Morning Comment from Tower Bridge Advisors

pic-meyerJames M. Meyer, CFA, Principal and CIO, Tower Bridge Advisors

Stocks finished mixed in a relatively quiet session the day after the Fed decided not to begin reducing its bond buying program.

If you never put a lid on the cookie jar, eventually your kids, and probably your dog, will get fat and sick. If your doctor prescribes an antibiotic every time you have chills or a fever, half the time there will be no benefit and eventually your body will develop a resistance to the antibiotics. If the Fed keeps dropping $85 billion every month out of helicopters, stock and bond prices will go up in the short run but eventually we will all have to face a set of unintended consequences.

9.20.13_TowerBridge_ComentaryWith that said, I don’t want to overstate any reaction to the Fed’s decision to keep its full bond buying program in place. Another couple of months of buying $85 billion per month instead of $70-75 billion won’t make a big difference. Stocks and bonds reacted Wednesday afternoon and that’s about it for the reaction. However, buying $85 billion of bonds every month is rather similar to persistently giving a strong antibiotic, whether it is needed or not. There may not be immediate harm but there will almost certainly be unintended consequences the longer the process persists. How long is too long? No one knows yet. But with the Fed’s balance sheet closing in on $4 trillion and the fact that soon it will own 40% of all government debt maturing five years out or longer, the problems in the future unwinding what it has created are only going to get more difficult if the Fed doesn’t stop adding to its balance sheet soon.

I understand that the government could shut down in October for a few weeks and that Republican conservatives might create a similar debt ceiling crisis to the one it created two years ago. But the Fed isn’t going to solve that problem with an extra $10 billion in bond purchases. In fact, the Fed isn’t going to solve those problems at all. I get the possibility that the Fed was concerned that real interest rates were getting too high and wanted to scare the bond vigilantes with a surprise. It get the possibility of delaying the start of tapering until the Fed knows who the next Chairman might be to make sure he or she is on board with the game plan. So I am willing to give the Fed a couple of months grace period. But with that said, QE is a much more effective crisis policy than a policy designed to maintain economic growth. Flooding the economy with money doesn’t create demand. Certainly, recipients will gladly take the money but the choice of spending it or investing it depends on market conditions. Given the very slow velocity of money both before and during QE, the market has said rather loudly that it would rather invest than spend. That means investors benefit with much stimulation of economic growth or job creation. Here once again is an example of misguided policy whose unintended consequence is to widen the gap between the wealthy and middle classes.

9.20.13_TowerBridge_Comentary_1We are almost certainly not going to see economic data over the next 1-3 months that is going to move the needle enough by itself to change forward outlooks. Indeed, our economy has been adding about 180,000 jobs per month for almost four years and the pace has remained remarkably consistent if you look at a three or six month moving average. Jobless claims are back to pre-recession levels. Existing home sales, which are about 15x new home sales, are booming. So are car sales. Ladies and gentlemen, we are not in a sick economy and everyone who voted to maintain the status quo yesterday should know that. And those who were unsure yesterday are likely to still be unsure next month or next quarter. Economics is never an exact science and there isn’t a formula that will determine tomorrow’s rate of growth. Federal Reserve forecasts of future growth have been persistently too high since the recovery began. Every subsequent forecast adjustment has been downward, including the adjustment announced on Wednesday. Yet forecasts of job creation and unemployment rates have been pretty accurate. The missing ingredient has been weaker than expected productivity, a function of weaker than expected investment. Tax policy, regulatory policy, fiscal policy and uncertainty created by a dysfunctional government all contribute to lack of investment spending.

With that all said, the Fed didn’t move and that leaves us with the question, “What now?” First of all, there is no need to change any economic or earnings projections. There is no need to change outlooks for Europe or China. Interest costs might be marginally less but the economic impact will be negligible. Obviously, throwing more money at financial assets raises asset prices. The impact of Wednesday’s surprise was felt Wednesday afternoon. There isn’t likely to be much follow through. Again, does anyone really believe that a change of $10 billion in Fed bond purchases would move any needle by a whole lot? I certainly don’t. Just as so many government programs in recent years (e.g. first time home buyer credits or cash for clunkers) pulled benefits forward without creating long term value, Wednesday’s decision created a pop in asset prices that probably simply borrow from future gains. No more or no less.

