Fourth Quarter 2017

Moving toward year-end, the Fed has confirmed that it will continue “normalizing” interest rates.  This means raising its key fed funds rate and trimming its massive $4.5 trillion bond portfolio, acquired in emergency response to the 2007-2008 financial crisis.  The former action will boost short-term rates and the latter will boost longer-term rates.  That said; some question the need to normalize rates, given only moderate growth and persistent low levels of inflation.

Benchmarks

12/31/2016

9/30/2017

% Change

Dow Jones Industrial Average (DJIA)

19,762.60

22,405.09

↑ 13.4%

Standard & Poor’s 500 Index (SPX)

2,238.83

2,519.36

↑ 12.6%

NASDAQ Composite Index  (COMP)

5,383.12

6,495.96

↑ 20.7%

Russell 2000 Index (RUT)

1,357.13

1,490.86

↑ 9.8%

Federal Funds

0.50%

1.00%

↑ 100.0%

10Y US Treasury Bond

2.45%

2.33%

↓ 4.9%

30Y US Treasury Bond

3.06%

2.86%

↓ 6.5%

London Gold PM

1,145.80

1,283.10

↑ 12.0%

Remember, when bonds yields rise, bond prices fall (and vice versa).

The Dual Mandate

In November 1977, Congress amended the Federal Reserve Act of 2013.  In doing so, it charged the Federal Reserve Bank (Fed) with what is known as the “dual mandate” … promoting maximum employment, price stability and moderate long-term interest rates.

Maximum Employment

Maximum employment doesn’t mean “zero” unemployment.  Rather, it means the lowest level at which employment can be maintained without triggering undue inflation.  Also, it recognizes there will always be a natural level of unemployment that occurs absent an economic boom or bust.  It occurs because people start and stop jobs for many reasons that have nothing to do with the economy.

Many economists believe equilibrium is reached at around 4.5% unemployment.  In September, the unemployment rate fell 4.2%.  This hints that equilibrium may have been surpassed and inflation may be lurking around the corner.  Very simply, when all available workers have jobs, they can drive a harder bargain in terms of their wages and benefits.

Price Stability & Moderate Long-Term Interest Rates

Just as maximum employment doesn’t mean “zero” unemployment, price stability doesn’t mean “zero” inflation.  Rather, it means a stable price environment, in which consumers and businesses can make the long-term financial commitments that fuel stable economic growth.  From the Fed’s perspective, this means inflation hovering around 2%.  At that level, a Goldilocks economist might exclaim, it’s “not too hot” (inflationary) and “not too cold” (deflationary), but “just right”.

Price stability and moderate long-term interest rates go hand-in-hand.  Long-term nominal interest rates are set based on lender expectations for inflation.  If prices become unstable and rise rapidly, this erodes the real interest rate the lender receives (and the borrower pays).  For example, if a lender charges 4% on a 30-year home loan and inflation rises from 2% to 4%, this reduces its real interest rate from 2% to 0%.  When lenders expect higher inflation, they raise their rates to manage this risk.

Why raise rates when things are looking good?

Today, the economy continues growing moderately.  During the second quarter, real gross domestic product (GDP) grew at an annualized rate of 3.1%.  Unemployment and inflation remain low.  For the year ending September 30th, unemployment was 4.2% and the Consumer Price Index for All Urban Consumers (CPI-U) had risen only 2.2%.

When things are looking good, why raise rates?  The reason is simple.  The Fed is raising them now because, strategically, it needs to raise them and it can.  Remember, their key monetary policy tool is changing the level and direction of interest rates.  When the economy is too cold, it can lower them to stimulate growth.  Conversely, when the economy is too hot, it can raise rates to slow it.

As it stands now, we’re 100 months into the current expansion and rates remain historically low.  This increases the odds that a “bubble” will form somewhere in the economy, it will burst and we’ll experience another recession.  With rates historically low, the Fed has no room to lower them further to ease the economy out of recession.  So, it must act now to make the tool available in the future.  The good news is the Fed believes the economy is durable enough to handle normalizing rates.

Current Outlook

In their enthusiasm, we believe most investors are overlooking two important risks.

1)   Interest rates are rising and this will cause all investments to fall in value.  No one can explain this more eloquently than investment legend Warren Buffett …

“ … we first need to look at one of the two important variables that affect investment results:  interest rates.  These act on financial valuations the way gravity acts on matter:  The higher the rate, the greater the downward pull.  That’s because the rates of return that investors need from any kind of investment are directly tied to the risk-free rate that they can earn from government securities.  So if the government rate rises, the prices of all other investments must adjust downward, to a level that brings their expected rates of return into line.  Conversely, if government interest rates fall, the move pushes the prices of all other investments upward.  The basis proposition is this:  What an investor should pay today for a dollar to be received tomorrow can only be determined by first looking at the risk-free interest rate.

Consequently, every time the risk-free rate moves by one basis point – by 0.01% -- the value of every investment in the country changes.  People can see this easily in the case of bonds, whose value is normally effected only by interest rates.  In the case of equities or real estate or farms or whatever, other very important variables are almost always at work, and that means the effect of interest rate changes is usually obscured.  Nonetheless, the effect – like the invisible pull of gravity – is constantly there.”

Excerpted From:     Mr. Buffett on the Stock Market:  The most celebrated of investors says stocks can’t possibly meet the public’s expectations.  As for the Internet?  He notes how few people got rich from two other transforming industries, auto and aviation.  By Warren Buffett and Carol Loomis for Fortune Magazine, November 22, 1999.

2)   The stock market appears over-valued.  Historically, the Standard & Poor’s 500 Index has had an average PE ratio of 15.65 and average dividend yield of 4.39%. Today, it’s over-valued by both measures.  Its current PE ratio is 25, which is more than one standard deviation (+/- 7.23) from its average PE ratio.  And, its current dividend yield is 1.9%, which is more than one standard deviation (+/- 1/72%) from its average dividend yield.  For the most part, this valuation has been driven by low interest rates and the prospects for major tax reform.  While the first driver is being reversed by the Fed, the latter has not materialized in Congress, leaving the market vulnerable.

 

We remain cautiously optimistic that Congress will pass meaningful tax reform, spurring the robust growth needed to justify current market valuations.  That said; we are beginning to place more emphasis on the cautiously and less on the optimistic.  If meaningful tax reform is not forthcoming, it is likely we will reduce stock allocations in the near future.

Disclosures

Click on the links below to find out more
about Asset Planning & Management's
Form ADV Part 2, Privacy Policy
and Disclosure Statement.

Form ADV Part 2

Privacy Policy

Disclosure

Company Info

Asset Planning & Management, Inc.

422 West Riverside Ave. Suite 722
Spokane, WA 99201
Phone: 509-838-4175 or 888-864-8827
Fax: 509-838-4206
Email: info@assetplanning.com