05 Jun 2015 Don’t Let Temporary Crosswinds Blow You Off Course
It’s been a choppy week for Treasurys and stocks with Greece once again roiling European Union stability and mixed signals about the strength of the US economy. The question every investor is asking is when the Federal Reserve will begin raising interest rates? And advice is becoming louder and more widespread.
Madame Christine Lagarde, Managing Director of The International Monetary Fund, dropped a bombshell yesterday when she boldly suggested that the Federal Open Market Committee should delay any-and-all rate increases until 2016, allowing domestic inflation to ‘overshoot’ even if there’s a risk of “slight overinflation” relative to the Central Bank’s 2% target. She went on to say that the dollar was “moderately overvalued” and a further marked appreciation would be “harmful.” At the same time, the IMF downgraded, for a second time, its projections for US economic growth.
The advice given by Madame Lagarde is among the most explicit on record. It suggests that Fed Chair Janet Yellen should side-step her mandate from Congress to maintain a stable domestic monetary supply in favor of her second mandate to maintain a healthy growing economy.
The comments could also be construed with political underpinnings because of their timing relative to upcoming presidential elections. Keeping rates low provides for looser monetary conditions which are stimulative to economic growth. Strong improvement in the coming quarters would benefit Democrats’ position in the presidential elections. Problem is, if overly loose monetary conditions exist when an economy takes off, the Fed likely loses its ability to rein in money fast enough to avoid inflation without significantly and unnecessarily disrupting markets. Either way, a spark is very dangerous when there’s too much gasoline floating around.
That the IMF is so boldly explicit in their advice demonstrates how important the US economy is to struggling European and global economies. Rising US rates and a strengthening dollar particularly threaten the economies and political stability of some emerging nations. As rates on US bonds rise, their sovereign debt (or ability to borrow) becomes considerably less attractive.
The Fed’s next steps are complicated not only by the fragility of the global economies but also by the fact that waiting too long could be just as dangerous in the longer run. Allowing any inflation ‘overshoot’ to get out of hand exposes the US to the the possibility of runaway inflation as well as price bubbles.
Fed Chair Yellen has said she expects to increase rates later this year if her targets for US growth are met. But the WSJ reports that Fed governors, Daniel Tarullo and Lael Brainard believe the first-quarter contraction was caused by more than harsh winter weather. Tarullo said Thursday that disappointing consumer and business spending this year raises questions about whether the US has “lost momentum in the underlying performance in the economy.” On Tuesday Brainard said “There is value to watchful waiting while additional data help clarify the economy’s underlying momentum.”
Today’s job growth numbers of 280,000 are mostly reported as strong, with stocks and bonds down on the idea that it adds to Yellen’s case for improving economic growth. But the US economy needs roughly 400,000 jobs growth every month to be additive to economic growth. Anything less fails to replace layoffs, attrition, and retirement. Besides, these initial reports have been revised downward the last few months rather significantly.
Janet Yellen and her Fed Governors give every impression of being long-term focused and not prone to be thrown off course by just a few data points. She and her fellows appear to have a steady hand on long-term policy for both monetary control and economic health, despite getting no help from Congress or the Administration on the fiscal or regulatory side. We see no reason to believe the Fed will overreact to current or future crosswinds.
Brief readers have learned by now not to expect predictions of markets or economic trends. Quite Simply, they are counter-productive to life planning. But, to the extent we live in an economy and are impacted constantly by news and opinions, we believe it helps every so often to assess where we are – economically and investment-wise.
We have already seen Treasurys become more volatile than usual and it is likely that stocks will also succumb as investors make their bets on what the Fed is about to do or not do. But please remember, you are not exposed to 100% Treasurys or stocks. Rather you own a mix that is continually reassessed according to the latest probabilities of meeting your plan. And as a blend, your portfolio rides the storm much more smoothly than stocks or Treasurys alone would. Let’s look at a couple of examples to see how our Balanced Model behaved during some pretty big swings in a significant bond and a stock market disruption.
You might recall the ‘taper tantrum’ of June 2013 when Fed Chair Ben Bernanke implied in his talk that the Fed would soon begin ‘tapering’ its program of Quantitative Easing. From May 1st to September 5th our 7-10 year Treasury component declined in price by 8.8% while our US stock component as measured by the CRSP US Total Market Index rose 6.3% during the same period. The Balanced Portfolio (60% stocks and 40% Treasury and Cash) was down .63% during that extreme Treasury decline. But overall, for the year 2013 it was up 13% – a very nice return, given the pressure on Treasurys.
We all remember the crushing declines of the stock market, shortly after its peak in October of 2007 through March of 2009. The total US stock market as measured by the Dow Jones US Total Stock Market was down 44%. Our Balanced Portfolio during that same period was down 22%, or half what the 100% stock index suffered. From the last market’s peak in 2007 to yesterday, our Balance Model is up an average of 5.7% compared to 6.9% for the Total US Market. But notice how steady the Balanced portfolio (green line) is relative to its other more volatile components.
Investing for lifetime purposes is a long-term proposition. Market disruptions are short-term, non-permanent events. If we allow ourselves to become overly focused on the problems of the day we can easily lose focus of more important purposes or worse, set ourselves up for behavioral mistakes that might profoundly impact our futures. A well-crafted long-term plan that addresses every goal and priority we value, a portfolio carefully designed to sustain severe market disruptions, and continual testing for confidence of meeting or exceeding goals is the best defense against the emotional power of disruptive markets.
If you would like to read more about why we use Treasurys in our portfolios to mitigate equity risk, please refer to the articles below and others on our site which can be found by searching for ‘Treasury’ in the search bar located in the right-hand column.