The true facts are that this economy is what it is, an economy growing about 2% per year, despite significant headwinds created by fiscal policy and Congressional gridlock. The headwinds may be a bit less next year as we anniversary the payroll tax increase but housing growth rates will decline next year and one can’t count on the trickle down impact of a 15-25% growth in stock prices to continue indefinitely. As noted, the Fed has persistently forecasted future growth that was too high. As Fed Chairman Bernanke noted yesterday, the fly in the ointment has been weak gains in productivity. With capacity utilization below 80% and incentives to invest virtually non-existent, one shouldn’t expect productivity to improve until investment spending accelerates. Certainly the uncertainty the Fed created this week surrounding monetary policy won’t help in that regard.

The bottom line is that my near term economic and stock market outlook don’t change. By near term, I mean through 2014. I don’t even see a storm that is likely to hit in 2015 at this time, but no crystal ball is that clear looking two years out. Eventually, and that means within five years, as the Fed does exit and interest rates return to normal levels, there will be problems. Big ones. Government debt service costs are going to skyrocket. That will not only cause further cuts in government spending and entitlements.

9.20.13_TowerBridge_Comentary_2Let me make one point very clear. Nothing has been done about entitlements to date because Congress wasn’t forced to act. When debt service costs rise by $200-400 billion per year, it will be forced to act. Market forces can overwhelm politics. Just look back to 2008. When Congress is forced to act, it will raise the starting age and/or means test Social Security more than it does today and it will cost shift Medicare so that recipients must pay some of the costs. Congress won’t do this because it is the right thing to do or because it is good politically. It will do this because it will be left with no other option. Again, it will happen this decade and the timing will be directly tied to the sharp increase in costs to service our Federal debt. Parenthetically, every developed nation plus China will face the same dilemma; how do you offset rising debt service costs. The responses may differ but the problem is widespread.

That storm is at least 2-3 years away. It may be 4-5 years away. But it isn’t 10 years out. Problems ultimately get solved when markets force them to be solved. Look at the health of U.S. banks today. Markets forced that. Markets made railroads efficient after the Penn Central bankruptcy. Mini-mills saved the steel industry. Japan and German car makers forced the U.S. Big Three to enter the 21st century. The good news is that crisis not only forces change, it forces change for the good because that is the only path to survival. Politicians almost always lack the courage to make changes ahead of crisis. That point transcends both borders and political parties. It takes crisis to force change.

Futures point to a flat opening.

The views expressed above are those of Jim Meyer and Tower Bridge Advisors and are not intended as investment advice.

# – This security is owned by the author of this report or accounts under his management at Tower Bridge Advisors.
Additional information on companies in this report is available on request. This report is not a complete analysis of every material fact representing company, industry or security mentioned herein. This firm or its officers, stockholders, employees and clients, in the normal course of business, may have or acquire a position including options, if any, in the securities mentioned. This communication shall not be deemed to constitute an offer, or solicitation on our part with respect to the sale or purchase of any securities. The information above has been obtained from sources believed reliable, but is not necessarily complete and is not guaranteed. This report is prepared for general information only. It does not have regard to the specific investment objectives, financial situation or the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed in this report and should understand that statements regarding future prospects may not be realized. Opinions are subject to change without notice.

The Next Chairman of The Federal Reserve Is…

Andy RosenbergerAndrew Rosenberger, CFA, Senior Investment Manager, Brinker Capital

In the study of various sciences such as physics, biology, or even economics, we often create models to help us better understand the world around us.  These models often start out simple and usually only account for a few variables at a time.  For example, when solving a physics problem, we may assume that friction doesn’t influence the movement of an object.  That may be an okay assumption if you were calculating the movement of an ice skater along the ice, but ignoring friction could have a devastating impact when discussing vehicle safety or sending a spaceship to the moon.  So too is the case with investments.  As investors, we often create models to try and explain the economic world around us.  For example, to explain the price of a stock or asset class, we may look to the future earnings power and discount rates to calculate a fair value.  But too often these models fail.  Just as many came to believe in the efficient market hypothesis theory, the 2008 financial crisis proved to be a wake-up call that the world of sociology and investor behavior is more complicated than even the most sophisticated models of today.

