YTD Benchmark Returns through 6/30/2017
T-Bill 1-3mo (Cash): 0.30%
Barclay’s Aggregate Bond Index: 2.27%
Barclay’s Municipal Bond Index: 3.57%
S&P 500: 9.34%
Russell 2000: 4.99%
MSCI EAFE (International Stocks): 13.81%
MSCI Emerging Market Stocks: 18.43%
Credit Suisse Hedge Fund Index: 3.35%
Data provided by Orion
FINANCIAL MARKET PERFORMANCE
Stock markets performed well across the board, continuing the great performance of the first quarter of the year. Performance in international and emerging market stocks was particularly strong. Fixed income markets performed well as longer term interest rates fell from the levels reached at the start of the year.
THE TAIL WAGS THE DOG
The economic performance for the first quarter was revised higher to 1.2 percent, which is still disappointing. The full year growth forecasts have been downgraded as fiscal stimulus expectations have disappointed, holding the economy on a 2 percent growth trend.[i] The estimate for long term growth in the US economy has been falling over the past several years according to the economists at the Federal Reserve. The Federal Reserve’s mandate of full employment and stable prices as defined by 2% annual inflation are both within grasp. Subsequently, the Federal Reserve continues to communicate its desire to steadily remove the accommodating monetary policy and increase short term interest rates towards a more neutral level.
The Federal Reserve Open Market Committee has increased the Fed Funds Rate twice this year, bringing the total number of interest rate increases to four since the benchmark interest rate was cut in response to the global financial crisis to an incredibly low emergency range of 0.0% to 0.25%. The longer maturity Treasury bonds have not reacted to this rise in short term interest rates. Due to expectations of lower growth, tamed inflationary pressures, and a lower target level for short term interest rates, longer maturity treasury bonds have continued to hold their premium. Eight years after the start of the post-crisis recovery, the economy continues to struggle to grow at a pace that only a decade-ago would have been regarded as slow. The headline unemployment rate is at a respectable low, but much of this is due to a smaller number of people in the labor market. The ability for monetary policy programs of an immense magnitude to spur growth seems to have fallen flat.
This all fits into the fact that asset prices are at lofty levels, operating profits and per share profits for companies will be exceedingly difficult to grow without revenue growth. The economic data that points to a cyclical peak within the U.S. business cycle is growing, and the pressure of the Federal Reserve’s continued rate hikes on the markets is finally starting to be felt. The economy and stock market may prove to be less than invincible, though the measures of volatility stubbornly continue to disagree. Index fund investing continues to grow in popularity, and too few people appear to be asking if it is prudent to buy an investment simply because it exists. The responses to the financial crisis by the Federal Reserve pushed the costs of borrowing to incredibly low levels in order to utilize the financial markets to drive economic growth. This policy impacted the real economy in such a way that the roles became reversed. Policymakers had been using financial markets to steer the overall economy towards a faster growth rate. In effect, financial markets had decoupled from their traditional role of seeking equilibrium, and grew distorted as they became a policy tool to engineer growth across the economy. The economy was forced to react to the financial markets, rather than the traditional relationship which demanded that the market react to the changes in the economy.
HUBRIS, INFALLIBILITY, AND UNINTENDED CONSEQUENCES
Markets are understood by academics and policymakers to be largely efficient. This concept was presented and adopted decades ago as academics failed to identify consistent example of inefficiency. Inefficiencies are difficult to prove as they are not usually static. The assumption of efficiency is useful, but dangerous. This assumption grows weaker when controls and policy tools restrict the behavior of individual investors and consumers. The creation and utilization of economic models to better understand the complex aspects of the economy has been undoubtedly fruitful, but it can become an issue when the models are applied in circumstances that greatly differ. The fundamentals of monetary policy are hinged on the ability of the central bank to anticipate the demand of money and adjust supply in such a way that the price and availability of money propagates through the economy effectively enough to create a stable growth environment that fosters employment growth and stable prices.
From a monetary policy perspective, interest rates are a blunt instrument. Economists expect that by decreasing interest rates to make borrowing cheaper, people will consume more and economic growth will increase. Many individuals outside of the high-income segment of consumers did not take the opportunity for cheaper borrowing to consume more. Cheap borrowing has the effect of shifting future consumption into the present. Low interest rates spur higher asset price valuations, and economists hoped that these higher asset prices would create growth through the wealth effect, a theory that attempts to explain a phenomenon that causes consumers to spend more when they feel wealthier due to rising asset prices. The expectation of very easy monetary policy was for consumption to increase, and inflation to rise as businesses may not be able to cope with the higher consumption and the additional money and spending in the economy would create a slightly higher degree of scarcity as more money would chase fewer real goods and services.
Paradoxically, this didn’t happen for a few reasons. Much of the surge in borrowing did not occur by individuals borrowing more as much it came from increased corporate borrowing. Lenders largely found corporations to be a more attractive borrower after the impact from the financial crisis left many individuals with poor credit scores and a much smaller appetite for borrowing as the scars from the Great Recession still lingered on. Under normal circumstances, this may have also boosted economic growth as spending by corporations is still counted as economic activity. A substantial portion of the funds were used for mergers, acquisitions, share repurchases, and special dividends. These activities, excluding dividends, do not get accounted for directly in calculations for measuring gross domestic product. They do not necessarily cause higher economic growth, and may hinder it in some cases. The purpose of these transactions is to boost earnings per share only to drive stock prices higher. Small and midsized companies contribute to much of the job growth and overall performance of the economy. These companies often struggle to obtain capital compared to their larger peers. Advantages of scale and size are not necessarily rewarding the biggest companies because they offer the best product at the lowest price. These advantages reward large companies by allowing them access to larger and cheaper sources of capital that their smaller peers cannot. This drives larger companies to acquire their smaller competitors, while also shielding larger companies from the competitive forces that they may be subject to with higher interest rates.
The current risk of using the blunt tool of monetary policy is not primarily that inflation will grow out of control, but that the effects low interest rates may contribute to broad misallocations of capital across the economy that can negatively impact growth. Low interest rates allow companies to borrow money and repurchase shares to grow profits much more easily. It pushed up financial asset prices, and property prices. Low interest rates also allow governments to continue to spend with much lower interest payments alleviating concern for fiscal reforms. Low interest rates also hurt older retirees that live off of the incomes generated by their investments. It pressures the business models of key industries such as insurance, and traditional banking. Lastly, it punishes saving, which is already at an unacceptably low level for many Americans. The Federal Reserve amongst other large central banks around the world have started the slow and lengthy process of moving towards a more normal interest rate policy just as economic data begins to weaken. It appears that the omnipotence of central bankers may be questioned with some legitimacy after all.
Fixed income will continue to be a more difficult asset class to navigate over the next 12 to 24 months, but our focus remains on managing the overall risk of the fixed income segment of the portfolio allowing it to provide a degree of stability while still generating current income. The Federal Reserve still maintains a broadly dovish bias in the process of rising interest rates. This may cause the process of normalizing monetary policy to become slower than the trajectory currently advertised. Many equity markets may struggle to maintain lofty valuations as growth in operating profits may be difficult to capture, and high interest rates may cause investors to decrease their search for yield in the higher dividend paying sectors of the market. These changing trends are not immediate, but they will likely have strong impacts on overall performance over a multi-year period.
These are the opinions of Newport Advisory and not necessarily those of Cambridge, are for informational purposes only, and should not be construed or acted upon as individualized investment advice. Diversification and asset allocation strategies do not assure profit or protect against loss. Indices mentioned are unmanaged and cannot be invested into directly. Past performance is not a guarantee of future results.