October 2015: What In The World?!

 

This quarter, we're going to address three current headlines: 

  •        Will Janet Yellen and the Federal Reserve finally begin raising interest rates?
  •        What’s going on in China, and why does it matter? 
  •        Why has the stock market become more volatile?

 1.     Will Janet Yellen and the Federal Reserve finally begin raising interest rates?

As we said last quarter, Janet Yellen has assured financial markets that the Federal Reserve (the “Fed”) is thinkin’ about fixin’ to get ready to maybe act upon the strong possibility of entertaining the idea of raising interest rates at some indeterminate time in the future.  We can now add to that her recent underlying message, “Trust me, I might decide to change my mind I’ll probably do what I’ve previously indicated I will do.” 

Will the Fed raise rates? The only conclusion we can derive from what the Federal Reserve has said and done is… maybe. It appears that they’re going by the seat of their pants, making stuff up as they go along. Continuing delays and excuses about raising rates has created, not lessened, uncertainty in financial markets and now calls into question the Fed’s credibility.

So, why the delay in raising interest rates?  After all, the Fed has been proclaiming for some time that they want to “normalize” interest rates and will begin raising rates “soon.” (“Normalize” is Fed-speak for lifting interest rates beyond zero. “Soon” means not now.)  We’re told the economy is growing and strengthening, and the Fed’s targets of 5% unemployment and 2% inflation have nearly been met.  Yet, is the economy too fragile to sustain a measly 0.25% interest rate increase?  Or, is there another agenda at work here? Is the Fed concerned that foreign economies are stuck in neutral—especially Europe and Japan—and that raising U.S. rates would go against their easy-money policies that aren’t working they are hoping will jump-start their economies?  If so, it appears we have yet another Fed mandate—propping up foreign economies.

Federal Reserve History:  To better understand the Fed’s actions, we need some historical context. When the Federal Reserve was established in 1913, they had a single, broad mandate, “provide the nation with a safer, more flexible, and more stable monetary and financial system.” (see: http://www.federalreserve.gov/faqs/about_12594.htm) After WWII, without an official change in charter, the Fed decided that their mandate should include “influencing money and credit conditions conducive to full employment and stable prices.” Okay, maybe it wasn’t an official mandate, but who would possibly oppose maximum employment, right?

The next step of the Fed’s unofficial transformation was adding another mandate, “maintaining the stability of the financial system and containing systemic risk that may arise in financial markets” (italics added). 

Under the guidance of Alan Greenspan (Chairman of the Federal Reserve from 1987-2006) the Fed made it their de facto policy to prop up the stock market and avert volatility (i.e., stave off declines from the bubbles the Fed helped create, like the tech bubble and housing bubble).  This unofficial mandate even earned a name on Wall Street, it was called “the Greenspan put.” (Note: In financial jargon, a “put” is the right, but without obligation, to sell at a set price, thereby providing a floor to limit stock market losses.) Again, not an official mandate, but Wall Street loved it! Besides, who would possibly oppose a high and stable stock market, even if it was contrived? 

Most recently, it appears the Fed has adopted another unofficial mandate, “propping up foreign economies.”  Based on what the Fed has done (forget about what it says and look at what it does), the Fed has taken it upon themselves to broaden its charter well beyond its official mandate. It is choosing to delay interest rate increases to avoid possibly roiling foreign economies and acting in opposition to Japan’s and the European Union’s easy-money policies.

The expanding Fed mandate now includes: full employment, price stability (low inflation, no deflation), propping-up stabilizing financial markets, promoting domestic economic growth, and, assist foreign economic policies. Wow! They’ve taken on everything except global warming!


Dorothy (Janet), You’re Not in Kansas Anymore

The Chairman of the Federal Reserve resembles the Wizard of Oz—the all-powerful Wizard purporting omnipotence, capable of all things.  The Wizard was not truly all-powerful, but people believed he was all-powerful. Then Dorothy looked behind the curtain and discovered that the “all-powerful Oz” was just a guy (or, in Janet’s case, a gal) working some levers and pretending to be all-powerful.  Today, the premise of “everybody knows the Federal Reserve Wizard is all-powerful and won’t let the stock market decline” is being questioned and examined; the confidence people have in the Fed’s capabilities is eroding.  This waning confidence is shaking investors from their complacency and causing them to re-evaluate their appetites for risk.

