Thoughts from Our Domestic Equity Team
On February 20th, the Fed released minutes from its most recent Federal Open Market Committee (FOMC) meeting which took place in late January. The release of the FOMC minutes contributed to a brief correction in the S&P 500 index in the subsequent days, amounting to a 3% decline before the market reversed course and recovered. The minutes included discussion of the Fed’s QE policy and there was more dialogue than in prior meetings about the potential need to slow the pace of asset purchases given the potential risks arising from continuing QE for prolonged periods. However, in the week or two following the release of the minutes, Chairman Bernanke spoke before Congress and at several other events where he indicated that QE would be unlikely to end in the near term.
Instead of viewing a rise in rates as an unconditionally negative event for capital markets, it is important to consider why the Fed might eventually want to taper down its very accommodative monetary policy. One concern held by investors is that the Fed’s policy will be too stimulative and will ultimately lead to inflationary conditions that could prove difficult to control. The Fed has been aware of this risk and as confirmed by its most recent statements, monitors inflationary pressures in the economy, which over the last few years have mostly been absent. Should inflation rear its head and compel the Fed to take action to reverse its current policy, however, we believe the impact on stocks and bonds in this case would be negative. On the other hand, if the Fed chose to tighten simply because it saw evidence that the economy was returning to health and stimulus was no longer required, one might expect the market to respond favorably to this news, once an initial knee-jerk response was more fully analyzed.
For a number of reasons, higher interest rates are negative for bond investors, regardless of the reason for the increase in rates. Inflation is the enemy of a bond investor, reducing the real yield available given a fixed coupon payment. Relatedly, a rapidly growing economy is also generally viewed as a negative for bonds since growth can ultimately lead to inflation. In addition, some investors view bonds as a ‘safe haven’ during periods when economic growth is lacking, and this cohort of investors tends to allocate away from bonds when economic growth is more robust and the need for safer investments is perceived to be lower. Although higher rates are generally viewed as negative for bonds, there are positives for corporate issuers to having a more robust economy that include better revenue growth, profitability, and balance sheet metrics, which overall should lead to improved credit quality. At the same time, the negative aspects of today’s artificially low interest rates would be ameliorated by a gradual rise in real rates, especially attractive to institutional investors such as pension funds and life insurance companies.
Global economic conditions today remain challenging, and central banks in various geographies have embarked upon QE programs similar to our own Federal Reserve. However, as we look at the data on the U.S. economy, despite the inability of our government to agree upon much of anything, many sectors of the economy are clearly improving. While unemployment is still well above ideal levels, private sector hiring is accelerating and the unemployment rate is slowly but surely grinding lower. The housing sector is now clearly trending higher as low levels of supply and improving demand have positively impacted home prices. Despite the effects of the sequester and January’s payroll tax hike, not only are consumers spending but they appear to be willing to borrow money to do so. Given these trends, it is logical that the Fed has already considered an eventual exit of its easy monetary policy. However, for the time being it is only a discussion rather than an indication of an imminent policy change. Our view continues to be that a change, if and when it occurs, is more likely to be the result of improved economic conditions which indicate that the same degree of stimulus is no longer needed, rather than the emergence of pernicious inflationary pressures.
Submitted by: John Roscoe, CFA – Senior Portfolio Manager
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