Since the failure of many traditional valuation models, many investors have shifted from a bottom-up-only view of the world to one that incorporates a more top-down approach.  Thanks in part to massive amounts of liquidity in the form of Quantitative Easing, Fed-watching has become a main source of the new top-down approach.  Unfortunately, leadership at the Federal Reserve remains in question and a seat change may be afoot again.  During an interview on June 18 with Charlie Rose, President Obama stated, “He’s [Ben Bernanke] already stayed a lot longer than he wanted, or he was supposed to.” The statement was a clear signal that new leadership will begin February 1 of next year.

Source: Zeorehedge.com via Paddy Power

Source: Zeorehedge.com via Paddy Power

Over the past month, the search for a new Fed Chairman has narrowed to an apparently short list of two candidates: Larry Summers and the current Vice Chairman of the Federal Reserve, Janet Yellen.  While many influential members of the economic community were quick to vocally support Yellen, the pendulum of consensus now appears to be forming around Larry Summers.  In fact, the nomination has garnered so much momentum in the financial community, that Paddy Power, a United Kingdom-based gambling site, is taking wagers on the outcome.  The current odds are fascinating, with Larry Summers a 1:2 favorite over Janet Yellen, with 2:1 (against) odds.  Amazingly, as charted by Zero Hedge, in less than a month’s time, Summers has moved from having an outside chance to being the favorite.  If you’re skeptical of foreign-based online gambling websites, even reputable sources such as Bloomberg put the odds of a Summers nomination at 60%[1].

What does this mean for investors?  Whereas the investing community largely expects a Yellen nomination to represent a continuation of the current monetary policy as directed under Chairman Bernanke, a Summers nomination is far more uncertain.  However, I’ll quote from one of our trusted research providers, 13D Research:

We have read everything that Summers has written in recent years and we suspect his views coincide very closely with that of President Obama. What makes this all so interesting is that Summers is a vocal supporter of fiscal expansion. It is highly possible that if he is nominated and confirmed by the Senate that he will push for a form of Overt Monetary Finance…Today’s Financial Times carries an article on Summers that quoted remarks he made about the effectiveness of quantitative easing at a conference last April. “QE in my view is less efficacious for the real economy than most people suppose…If QE won’t have a large effect on demand, it will not have a large effect on inflation either.” Summers also gave a highly optimistic outlook for the U.S. economy. “I think the market is underestimating the pace at which the Fed will alter its current course and the consequences of that for interest rates.” This means a radical change in the markets’ expectations. The article also emphasized the following: “People who have discussed policy with him say Mr. Summers regards fiscal policy as a more effective tool than monetary policy.” What has been lacking at the Fed is a strong personality and intellectual leadership. Summers is brash, intelligent and self-confident, traits which may enable him to take charge of the FOMC. A regime change of this order of magnitude would be a game changer of the highest order, impacting inflation, economic growth, wages, gold, and the U.S. dollar….

8.13.13_Rosenberger_NextFedChairman_1The jury is still out as to who will ultimately be the next Fed Chairman and what their policies will be.  Similarly, given that Summers represents a shift away from the status quo, his recent surge in garnering the nomination may partially be why markets have decided to take a breather.  After all, markets prefer predictability and quantitative easing has been a major tailwind for investor confidence.  Thus, we wouldn’t be surprised to see higher market volatility as investors adjust their models and conceptual frameworks to reflect the possibility of a new Federal Reserve paradigm led by Larry Summers.


[1] Bloomberg, http://www.bloomberg.com/news/2013-08-12/the-fed-race-heats-up.html

Monthly Market and Economic Outlook: August 2013

Magnotta@AmyMagnotta, CFA, Senior Investment Manager, Brinker Capital

The U.S. equity markets hit new all-time highs in July after investors digested the Fed’s plans to taper asset purchases.  The S&P 500 Index gained over 5% during the month while the small cap Russell 2000 Index gained 7%. So far 2013 has been a stellar year for U.S. equities with gains of 20%. Second quarter earnings have been decent with 69% of S&P 500 companies beating estimates (as of 8/5)[1]; however, revenue growth remains weak at just +1.3% year over year. We will need to see stronger top-line growth for margins to be sustainable at current high levels.

8.8.13_Magnotta_AugustOutlook_1Developed international equity markets also participated in July’s rally, helped by a weaker U.S. dollar. The MSCI EAFE Index gained just over 4% for the month in local terms and gained over 5% in USD terms. Japan’s easing policies have been celebrated by investors, driving Japanese equity markets 17% higher so far in 2013. Emerging markets were able to eke out a gain of just 1% in July as Brazil and India continued to struggle in the face of slowing growth and weaker currencies.

