Let’s start with a quick market update:
The market has had a bit of a push and pull with new economy stocks (growth stocks, mostly tech-focused) and old economy stocks (financials, industrials, commodity companies). Much of this has been driven by three things: taxes, interest rates, and reopening.
- Taxes: we’ve talked about this in past commentaries, videos, and Facebook Lives, but the big picture is that rates are going up on companies and potentially capital gains. We aren’t sure yet where this pans out, but the uncertainty has caused jitters in parts of the market and contributed to some rotation.
- Interest rates: rates spiked from under 1% at the end of last year to as high as 1.75%. On a percentage change basis, the change was huge, and really sparked more fear than actual economic impact or earnings impact. This exacerbated the rotation from new economy growth names to old economy names. We have talked about how the move in rates was hitting some resistance in early March, and since then, rates have settled down and pulled back some, despite strong economic news. We touched on this in our Facebook Live and will continue to bring this up as things progress.
- Reopening: the economy is in a transition phase, and that brought with it a lot of change in reported earnings. We expect the uncertainty in earnings to continue with supply constraints, price inflation, variants and changes in vaccination rates, and changes in business.
All in all, the economy is rebounding nicely, interest rates seem contained, and inflation is all the talk these days. But while the world seems totally different from what we’ve been used to over the past decade, it is in many ways the same...low rates, greater emphasis on technology solutions, and a strong consumer.
What Investors Need to Know About The Fed
So let’s get to our main topic -- the Fed. We are not going to get all academic about the Fed and go into their creation, purpose, and so on. We are going to really focus on the last 25 years and why the investing world has changed as a result, what those changes are, and how those changes might impact investing strategies and characteristics of the market.
The Fed controls short-term lending rates to banks. That is the main monetary tool that they use. They influence the money supply. Some might say they control it, but that is not entirely accurate. They influence interest rates in the market, but again, don’t actually control rates in general. They have a couple of other tools they can use, but for the most part, their big tool in the past 10 years has been public speaking.
The Recent Impact of The Fed
The last 25 years: During the tech bubble, Greenspan (the acting Fed chair at the time) was famously called “Maestro.” Interest rates had dropped from nose bleed rates of being in the teens to a much more palatable single-digit range. What lowered them?
- Advances in technology
- Introduction of the internet
- Recovering economy from the gulf war
- Savings and loan crisis
- A few currency crisis
This brought us robust growth and low interest rates.
We also saw an exuberant market chasing all types of new business. What followed was a crash in technology stocks that had gotten a bit ahead of themselves, the Y2k scare, 9/11, and a new war in the Middle East. Before these events, interest rates were rising in a steady fashion. With all these new concerns and a deflated market, interest rates were cut aggressively by the Fed. And this is what we have seen since. Slow to raise short-term rates, but they are quick to cut rates when things get dicey.
Low rates fueled the housing market and general inflation. However, we had a lot of deflationary pressures at the same time through technology, innovation, and globalization. The net result has been low inflation over the past 25 years. We won’t get into the accuracy of the inflation numbers, but on a reported basis, inflation has been below the Fed target inflation. This gave them a huge green light on keeping rates low, and one might even say has made them somewhat less concerned with inflation in general and more focused on growth and market fragility.
In 2008, the game changed for the Fed. Rates hit a lower bound of zero. Financial risk had a newly elevated status in the minds of fed officials. The Fed became much more of a household discussion and political entity. But, through the efforts of both the Fed and government, we saw a quick recovery from the financial crisis, at least in stock market terms. Ben Bernanke, the Fed chair at the time, got the nickname “Helicopter Ben,” and cartoons were drawn of him flying over cities throwing money out of a helicopter...what a visual!
In some ways, that is the end of the story. Of course, we could go on forever, but we want to keep it simple and digestible. Here is a quick summation in cliff note form:
- The Fed gets comfortable with lower interest rates in general and is celebrated for contributing to growth.
- Inflation becomes a lesser threat versus other threats the Fed considers.
- Massive monetary stimulus is justified, and the Fed becomes politicized. They receive non-stop pressure from politicians and market participants to help fuel growth through easy money policy and are viewed as always refilling the punch bowl.
- Massive risk taking, moral hazard, and increased leverage become a natural outcome.
What changed in the investing world as a result of all this:
- Sells offs are sharp and swift: as we look at the last 25 years, we have had three crashes. That is a lot in a short amount of time, but each of these crashes were followed by quick rebounds. Part of this quick rebound has been swift intervention by the Fed. If we look at the nuts and bolts of how the market works (statistics and distributions for the geeks out there), we see sharper downturns and quicker recoveries as a result.
- Interest rates are super low; this causes a lot of excess risk taking, both in seeking higher yield through lower quality paper and also pushing extremes in leverage and allocation decisions. Equity investments look a lot more attractive when compared to zero interest in the bank or sub 4% yields in bonds. Hedge funds and real estate also look like better options.
- Debt makes sense with low interest rates, and we see that. More debt leads to more leverage, and more leverage means greater impact to net worth from changes in the market.
- There are other impacts, but we want to keep it simple. Higher leverage from individuals and companies with low rates, directionally more risk taking, and changes in market dynamics are the main three byproducts of current day monetary policy.
How Should The Fed Impact Your Investment and Financial Strategies?
- Be ready for volatility. With greater leverage and more uncomfortable, and at times, inappropriate risk taking, we should expect more boom/bust behavior in the market. On the plus side though, these busts should be viewed as opportunities. When we see markets sell off, the Fed is quick to start sounding more market friendly and accommodative, and the market loves that tone!
- Expect interest rates to remain low. I have heard people talk about interest rates normalizing for over 10 years. There is a slew of reasons why that has some obstacles:
- We can’t really afford it….both from the interest the government is paying on exploding debt, international interest rates not being any better, and the current asset prices we see after a decade of effectively zero interest rates, it is hard for these rates to go up.
- We are stuck in a merry go round...if rates go up, we would have a massive repricing of assets. This would cause a shock to the system and result in a recession. That recession would force the Fed to pump money into the system and lower rates. And around we go. We have seen examples of this in 2013 and 2018. In many ways, we are stuck.
- No inflation: inflation has been stubbornly low for over 20 years as reported. We could argue all day if this is valid, or if inflation is now going to be a concern, but the Fed has been clear on this matter...they don’t see enough inflation for them to materially change course.
- The Fed has altered its mantra. Long gone are the days of Volker and heightened concern over price stability. Today, growth and risk to the downside seems to be the major issue the Fed focuses on
- Expect higher prices of assets: monetary policy is a blunt tool. It is more like a grenade than a scalpel. Not all market participants benefited equally to low rates and quantitative easing. Big conglomerates and the wealthy have been the main benefactors, and this recognition helps explain what has outperformed in the past decade.
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