Download Unintended Consequences of Federal Reserve Policy

The Stevens Advisor
Stevens, Foster Financial Services, Inc. Registered Investment Advisor
7901 Xerxes Avenue South, Suite 325, Bloomington, Minnesota 55431
www.stevensfoster.com
[email protected] Ph: 952.843.4200
July 11, 2014
Volume 11, Issue 14
Toll Free: 877.270.4200
2014 SECOND QUARTER PERFORMANCE
Unintended Consequences of Federal Reserve Policy – disappearing volatility
Stocks and bonds have rallied on the Federal Open Market Committee’s (FOMC) decision to
continue rolling back the central bank’s bond purchasing program. The FOMC statement
sounded reasonably upbeat on economic growth for the rest of the year, yet the Federal
Reserve (Fed) sees no immediate inflation risk. The Fed has all but reassured financial
markets that its zero interest rate policy is here to stay, effectively taking out any risk of
earlier-than-expected monetary tightening. In a nutshell, the Fed has acted as if it wants to
see higher asset prices.
The Fed has fought a successful battle against possible deflation since 2008, and according
to Bank Credit Analyst (BCA), the experiment should be cherished and followed by other
central banks, the European Central Bank in particular. By making its policy as transparent
as possible, the Fed has substantially reduced uncertainty surrounding monetary policy.
This has helped the U.S. economy recover. Strengthening commercial and industrial loan
activity suggest that the U.S. economy is passing through its first quarter soft spot, which is
confirmed by continued improvement in the labor market.
Nevertheless, we believe no success comes without a cost. The biggest unintended
consequence of the Fed’s policy is disappearing volatility in the financial markets. As
viewed from the chart below, market volatility in all asset classes – equities, bonds and
currencies – has dropped to either all-time lows or is very close to a record low.
The extraordinary fall in market volatility has much to do not only with zero interest rate
policy but also with sharply increased transparency of monetary policy. If central banks are
trying to knock down market uncertainty by telegraphing their policy intentions as well as
giving precise interest rate projections for the future, financial markets will listen, and
market volatility will fall.
It is interesting to note that the last time the volatility for all three asset classes fell to
similar levels was in the summer of 2007, when complacency about the underlying world
economy reigned. This time around, economic conditions are different and the steady drop
in various volatility measures is likely entirely attributable to zero rates and sharply
increased policy transparency.
The interesting question is: what is the problem with low
volatility? Doesn’t low volatility help rather than hurt investors and markets?
As BCA sees it, and we agree with their wisdom, there are adverse effects for both the
underlying economy and financial markets. First, financial markets need a certain level of
volatility to properly price various assets. During periods of heightened volatility the market
can unduly place too high a risk premium on risky assets resulting in excessively depressed
valuations. By the same token, we are likely witnessing a sustained period of very low
volatility that can also lead to a false sense of security, distorting risk premiums or required
rates of return by investors to unrealistically low levels and thereby potentially creating
asset overvaluation.
Second, a sustained fall in volatility combined with zero nominal rates and a negative real
rate will embolden risk-taking and encourage financial leverage. However, the Fed’s
position over the past years suggests that the authorities are taking a benign view on the
prevalence of financial leverage, and continued negligence on the issue can only lead to
further excess of widespread financial leverage. The potential danger is that the more
leveraged a financial system becomes, the more pain will be inflicted on investors once a
de-risking cycle begins. The uncertainty is always about when, not whether, the de-risking
cycle will start.
The last point by BCA – and we see this as the most meaningful -- concerns sustained zero
interest rates: though very helpful for the underlying economy, the low rates also may
have created some perverse economic consequences. Since 2009, zero rates have
anchored down borrowing costs across the board, which in turn has made equity financing
costs appear prohibitively high. The vast disparity between the two has led companies to
rush out and issue debt to buy back their shares. Some have taken themselves out of the
public market altogether. In other words, the sharp disparity between exceedingly low
borrowing costs and a comparably high earnings yield for common stocks has turned the
equity market into a savings scheme for shareholders – not an investment mechanism for
the overall economy.
We aren’t smart enough to second guess the Fed (but we’ll do it anyway) – reviewing BCA’s
comments above regarding Fed transparency, the question of purpose under the market's
continued and more intense review of Fed minutes and interpreting every move that the
Chairman states or queues rhetoric….is becoming ridiculous. Sure, by making monetary
policy transparent, central banks can reduce uncertainty and market volatility. However, by
broadcasting its intention and expected path of policy shifts, isn’t it true that the central
bank is also diminishing its potential impact on the real economy to a minimum? In a world
of perfect foresight, monetary policy becomes frictionless (or useless). Why is the Fed
trying to make itself useless? We argue if the Fed wants to play a neutral role in free
market capitalism, then how do you explain its activist stance over the last few decades?