While interest rate volatility overwhelmed the second quarter, the fixed income markets stabilized in July. After moving sharply higher in May and June, the 10-year U.S. Treasury rose only nine basis points during the month and at 2.64% (as of 8/5), remains at levels we experienced as recently as 2011. The Barclays Aggregate Index was relatively flat for the month. Small losses in Treasuries and agency mortgage-backed securities were offset by gains in credit. The high yield sector had a nice rebound in July as credit spreads tightened, gaining 1.9%.

8.8.13_Magnotta_AugustOutlook_2With growth still sluggish and inflation low, we expect interest rates to remain relatively range-bound over the near term; however, the low end of the range has shifted higher.  Volatility in the bond market should continue as the Fed begins to taper asset purchases.  Negative technical factors, like continued outflows from fixed income funds, could weigh on the asset class. Our portfolios remain positioned in defense of rising interest rates with a shorter duration, an emphasis on spread product, and a healthy allocation to low volatility absolute return strategies.

The pace of U.S. economic growth has continued to be modest, but attractive relative to growth in the rest of the developed world. U.S. GDP growth in the first half of the year has been below expectations; however, there are signs that growth has been picking up in the second quarter, including an increase in both the manufacturing and non-manufacturing purchasing manager’s indices (PMIs) and a decline in unemployment claims.  The improvement in the labor markets has been slow but steady.  Should the Fed follow through with their plans to reduce monetary policy accommodation, it will do so in the context of an improving economy, which should be a positive for equity markets.

We continue to approach our macro view as a balance between headwinds and tailwinds. We believe the scale remains tipped in favor of tailwinds as we move into the second half of the year.  A number of factors should continue to support the economy and markets for the remainder of the year:

  • Monetary policy remains accommodative: The Fed remains accommodative (even with the eventual end of asset purchases, short-term interest rates will remain low for the foreseeable future), the ECB has pledged to support the euro, and now the Bank of Japan is embracing an aggressive monetary easing program in an attempt to boost growth and inflation.
  • Fiscal policy uncertainty has waned: After resolutions on the fiscal cliff, debt ceiling and sequester, the uncertainty surrounding fiscal policy has faded.  The U.S. budget deficit has improved markedly, helped by stronger revenues.  Fiscal drag will be much less of an issue in 2014.
  • Labor market steadily improving: The recovery in the labor market has been slow, but steady.
  • Housing market improvement: The improvement in home prices, typically a consumer’s largest asset, boosts net worth and as a result, consumer confidence.  However, a significant move higher in mortgage rates could jeopardize the recovery.
  • U.S. companies remain in solid shape: U.S. companies have solid balance sheets that are flush with cash that could be reinvested or returned to shareholders. Corporate profits remain at high levels and margins have been resilient.

However, risks facing the economy and markets remain, including:

  • Fed mismanages exit: If the economy has not yet reached escape velocity when the Fed begins to scale back its asset purchases, risk assets could react negatively as they have in the past when monetary stimulus has been withdrawn.
  • Significantly higher interest rates: Rates moving significantly higher from here could stifle the economic recovery.
  • Europe: While the economic situation appears to be bottoming, the risk of policy error in Europe still exists.  The region has still not addressed its debt and growth problems; however, it seems leaders have realized that austerity alone will not solve its problems.
  • China: A hard landing in China would have a major impact on global growth.

We continue to seek high conviction opportunities and strategies within asset classes for our client portfolios.  Some areas of opportunity currently include:

  • Domestic Equity: favor U.S. over international, financial healing (housing, autos), dividend growers
  • International Equity: frontier markets, Japan, micro-cap
  • Fixed Income: non-Agency mortgage-backed securities, short duration, emerging market corporates, global high yield and distressed
  • Real Assets: REIT Preferreds
  • Absolute Return: relative value, long/short credit, closed-end funds
  • Private Equity: company specific opportunities
8.8.13_Magnotta_AugustOutlook_3

Investment Insights Video: Responding to Rising Interest Rates

In May, Federal Reserve Chairman, Ben Bernanke, announced the possibility that they will begin tapering in the upcoming months. As that notion looms, so too does the prospective of rising interest rates.