How do we respond?  We sit tight and stay conservative with our investment funds. 

2.     What’s going on in China, and why does it matter?

China’s reported growth has declined from a 2007 peak (pre-financial crisis) of 14%, to a recent rate of about 7%.  These official Chinese figures cannot be verified (and, amazingly, are so accurate they are never revised). It’s likely that actual growth is less than the official rate. Still, China, like Japan in the 70’s and 80’s, has been a miracle economy, growing at an astounding average annual rate of nearly 10% from 1990 through 2006.  However, just like Japan and every other miracle economy, the “magic” wears off after awhile.

Still, 7% growth is significant growth!  So, why does it matter? It matters because when an economy slows, it impacts all its trading partners.  Like it or not, no country’s economy operates in a vacuum.  Further, as the world’s second largest economy, China is responsible for nearly half of the world’s annual consumption of basic industrial commodities: aluminum (54%), nickel (50%), copper (48%), zinc (46%), tin (46%) and steel (45%). When China’s demand plummets, like it has in the past year, the economies of the countries that provide those commodities to China are adversely impacted significantly.

China’s slowing is not sufficient to derail the U.S. stock market.  However, it’s just one more thing to shake investors from their complacency and cause them to re-evaluate their appetites for risk.

How do we respond?  We sit tight and stay conservative with our investment funds.      

3.     Why has the stock market become more volatile?

We have, ad nauseum, talked about the distortions in financial markets caused by loose-money policies (e.g., Quantitative Easing and zero interest rates). Five years of creating trillions of new dollars looking for a home, along with suppressed interest rates, has caused investors to pursue alternatives to near-zero interest rates on cash; investors have piled into riskier investments they would normally avoid.  The Fed’s efforts to stimulate economic growth—by flooding the marketplace with cash—have resulted in investors taking on ever-increasing risk. That willingness to accept risk is now being questioned.

In addition, investors have recently experienced an inconvenient truth about stocks—when stock prices decline sharply, the equivalent of several years of dividend income can be lost in just a few days.  This hard-learned experience tarnishes the attractiveness of stocks as alternatives to low interest bank deposits.  Investors’ willingness to accept risk is fading and is being replaced by a more guarded outlook.  As complacency gives way to concern, downward volatility creates fertile ground for still more downward volatility. 

Bear in mind that markets are simply a clearinghouse for disagreement.  There must always be two opposing sides to each transaction—when one investor sells, another buys.  Usually, the supply and demand is closely matched and prices move gently. But, when there is an imbalance—for example, when more investors want to buy than want to sell—prices spike higher to adjust the surplus of buyers and shortage of sellers.  Conversely, when more investors want to sell than buy, prices plummet quickly, like on August 24th when the Dow Jones Industrials lost 1,089 points in the first six minutes of trading.  If investor concern continues to grow, investor preferences will shift away from risk-taking toward risk-aversion, demand for stocks will fall, and stock prices will decline.  Increased volatility is yet another reason for investors to pause and re-evaluate their appetites for risk.

How do we respond?  We sit tight and stay conservative with our investment funds. 

Conclusion

There is no getting around the fact that these are strange and difficult times for investors.  When we talk to clients and associates about the economy and investment markets, we hear a recurring theme—things just don’t seem right. They explain it in a variety of ways, but always convey the same uneasy feelings about out-of-whack markets and distortions in the economy. 

We and they are not the first to recognize this.  Since the beginning of the year, the following notable investors have expressed similar concerns: Ray Dalio, Jeremy Grantham, Stanley Druckenmiller, Paul Tudor Jones, Carl Icahn, Sam Zell, George Soros, Crispin Odey, Robert Shiller, Julian Robertson and Mohammed El-Erian. 

Since no one has ever experienced monetary policies of these proportions from beginning to end, we can’t rely solely on prior experience.  However, we can rely on a few axioms that hold true in all circumstances—overvalued stocks will not stay overvalued forever, diversification is your ally, and portfolios are best positioned conservatively when fundamentals have been artificially overridden, like now.  That’s why our managed portfolios are broadly diversified and conservative, with below-average stock allocations.

We invest your money carefully and prudently, as if it were our own.  That’s why we invest our clients’ portfolios (moderate allocation strategy) and our company pension plan the same way.  Thank you for your continued confidence and support. ***

Greg Schultz & Bruce Grenke

© Asset Allocation Advisors, Inc. 2015