Whatever the case, the recent collapse in various risk-spreads and increasing signs of
escalating leverage in the financial system may suggest that potential problems being
created by low volatility and policy transparency are beginning to outweigh the benefits
from them.
Index performance
Large-cap domestic stocks jumped sharply in the quarter and notably outperformed their
mega- and small-cap brethren over the past 6 months. Emerging markets accelerated in
Q2 with less concern about China's leverage imbalances and positive growth in traditional
Asian Emerging Markets. Looking back over the last 12 months, investors were served with
attractive risk-adjusted returns, including bonds.
Bloomberg data
as of 6/30/2014
Index
S&P 500
Dow Jones Industrial
Russell 2000
MSCI Emg Mrkt Free ($)
Morningstar U.S. Market TR USD
MSCI All-Country World Ex-U.S.
Barclays Aggregate Bond
2Q
2014
5.22%
2.83%
2.04%
6.71%
5.01%
5.03%
2.04%
YTD
7.12%
2.67%
3.18%
6.13%
7.11%
5.56%
3.93%
1
Year
3
Year
5
Year
10
Year
24.57%
15.54%
23.63%
14.64%
25.04%
21.75%
4.37%
16.54%
13.53%
14.55%
-0.05%
16.47%
5.73%
3.66%
18.80%
17.80%
20.18%
9.59%
19.35%
11.10%
4.85%
7.77%
7.62%
8.66%
12.33%
8.42%
7.74%
4.93%
5 Year
Std Dev
12.3%
11.5%
17.0%
21.3%
21.8%
17.0%
2.9%
Tactical Strategy – our plan is to let the broader markets present the next move
Markets never move in a straight line, and so the recent rally in risk assets – from U.S.
stocks to peripheral European bonds – should give investors pause. We discussed key
economic metrics to an improving economy in the last quarterly letter and all of those
macro links to a sustainable recovery are beginning to show. Housing recovery statistics,
bank lending and hiring intentions by small business have all come in incrementally positive
as of late. And the returns in the global markets (including the U.S.) have been
meaningfully positive (noted above.)
Yet, the economic outlook on both sides of the Atlantic remains challenging, and investors
and policymakers seem unfazed by the ever-present storm clouds. Against this backdrop,
the biggest risk is a premature tightening of monetary policy. If the job of central bankers
is to take away the punch bowl just as the party is getting started, a significant risk is
introduced into the markets that no one anticipates. Accordingly, as risk assets move
higher, we’ll continue to follow our plan to harvest holdings in our overweight U.S. equity
weights and allocate to more exposure to International Developed regions, in particular the
European countries. Our stance is that Euro-land is relatively cheaper on valuation than
U.S. equity markets, the political leadership has imposed its will, structural reforms are on
the right track, the European banking system is coming to the end of a the deleveraging
cycle, and the region has the most “flexibility” in monetary policy to provide the best
opportunity for risk-adjusted returns. Think U.S. monetary policy 3 years ago.
Additionally, we continue to introduce and educate the use of “less-correlated” proven
absolute return strategies inside the transparent and liquid mutual fund vehicle in both our
U.S and Global equity allocations and a select strategic income bond fund set of managers
that have an established record in managing interest rate risk throughout the cycle. All of
these allocations are in front of us and planned as the market serves higher highs on
potentially more speculative growth prospects.
Today our base Growth with Income model holds 10+% in cash and a slight overweight in
equities and underweight in bonds to the measure of our cash position. Our current bias is
towards larger cap U.S. equities and readied to own more international exposure if the
market gyrates lower in return over the coming weeks/months. We’ll let the global markets
place our next move. Again, risk higher, take off U.S. equities and re-allocate to “less
correlated” vehicles. Market moves lower, own more International Developed to match or
come closer to the benchmark weight.
Important here, we really do want to hear your concerns and perspectives on the markets
and always welcome conversations and expect to take time to understand your queries and
ensure that we’ll work with you and your Client Account Manager to communicate our work.
- Jon Horick, CFA, CPA(inactive), Vice President, Investments, July 7, 2014
“The Stevens Advisor” is a market update from sources deemed reliable, but Stevens, Foster Financial Services, Inc. does not make
any warranties of its accuracy. The opinions and forecasts are those of the author and are subject to change without notice; no
representation is made concerning actual future performance of the markets or economy. The opinions voiced herein are for
general information only and are not intended to provide specific advice or recommendations for any individual. Past performance is
no guarantee of future results.