The following is commentary from a financial planner in hunt valley md, on the recent news of the Federal Reserve’s decision on whether or not to raise the fed funds rate.
For weeks, the investment world has been anxiously waiting for the Federal Reserve to announce its decision to raise the fed funds rate by 25 basis points, the first increase in roughly six years. The climax scheduled for this Thursday will be the most widely advertised and anticipated change in Fed policy in history. It is also proving to be one of the more difficult to handicap, since Fed Governors have been playing cat-and-mouse with the media. Professional betting sites indicate slightly more than a 50% probability that rates will be raised, but there is a large and vocal minority that believes the Fed will delay any such change until December. There is rampant speculation as to what the effects will be on the stock market either way. This uncertainty has taken on more significance since investors are dealing with the first meaningful correction in almost four years, growing concerns regarding global economic prospects in light of the slowdown in China and instability in currency markets. This unrelenting Fed fixation has given rise to unending opinions and commentaries, and any attempt to replicate or distill would only serve to confuse the issues. We prefer to offer a few perspectives on the real significance of the pending decision and the implications for portfolio strategy.
PERCEPTION VERSUS REALITY
The first point to be emphasized is that no one “knows” what will happen on Thursday. While the Fed officials have made it clear that the decision will be dependent upon data showing strength in the U.S. economy, inflation trends and employment, there are caveats related to global developments, currency fluctuations and market conditions that make it uncertain as to when they will pull the trigger. Recent data releases could be used to argue either for or against an immediate rate increase, while global market instability and currency pressures provide ample cover for the Fed to blink once again and defer such a policy shift for later in the year. Public comments by Fed Governors indicate divided opinions which make this decision a coin toss.
More elusive, however, is the likely impact on stocks in reaction to any decision, and therein lies the rub. The Fed has created confusion and a policy nightmare by pursuing massive liquidity injections through Quantitative Easing and Zero Interest Rate policies for the past six years. While appropriate as a response to a banking crisis initially, sustaining these unprecedented measures has created false expectations on the part of investors and has raised serious challenges in trying to develop an exit strategy. The Fed embraced an untested theory that excess liquidity would flow into risk assets (primarily real estate and equities) which would increase in value and enhance household sense of wealth. Rising wealth would then translate into rising spending and broad economic recovery. Thanks to zero returns available on safe investments, a portion of the $3-4 trillion in excess liquidity created by QE did flow into financial assets; however, the presumed secondary effect on the economy did not follow. The key point is that investors have clearly linked the recovery in equities to the Fed’s aggressive monetary policies rather than to any conviction in the strength in the underlying economy. If the Fed now takes away the proverbial punchbowl, the conventional thinking is that the party is over.
In contrast to this perception are two realities. First, over the past fifty years, there have been numerous cycles characterized by reversals in monetary policy. In over 80% of these periods when the Fed has decided to adopt a less accommodative policy by raising interest rates, equities have encountered a temporary setback followed by an extended uptrend that produced very positive returns over the next 12-18 months. While it could be argued that economic conditions were different during those experiences, the fact remains that it required a string of successive rate increases that ultimately restricted further economic expansion before stocks took it on the chin.
And second, history also demonstrates that previous periods of extended, excessive monetary accommodation and ZIRP contributed to a mispricing of risk, a misallocation of capital and asset bubbles that ultimately led to more serious economic dislocations and market losses. Simply examine the 2008 collapse in real estate following the Fed’s ZIRP from 2001 on. ZIRP on a sustained basis does not produce economic benefits and can lead to continued sub-par growth and deflation. Japan’s meager economic progress over the past 25 years is ample proof of that perspective.
The purist in us would advocate that the Fed should discard its perceived role as a manipulator of markets and restore its credibility by beginning the process of allowing interest rates to normalize to reflect free market forces. A 25 basis point increase in fed funds will not shock the economy or precipitate a recession; it is about symbolism of a return to appropriate monetary policies that will allow capital to be efficiently allocated by free market forces.
The portfolio manager within us has to acknowledge that a pre-emptive move by the Fed on Thursday contains short-term risk since investor reactions are unpredictable. Over the past month, 75% of trading days have resulted in triple-digit moves in the Dow. The only comparable periods of market volatility in recent history were December 2008, November 2011 and July 2013. Uncertainty currently dominates fragile psyches. A meaningful percentage of both individual and professional investors have never had to manage money in a rising rate environment, making it difficult to gauge how they will respond to a new Fed paradigm. Over short periods of time, perception can be reality, and a market decline borne out of fear can become self-sustaining. No Fed Chairman wants to preside over a serious decline in the equity markets and be blamed for exacerbating turbulence in global economies and currency markets, so the probability for Yellen & Co. to blink on Thursday and defer increasing rates until later in 2015 is high. This is a classic confrontation of short-term pain versus long-term gain.
Up to this point, the market decline has been very typical of a “standard” intermediate correction that has characterized every bull market. The differences are (a) that we have had to wait almost four years to experience one, and (b) the speed of this decline (about 14% peak-to-trough) has been more rapid. Since we are agnostic on which way the Fed will go, we are guided by prior periods and believe that probabilities point to a retest of recent lows before equities can resume a more sustainable uptrend going into yearend. We do not see a high risk of a global recession or systemic financial crisis that would validate a cyclical bear market in equities at this point – even if the Fed raises rates. As a result, we view this correction as an opportunity to harvest losses for tax purposes and upgrade holdings. The contrarian in us is tempted by the sold-out valuations in many value issues and foreign markets; however, we suspect it is still too early to abandon our emphasis on U.S. stocks with a growth style bias due to the likelihood of continued strength in the dollar.