Price Against a Regression Trendline as outlined by www.dshort.com – author Jill Mislinski - https://www.advisorperspectives.com/dshort