We sat down with Bill Miller, Chief Investment Officer, and Jeff Raupp, Senior Portfolio Manager to discuss how Brinker is prepared to respond to the upcoming policy changes.  In this installment of Investment Insights, Bill and Jeff will give financial advisors and investors a clearer understanding of the tools available to Brinker Capital and how our portfolios can manage the impending environment of rising interest rates.

Should I Sell My Fixed Income?

Jeff RauppJeff Raupp, CFA, Senior Investment Manager

Now that we’re able to look back with the benefit of hindsight, it’s pretty easy to pick on the mistakes that investors made during the financial crisis of 2008. For instance, as equity markets sold off, emotion took over, and many investors that entered the crisis with a well balanced portfolio abandoned their plan and made wholesale changes to fixed income or, even worse, cash. At the time, it seemed like a rational reaction—Wall Street institutions that had existed for decades were insolvent, and each day seemed to bring a new, ineffective government program to stabilize the credit markets, along with yet another triple-digit loss in the stock market.

7.18.13_Raupp_FixedIncomeWe know now that what had started as an economic slowdown and then recession extended into a full-fledged market panic, where investors sold indiscriminately of price. In the years that followed, those that kept their heads recovered and reached new highs with their investments; those that joined the panic are, in many cases, still hoping to recover their 2008 losses.

Today, many investors are considering a question that could very much have the same negative long-term consequences, namely, “Should I abandon fixed income altogether?”

The question comes up after interest rates spiked in reaction to Federal Reserve Chairman Ben Bernanke’s May testimony in which he outlined a scenario where, with the right economic growth in place, the Fed could start lowering the level of bond purchases they’re making as part of the quantitative easing (QE) program. Over a two month period, the yield on the 10-year Treasury jumped from 1.6% to 2.8% and at -2.3%, the Barclay’s Aggregate Index had its worst quarterly return since the second quarter of 2004 when it fell 2.4%.

To answer the question, first let’s look at the downside potential. It’s been a long time since we went through an extended rising rate environment. As our research indicates, from 1945 to 1981 the yield on the 10-year Treasury rose from 1.5% to over 14%. Over that 36-year period, the return an investor in the 10-year Treasury received was actually a positive 2.8%, with 75% of the calendar years in that period having positive returns. The worst one-year loss, 5.0%, was in 1969, and the worst multi-year losing streak happened twice—1955-1956 and 1958-1959 (1957 was a strong year and the five-year period 1955-1959 was close to flat). Compared to a stock market bubble, the downside on fixed income is extremely tame.

7.18.13_Raupp_FixedIncome_1Secondly, you have to think about the role fixed income plays in your portfolio. In heavy stock market sell-offs, fixed income is often the only asset class with positive returns and therefore can act as a hedge against market volatility. Since 1945, there has only been one year (1969) where both stocks and bonds had negative returns. In today’s world, a global flight to safety results in demand for high quality fixed income, driving yields down and bond prices higher. No other asset class plays the low volatility hedging role quite as well. Responding to the threat of low rates by greatly increasing equity, or even alternative exposure, can prove disastrous if markets crater.

Finally, fixed income comes in many varieties. At any given point in time, there are areas of fixed income that provide opportunity and/or protection. By broadening your universe beyond simple treasuries to take advantage of these you can get a better end result.

Let’s be clear, core, investment-grade fixed income doesn’t provide a great investment opportunity right now. With yields still at low levels and likely to rise in the coming five to ten years, we’ll likely see muted returns at best with fits and starts of performance along the way. Inflation is currently in check below 2%, but if we started to see it flare up, investors, especially those with longer horizons, would need to consider the impact rising prices would have on their purchasing power. But even in an adverse environment, fixed income still plays an important role in portfolios.

Monthly Market and Economic Outlook – July 2013

Magnotta@AmyMagnotta, CFA, Senior Investment Manager, Brinker Capital

Risk assets were off to a decent start in the second quarter but then retreated after Federal Reserve Chairman Ben Bernanke’s testimony to Congress on May 22 laid the ground work for a reduction in monetary policy accommodation through tapering their asset purchases as early as September. While the U.S. equity markets were able to end the quarter with decent gains, developed international markets were relatively flat and emerging markets experienced sizeable declines. Weaker currencies helped to exacerbate these losses.

