The Fed's Double Whammy

Greetings!  I hope everyone is having a great start to their summer.  The markets have shown continued strength since we elected Donald Trump as our President back in November.  The Federal Reserve also raised short term interest rates again, and expects to do so once more later this year.

The economy does appear to be strong right now, but politically things are starting to heat up.  Tension with North Korea and Russia continues to grow, and Mr. Trump is consistently finding himself in self-inflicted turmoil.

Despite the political climate, many investors I’ve spoken with recently seem to be “lulled” into a false sense of security.  It’s hard to blame them with the stock market marching steadily upward.  It’s been so long since our last correction that it’s easy to forget the market can go down, too!  

As I touched on last quarter, the stock markets are somewhat expensive right now.  I wouldn’t recommend selling your positions in expectation of a crash.  Instead, recommit now to your long-term investment strategy.  When another crash eventually comes, you’ll know where you stand, and have more confidence in your strategy going forward.

U.S. Economy & Government Bonds

Seems like every time I sit down to write Investment Insights, it begins with an update on the Federal Reserve and a recent interest rate decision they’ve made.  I don’t mean to be redundant, but this is an important theme that investors should be following.  The Fed met on June 14th, and decided to raise short term interest rates to 1%-1.25%.  

The move conveys our central bank’s belief that the economy is strong and will continue to grow.  Unemployment is at its lowest rate since 2001 at 4.3%, as the economy has added jobs for 80 consecutive months.  

What’s also interesting are Fed chair Janet Yellen’s comments about the bank’s balance sheet.  Starting in 2008, the Federal Reserve began buying up assets to inject cash into the banking system and further stimulate the economy. 

You can see in the chart above that asset purchases tapered off in 2014.  The Fed hasn’t bought anything since then, but still holds $4.5 trillion in mortgage backed & treasury securities on its books. 

In her press conference after the Fed’s June meeting, Yellen commented that the bank would begin selling off some these holdings.  Starting at $10 billion per month, the bank would unwind their balance over time depending on the how economy “evolves”.

There are two reasons that these comments are important.  First, just like raising interest rates, asset sales indicate a tighter monetary policy.  By selling off assets, the central bank is inserting mortgage backed and treasury securities into the capital markets.  In return, it’s accepting cash that’s currently circulating through the banking system. 

But rather than reusing that cash, the Fed will simply remove it from circulation.  Less cash in the banking system is a ”tighter” policy, which tends to put a damper on economic growth.  With the interest rate hikes, this means the Fed is employing a tighter policy from two different angles.  It’s a lot like tapping the foot brake and parking brake on your car at the same time.  Slam on them too hard and you’ll skid to a stop.

The second reason this policy is important relates to the markets for treasury and mortgage backed securities.  Of the $4.5 trillion of securities the Fed holds on its balance sheet, $2.5 trillion consists of U.S. treasuries (debt issued by the federal government).  And with around $14 trillion of U.S. treasury securities in existence today, that means the Federal reserve owns 17.7% of all U.S. debt that’s held by the public.

The largest foreign holders of U.S. debt are Japan ($1.1 trillion) and China ($1.09 trillion).  This makes the Federal Reserve a huge portion of the market for our government’s debt. 

So what will happen when the bank begins to sell this debt?  The market for U.S. treasuries is somewhat tenuous, now that we’re in a rising rate environment again.  But when one of the biggest debt holders starts to unload their positions, prices could U.S. treasuries could see additional downward pressure.

Should investors be concerned?  Only if you’re planning on unloading U.S. treasuries yourself in the next 3-5 years.  Most investors hold treasuries until maturity, for security and income purposes.  An unwinding of the Fed’s balance sheet would only affect their market value.  If you own treasury bonds you’ll continue receiving income, as well your principal when the notes come due.  If you plan to sell bonds in secondary market before they mature, just know that you could be competing with an oversupplied market, thanks to the Fed.

Of course, the Fed’s current direction is heavily influenced by its chair, Janet Yellen.  Fed chairs serve four year terms after presidential appointment, and Yellen’s will be up in January of 2018.  President Trump has indicated it’s unlikely that he’ll reappoint her to another four-year term, but hasn’t yet made up his mind.  At this point, Trump advisor Gary Cohn is leading the search for Yellen’s successor.  With no clear frontrunner, there’s no telling whether the central bank’s current course of rising rates & balance sheet reduction will continue at its current pace….or at all.


U.S. Equities

The big news from the stock market recently is Amazon’s agreement to purchase Whole Foods.  I don’t usually comment on individual securities (as I prefer low cost, diversified funds).  I’m making an exception for this deal, though, because of because of the subsequent sell-off in consumer products – Amazon’s direct competitors.

This move seems like a very strategic purchase by Amazon.  Whole Foods gives Amazon an opportunity to gain a larger brick and mortar presence, as well as access to higher-quality fresh foods.  Ultimately, this could be a move toward expanding Amazon’s fresh grocery offering.

Household, personal care, and packaged food stocks sold off in response to the news of Amazon’s intention to purchase Whole Foods on June 16th.  And since then, a slight bit of volatility has returned to the broader market.  Tech stocks hit a speed bump in mid-June, as investors across the world are starting to question the durability of the bull market we’re in.  Since President Trump was elected back in November, the market’s done hardly nothing but push higher, little by little, nearly every day.

