Recent headlines around the country, and even around the globe, are focusing on the two-day meeting this week by the Federal Reserve Open Market Committee (FOMC) and its decision to maintain its current pace of quantitative easing by buying $85 billion of U.S. Treasury and mortgage-backed instruments each month. This announcement surprised most investors who had been following what Fed Chairman Ben Bernanke had been saying since June. In Congressional testimony and subsequent Federal Reserve minutes, Bernanke had been signaling to markets that the overall economic condition of the U.S. was good and improving, making the need for stimulus less important. Most believed the Fed would begin a process of tapering their liquidity injections as they said they would. We had seen interest rates increase in anticipation. The Fed had done its job well, signaling well ahead of its action, and markets seemed poised to accept the new reality.
And yet, that is not what happened. Slowing economic growth, coupled with uncertainty about future budget and debt ceiling machinations within the Beltway, led the FOMC to leave their current rate of bond buying unchanged. Markets quickly reacted to the news, with U.S. equities setting new highs and the ten-year Treasury yield declining by more than 20 basis points (0.20%). Foreign markets liked the news even more, posting even bigger gains on the announcement. As we write this, U.S. markets are flat, while international markets continue to revel in the news.
The initial reaction by the markets is not a big surprise. They had expected higher borrowing costs as a direct effect of a tapering and now have a new data point that costs will not be going up due to Fed action in the near term. We will at some point have to re-live these last three months. Once the Fed signals for a second time that they will need to begin to taper, markets are likely to retrace their path of the third quarter. Certainly "the boy who cried wolf" will cross some investors' minds. We are concerned about two things: Is the Fed seeing something that markets have yet to realize? And, if not now, when – and how – do we find our way back to a market independent of Fed easy money?
The FOMC's Reasoning
The FOMC stated that the growth it had observed since its last meeting was less than it had expected, and the increase in interest rates in reaction to its previous statements caused concern that such rate increases might still negatively impact growth for the remainder of 2013. We have to imagine that the Fed knew tapering would increase rates and that increased rates tend to slow economies, so their reasoning does not come as a surprise. The issue facing the Fed is that the expectation of tapering created tightening financial conditions. This tightness, in the form of rising interest rates, has been affecting the economy, most notably in housing costs but in other areas of credit creation as well. The Fed seems to be saying it needs to signal tapering, but to have that signal not impact markets. The inclusion of the fiscal issues in Washington is a new data item in Fed releases, but is not a new item as far as markets and the FOMC's consideration are concerned. Interestingly, the Fed's concern about tightening does not seem to align with other sources of information.
The Conference Board released its Leading Economic Index (LEI) today, showing the economy improved in August, the fourth month of improvement in the last five months. The Conference Board stated that "the expansion in economic activity will continue, and the pace of growth may gradually pick up in the near term." New orders and rate spreads were two of seven indicators showing marked improvement across the ten LEI components. The Philadelphia Federal Reserve General Business Activity Index was up strongly in September, and existing home sales rose 1.7%. Because of these facts, markets were primed for the Fed to carry out its long-signaled tapering.
The lack of Fed action makes us wonder what the Fed is now seeing that markets are not. The two-pronged mandate of full employment and low inflation still seem to be attainable with a moderate and measured tapering. The Fed is obviously concerned that additional weakness will be a concern over the remainder of 2013, such that the economy needs further liquidity. The most direct impact of QE3 has been felt by financial markets, since it is a financial action to buy bonds. Much of the commentary we have heard over the last two days suggests strong support for equities for the rest of the year. On our end, we are looking less at the effects of easing and more at corporate earnings, and their rate of growth, for the remainder of the year. The third quarter will begin reporting in a few weeks, and so far the indications are for slowing revenue and earnings growth. If the Fed is seeing further economic weakness, that could play into late 2013 and early 2014 earnings, dampening the attractiveness of stocks. That being said, declining interest rates would mean that buying bonds also would pay even less than it did earlier.
How – and When – Will QE3 End?
The pick-up in rates and the equity price action we saw in early summer in reaction to the hints left by the Fed were impactful. We thought we knew how this play would run over the next 18 to 24 months. Markets were orderly, intentions well signaled, and the glide path long enough. However, now we are less sure about how the Fed will eventually end QE3. Certainly, the change in front-runner for the chairmanship of the Fed might have been a catalyst for the Fed to suspend action; Janet Yellen is well liked by the markets and perhaps even more so now. But the long-term health of the U.S. and an orderly exit from market activities by the central bank are more uncertain today than they seemed a week ago. We think there is a lot of work to do in general and now more so than ever before by the Fed.
All of this comes down to our current positioning within portfolios. Our starting point has a bias toward the U.S. versus the global capitalization of equities, and we remain close to that starting point, with a slight tilt toward smaller capitalizations, which we think will continue to benefit from cheaper interest rates. We continue to tilt our fixed income toward slightly lower quality, higher-yielding credit, looking to benefit from what little yield the market still has left to give. We are underweight our inflation hedges, both because we see little opportunity for an inflationary shock and because the price we have to pay for those asset classes today is relatively high. What inflation hedge we do maintain has been placed mostly in equities; we continue to believe that there is better near-term potential in stocks. The Fed's non-move helped bond investors claw back a little of what they had lost to begin the summer, but stocks have continued to be the biggest winner. While we will be overweight stocks, the concern about slowing growth and the Fed's hesitation leads us to still have a dose of bonds, hedging that by holding more credit risk to pick up yield.
As always, we appreciate your questions and comments.
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