The Federal Reserve’s current quantitative easing (QE) program that started in 2008 has been the most extreme monetary stimulus that it has ever applied to the U.S. economy. In an effort to provide the markets advanced warning of any future changes, Federal Reserve Chairman Ben Bernanke recently began discussing that the Fed could begin to taper QE; that is, reduce its pace of asset purchases, possibly as early as later this year. The bond market immediately went into a tailspin as the reality of rates moving higher over time set in.
Our opinion is that while Ben Bernanke has been an incredible Chairman during the financial crisis helping save our financial system, his recent comments seem premature and could end up being detrimental to the goals they are attempting to achieve. The last thing the Fed wants to do is reduce the “medicine” too quickly at the first sign of improvement and then watch the patient fall back into a coma. They have come too far with this historic monetary policy campaign to suddenly make dramatic changes before unemployment improves and economic growth picks up. They seem to agree as a number of Fed officials have been in damage control mode the past few days as they try to walk back the comments made by Ben Bernanke on the timing of winding down QE3.
Since last September, the Fed has bought Treasuries and mortgage-backed securities at a monthly pace of $85 billion, while reinvesting interest and principal payments. This pace of purchases, if maintained, would boost the Fed’s assets from $2.9 trillion in early 2013 to $3.9 trillion by year’s end. These huge asset purchases, combined with a federal funds rate at 0-0.25% and explicit guidance on the conditions necessary for Fed tightening, represents the most extreme monetary stimulus ever applied to the American economy.
The Fed is also increasingly aware that its fast-expanding balance sheet carries dangers of its own. The Fed has increased the size of its balance sheet by paying banks interest on the reserves they hold with the Fed (as opposed to lending out to the private sector). However, this also implies that in order for the Fed to raise the federal funds rate (when they finally deem this appropriate) it will need to increase the interest paid on reserves in tandem. The problem is, that with banks holding a projected $2.5 trillion with the Fed by the end of 2013, if the Fed, over the next few years, raised the federal funds rate to a roughly “neutral” level of 4%, the 4% interest that they would then have to pay on bank reserves at the Fed would cost them $100 billion per year, which could leave them in a net negative income situation. If they tried to avoid this by selling bonds and shrinking their balance sheet they could push long-term interest rates up too quickly. Conversely, if they postponed rate hikes altogether, they could set the economy up for inflation. The bottom line is that the bigger their balance sheet gets, the more expensive it will be to maintain it and the more disruptive it will be to dismantle it. This is why the Fed felt it necessary to start discussing the process of slowly unwinding the historic amount of stimulus well in advance of any real changes in policy. This is a very tough job for Mr. Bernanke and the Fed but as long as economic growth improves and earnings continue to rise the stock market should hold up.
The real concern is in the bond market after the “preview” we got over the last few weeks in response to the Fed’s comments. The traders in the market will certainly try to make the short term “fear” of bond prices falling as interest rates rise more painful so they can make a quick buck. We are analyzing all of our bond positions to make sure we have shorter maturities and are also researching floating rate and convertible bonds that adjust to rising interest rates. The market reaction to the Fed’s comments was premature and we expect bonds to bounce back short term which will allow us to adjust our portfolios over the remainder of the year. Until we see jobs of over 200,000 for several months and GDP numbers moving back to 2% or above the Fed is likely to put a lid on any comments about any impending unwinding of stimulus. Otherwise they risk failing to achieve their intended goal of reducing the unemployment rate into the 6.5% range. Just the threat of higher rates last week is likely to have reduced consumer and business confidence short term – I would imagine they wish they had a “mulligan” on Mr. Bernanke’s comments…
Year to Date Investment Results at Halftime:
While U.S. large cap stocks have gone up nicely in 2013, diversified investors have seen results hampered by underperforming asset classes such as bonds, emerging markets, commodities and developed international stocks. To give you some basic yardsticks here are the estimated performance figures year to date in these asset classes:
Intermediate Bond Market: -2.5%
Emerging Markets: -12.8%
Broad based Commodities: -9.8%
Developed International (ex Japan): -0.6%
We also have a few U.S. large cap stocks in some of our portfolios that have trailed the market short term:
Apple -26% (trading at 9 p/e with a 3.13% dividend)
Caterpillar -7.7% (trading at 11 p/e with a 2.9% dividend)
Deere -3.86% (trading at 10.2 p/e with a 2.45% dividend)
Exxon +3.94% (trading at 9 p/e with a 2.8% dividend)
Outlook for the remainder of 2013:
The rotation out of bonds we anticipated has begun, which will continue to be a catalyst for stocks. One concern we have in the short term is that earnings comparisons are tough for second quarter and investors will be very interested in CEO comments on estimates for the remainder of the year. If guidance is good the market should handle lower earnings growth rates in the current quarter vs. a year ago. A number of U.S. large cap stocks have seen a rise in price that takes their p/e multiple into the higher end of fair value (17-20 times earnings). While the preference for dividends will support large cap stocks for the foreseeable future, institutional investors are likely to re-allocate more funds to other asset classes that are trading at a discount throughout the remainder of the year. Emerging markets and commodities could see a turn around and finish the year much stronger if China lays out a clear plan for balancing growth with the goal of curtailing the upward trend in loans. The second half of the year will also see politics return to the front page with immigration and spending bills coming up for vote. We talked about Congress could be a catalyst for the markets if they “just do anything” but much to their recent track record thus far in 2013 they have done nothing. Hopefully they will surprise investors and cooperate on a few major issues later in the year…