One measure of volatility that I refer to somewhat frequently is the VIX index.  This index uses premiums in options contracts of S&P 500 stocks to measure how “calm” the markets are. 

You can see here that when the markets correct, the volatility index spikes.  Notice how the VIX chart above spiked during the last several market crashes: around 40 during the dot com bubble, over 80 during the mortgage crisis, and in the 35 range after Britain exited the EU last year.

Since Mr. Trump was elected back in November, the VIX index has averaged under 12.  Its high point was 16 back in April, and it’s consistently sat in the 10-14 range.  These data points are helpful, but they’re only telling us what we already know: the markets are very calm right now.

I bring this up to remind you that this is not the norm.  At some point the stock markets will correct again, testing your resolve to adhere to a long-term investment strategy.  It’s at that point that you’ll need to keep your focus on the horizon – not what happened to your account over the last week or month. 

Last quarter I wrote about how high the market’s valuations were.  There are many ways to measure how expensive or cheap the market is, but P/E ratio is probably the most common.  By dividing the market’s price by the shareholder earnings produced, we can get a decent feel for where the market sits at any given time. 

The U.S. stock market’s P/E ratio currently floats at about 21 times earnings, using the MSCI USA Index as a proxy.  This is significantly higher than its long-term average.  Why is this important?  Because P/E ratios tend to be mean reverting, meaning that this measure will probably fall back toward long terms norms at some point.

There are two ways this can happen.  First, market prices can fall (see the previous section on volatility).  Second, the denominator (earnings) can increase.  And thus far in the year, corporate earnings have been good.  Last quarter 80% of companies in the S&P 500 beat their consensus earnings estimates.  A lot of this can attributed to the strengthening economy and business cycle…but whoever complains about a tailwind?

In addition to strong earnings, 60% of companies in the S&P 500 beat their revenue numbers.  This is telling.  Earnings can be manipulated somewhat by management, but revenue is harder to influence.  Looking ahead, I’d note that this business cycle cannot last forever.  As the Fed begins to put the brakes on the economy with tighter monetary policy, it will become more difficult for companies – here and abroad – to consistently beat their earnings estimates. 


International Stocks

Economic growth is off to a strong start to the year in the U.S., but it’s a mixed bag globally.  Europe and Japan both had strong first quarters, but the United Kingdom slowed to a 0.8% annual GDP growth rate.  At least some of this slowdown can be attributed to the UK’s exit from the European Union.

In China, first quarter GDP growth was reported at 6.9%, which is above the government’s target of 6.5%.  Since then, economic reports coming from China suggest that their economy is slowing.  Retail sales, industrial production, investment, and aggregate borrowing numbers all came in below economists’ expectations.

If China’s growth continues to decelerate, the ripple effect could impact investors in three distinct ways.  First, an economic slowdown in China would likely spread to other countries.  The U.S. is somewhat insulated, thanks to our diverse economy (even if we do trade a great deal with China).  But countries like Japan and those in the Eurozone are more reliant on the Chinese economy.  Slower growth in China would surely hamstring future earnings for many companies in these countries.

Second, if there is a slowdown, there’s a good chance it’d be concentrated in construction activity.  Government infrastructure in China has grown at an incredible pace that’s unsustainable in the long run.  When it eventually slows, commodities will likely see downward pressure, since this type of construction requires a great deal of oil and natural gas.

Third, if growth slows in China, the Chinese government may react with economic stimulus.  This was their reaction when growth slowed in late 2015 & early 2016.  During that span, the MSCI AC World Index dropped 12% between the beginning of 2016 and when China reinstated stimulus measures – a 29 day period.  If this cycle is any indicator, world markets could sell off if Chinese growth slows again…at least until China’s government announces another stimulus package.



For years, OPEC has pressured its oil producing competitors by continuing to drill during periods of weak prices.  Historically OPEC normally chooses to cut back on new production when the oil markets fall, in order to buoy prices and revenues.  But over the last several years the group has continued to drill, to put pressure on global competitors and new shale producers in the Midwest United States. 

This has proved to be an effective strategy, since OPEC countries typically have lower fixed drilling costs than competitors.  By driving prices lower OPEC has been successful in forcing competition out of the market.  Shale & offshore drilling operations across the world have been abandoned over the last three years.  Very simply, the cost of getting the oil out of the ground is greater than its value on the open market…until prices rebound at least.

While this decision was effective for OPEC in the short run, it wasn’t sustainable longer term.  The cartel’s member countries do ultimately want higher oil prices.  They can only apply pressure to competitors for so long before the harm on themselves becomes too great. 

In May, OPEC changed its strategy and again moved to cut production to support oil prices.  This will likely lead to marginally higher oil prices over the next 6-9 months (even though prices have slipped in the few weeks following OPEC’s announcement).

Longer term it’s not as clear which direction we might see oil take.  Oil prices above $52 provide favorable economics for shale producers, according to the energy analysts I follow.  That means that even though OPEC’s move might boost prices, once they eclipse $52 more producers will re-enter the market.  It takes shale & offshore drillers 6-9 months to get their operations up and running again.

So while prices may continue an upward trend in the short term, it’s likely that once the competition comes back online, they’ll be able to satisfy unmet demand in short order.  With this level of production flexibility, we could be in for a weak oil market for some time.  That’s great news drivers at the gas pump, but not as great for long term investors in the commodity.