My apologies for the lateness of this post but it’s been a rough few days for the Yinzer Analyst. I’ve been meaning to write a post-FOMC update for a while, but did you ever have one of those days where you couldn’t start something without a distraction coming along? Well after a few days of dallying with mutual funds, derivative prices and telenovelas, I’m back in the saddle. Don’t judge me, you try not getting sucked into La Patrona. But to make up for it, it’s time to do a deeper dive on what the FED is planning, why they’re doing it and how it could affect your portfolio.
When it comes to the FED and their announcement on Wednesday, there is literally so much you could talk about and almost none of it is worth mentioning. Meetings that end with a press conference are fascinating; so much energy is spend debating the meaning of every word that Chairwoman Yellen utters that I think a lot of people tend to miss the bigger picture. Some focused so much on the term “extended period” that they overlooked the importance of the dot matrix and that the FOMC thinks interest rates will have to rise faster than they previously thought. To be fair, they always think that and for the last few years, they’ve always been wrong too which is partly why the FED fund futures show a far less steep advance over the next two years. But the amount of separation between the fed funds futures and the dot plots is pretty amazing. But remember the essential message, rates are going to go up and whether they start in the 2nd or 3rd quarter of 2015, it’s time to start thinking about ramifications. Besides, the most important lesson to remember is that the Fed doesn’t have to raise rates to get them to move higher. They just have to signal what they plan on doing and the market will often beat them to it.
For my money, I’m not so willing to bet against the FED on this one. Recently a friend invited me along to hear the new president of the Cleveland FED speak at a luncheon hosted by the Economic Society of Pittsburgh (yeah, we have one of those and what’s it to you?) I mostly skip the prepared remarks and just go to the Q/A because you will always two questions:
- Why does the FED hate savers? Always asked by a local credit union manager. The answer is that there are more borrowers than savers, so get over it.
- When will velocity rise?
Loretta Mester (Cleveland FED) did something I’ve never noticed before when someone asked her about #2, she smirked and from her answer I took away that the FED’s goal is to increase velocity and they’re going to do it the only way they can…by raising interest rates. I don’t want to spend too much time debating the quantity theory of money or whether Keynes or Tobin’s Liquidity preference theory was the right one because at the end of the day, no one cares. What they do care about is that there’s a clear and established relationship between velocity and short-term interest rates and correlation doesn’t equal causation but the FED has one thought it mind. When QE3 ends, how can they stimulate the economy further? Fiscal policy is too tight and they don’t want to create additional imbalances through low rates, so why not raise them instead?
Remember, there’s always a certain amount of “money” being kept in transaction accounts because enough individuals know that at some point, rates are going to go up and the value of their bonds (or in this case, bond funds or etfs) will suffer. They hold onto to excess cash because they know that in the future, rates will rise and affecting the value of their bonds. Some invested in equities, but even then there’s a resistance to investing more in risky assets. The textbook (and old one in this case) says that as rates rise, liquidity held in reserve will fall. Why?
I. Because at every rate increase, some investors will believe that future rate increases are less likely.
II. Some will want to lock in lower financing costs now by borrowing and spending.
Think of it with a home mortgage; if a 30 year mortgage is now 4.25% but you think could be 5.25% in six months, that’s a motivation to spend today. If two holds, you could actually get an increase in economic activity as the FED raises rates which would lead to their needing to rise faster than most investors originally thought.
Strategies around the FED:
I can’t pretend that I have all the answers or even very well thought-out answers about how to deal with life after the end of “extended period” but I know it’s time to be asking the questions. It helps to take the major steps of the QE process one at a time:
- Real rates have been negative in the U.S. for some time, which encourages all sorts of risk taking behavior that don’t result in riding a shopping cart of a roof. Actual inflation was modest but still higher than short-term rates. The U.S. took over the role of Japan in the late 90’s carry trade.
- Those negative real rates spurred investors to seek out yield wherever they could with a major capital flows into emerging markets, commodities, equity precious metals and real estate. Those trends reversed over the last few years due in large part to all the hot money that flowed into them in 2010 and 2011 and because the specter of deflation has largely been defeated.
- Within the credit arena, there was a massive quest for yield that led spreads lower almost universally across all fixed income asset classes. Think emerging market bonds where at times a 10 year Egyptian bond could offer the same yield as a ten year Treasury.
- Negative real rates or even very low nominal ones allowed for much higher equity valuations. Even if you hate MPT, remember that it’s the most commonly used language within the capital markets. I remember using a modified dividend discount model to estimate investor return expectations and was shocked by how low that could be until a friend at Booth reminded me that real rates were negative. Even the old fashioned CAPM will show a low cost of equity given how low rates are right now.
And all of that is about to change. Peel back the surface and it’s already happening as the reality of higher rates in the near term meets falling inflation expectations to help lift real rates into positive or at least less negative territory.
First, the US dollar has broken out its long term (using monthly charts) pattern and moved higher. A cooling off is in order but with the reduced attractiveness of EM investments not to mention the pain trade in the Euro, the dollar will probably have a floor before too long and good luck getting it lower which should cause only more pain for commodities from here on unless inflation becomes a clear and present danger.
The brief rally in commodities and precious metals at the start of 2014 as a period of economic weakness kindled hope that QE would have to be prolonged has ended as higher rates are a certainty while inflation is still low. The FED’s made it clear that they really aren’t all that willing to consider higher inflation at this point.
Sectors that were bid up because of their higher dividend yield have suffered as rate increases are a surety at this point. Utilities and REIT’s are also “price takers” in that higher interest rates will directly affect their return to investors, XLE is tied to oil and thus to inflation as is GLD while XLF is a price maker and a steeper yield curve and the prospect of higher rates and higher transaction demand is giving hope to both higher net interest income and fee revenue. Take a look at the chart of the last 6 days ending 9.18. XLU is doing better today, but only as a defensive sector against broader equity weakness.
History has shown that stocks can do well in a rising rate environment, but earnings have to be growing at a faster clip. Rising rate environments usually occur during periods of fast economic growth as the FED seeks to pump the breaks on economic output. So far in 2014 the trailing twelve months EPS growth for the S&P 500 has been approximately 3% (which includes about .5% drop in shares outstanding) so not much faster than overall GDP while margins have begun to pull back. The mild p/e multiple expansion in 2014 partly accounts for that lack of earnings growth. Going back to the DDM, if interest rates rise and growth remains anemic, it becomes that much harder to justify current valuations.
So my question to you is this, what else is going to change going forward and how can you plan for it? While Europe continues to take too much getting its act together, I think favoring the areas where fiscal policy has to be loosened while monetary policy is also easing makes sense. That’s Europe in a nutshell and certain EM markets have seen the bulk of their capital outflows happen already. China looks like it’ll stabilize at a lower growth rate, but given the equity weakness of the last 3 years that’s already baked in.