Second Quarter 2013 – The Fed Still Says Up!

The Federal Reserve recently put fear into the bond market as they implied they would reduce their buying of debt. This form of quantitative easing was initiated to stimulate the economy. The result of the Fed’s recent comments was an immediate jump in treasury rates from 3% to above 3.5%, leading to a significant loss in interest-sensitive securities during the second quarter, along with a 7% stock sell-off in mid-June. For the most part, our clients’ portfolio gains in the second quarter were erased by this fear as all interest-sensitive securities ended with negative returns, led by utility stocks down 6% and some fixed income funds down 8%+.

Then, in early July, Bernanke countered this premature fear by stating that tightening is not in the Fed’s immediate plans since the economy is still sluggish. Simply put, the market direction for the Fed is still up! The markets responded by closing at all time highs by mid-July.

Besides getting national liquidity up in 2009, we needed the entire housing industry up, mortgage bonds up, confidence up, employment up and of course stocks up. Today, the Dow Industrial Index is up 140% from its 2009 lows. Employment is gradually improving and real national growth is expected to hover around the 2% level for a few years. Who can argue at this point with Bernanke and the Fed’s approach? Certainly, we have fared better than our ancestors during the Great Depression.

Unfortunately, other Fed ups are income taxes, health care costs and regulations. As a small business, we are anticipating new burdens from all directions, but the markets seem to think we will all survive and grow. Indeed, from 1990 to 2000, when the maximum federal income tax rose from 28% to 39.6%, the S&P Composite rose 350%. Higher taxes did not kill the markets.

At the root of this recent volatility is the fear of rising interest rates, so we need to take a look at just how much we think rates can rise. There are several factors affecting the level of interest rates, such as credit quality and money supply/multiplier, but more importantly perhaps are inflation and consumer demand.

Demand is modest. The anticipated 2% in GDP real growth compares to the post-WWII average of 2.9%. The S&P Industrial real return during this era is closer to 7.5%! It is difficult to foresee long-term treasury rates above 5% while real growth remains under average.

Inflation is subdued. Low demand and slow growth do not push prices up. In the late seventies, we did experience what we called “stagflation” when we had slow growth and high inflation, but that was a unique combination of an oil embargo, federal price/wage controls, and U.S. removing the dollar from the gold standard. The Fed has been much more proactive and predictable this time around. Their inflation target of 2%, historically, would imply treasuries might average 4.75%.
In spite of the second quarter’s results, the outlook for stocks should remain positive. When yields are below 5%, rising interest rates signal economic strength and are generally associated with rising stock prices. Yes, summers are always interesting in the stock market, but this time we should relax and enjoy it.

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