After starting to move higher in May, interest rates rose sharply in June and into early July, helped by the fears of Fed tapering. The yield 10-year U.S. Treasury has increased 100 basis points over the last two months to a level of 2.64% (through 7/10). The increase in rates was all in real terms as inflation expectations fell. Bonds experienced their worst first half of the year since 1994, in which we experienced four short-term rate hikes before June 30.

7.12.13_Magnotta_MarketOutlook_2While we have seen these levels of rates in the recent past (we spent much of the 2009-2011 period above these levels), the sharpness of the move may have been a surprise to some fixed income investors who then began to de-risk portfolios. In June, higher-risk sectors like investment-grade credit, high-yield credit and emerging market debt, as well as longer duration assets like TIPS, fared the worst. With growth still sluggish and inflation low, we expect interest rates to remain relatively range-bound over the near term; however, we do expect more volatility in the bond market. Negative technical factors like continued outflows from fixed income funds could weigh on the asset class. Our portfolios remain positioned in defense of rising interest rates, with a shorter duration, emphasis on spread product and a healthy allocation to low volatility absolute return strategies.

After weighing on the markets in June, investors have begun to digest the Fed’s plans to taper asset purchases at some point this year. Should the Fed follow through with their plans to reduce monetary policy accommodation, it will do so in the context of an improving economy, which should be a positive for equity markets.

7.12.13_Magnotta_MarketOutlook_3We continue to approach our macro view as a balance between headwinds and tailwinds. We believe the scale remains tipped in favor of tailwinds as we move into the second half of the year. A number of factors should continue to support the economy and markets for the remainder of the year:

  • Monetary policy remains accommodative: The Fed remains accommodative (even with the scale back on asset purchases short-term interest rates will remain low), the ECB has pledged to support the euro, and now the Bank of Japan is embracing an aggressive monetary easing program in an attempt to boost growth and inflation. This liquidity has helped to boost markets.
  • Fiscal policy uncertainty has waned: After resolutions on the fiscal cliff, debt ceiling and sequester, the uncertainty surrounding fiscal policy has faded. The U.S. budget deficit has improved markedly, helped by stronger revenues. Fiscal drag will be much less of an issue in 2014.
  • Labor market steadily improving: The recovery in the labor market has been slow, but steady. Monthly payroll gains over the last three months have averaged 196,000 and the unemployment rate has fallen to 7.6%. The most recent employment report also showed gains in average hourly earnings.
  • Housing market improvement: An improvement in housing, typically a consumer’s largest asset, is a boost to net worth, and as a result, consumer confidence. However, a significant move higher in mortgage rates, which are now above 4.5%, could jeopardize the recovery.
  • U.S. companies remain in solid shape: U.S. companies have solid balance sheets that are flush with cash that could be reinvested or returned to shareholders. Corporate profits remain at high levels and margins have been resilient.

However, risks facing the economy and markets remain, including:

  • 7.12.13_Magnotta_MarketOutlook_4Fed mismanages exit: If the economy has not yet reached escape velocity when the Fed begins to scale back its asset purchases, risk assets could react negatively as they have in the past when monetary stimulus has been withdrawn.
  • Significantly higher interest rates: Rates moving significantly higher from here could stifle the economic recovery.
  • Europe: The risk of policy error in Europe still exists. The region has still not addressed its debt and growth problems; however, it seems leaders have realized that austerity alone will not solve its problems.
  • China: A hard landing in China would have a major impact on global growth. A recent spike in the Chinese interbank lending market is cause for concern.

We continue to seek high conviction opportunities and strategies within asset classes for our client portfolios. Some areas of opportunity currently include:

  • Domestic Equity: favor U.S. over international, dividend growers, financial healing (housing, autos)
  • International Equity: frontier markets, Japan, micro-cap
  • Fixed Income: non-Agency mortgage backed securities, short duration, emerging market corporates, global high yield and distressed
  • Real Assets: REIT Preferreds
  • Absolute Return: relative value, long/short credit, closed-end funds
  • Private Equity: company specific opportunities

Asset Class Returns
7.12.13_Magnotta_MarketOutlook_1

Winds of Change

Joe PreisserJoe Preisser, Portfolio Specialist, Brinker Capital

The winds of change have begun to blow through Washington, D.C. carrying with them whispers that the Federal Reserve Bank of the United States is contemplating a more immediate slowing of the unprecedented stimulus measures it has employed since the financial crisis than many analysts anticipate, which could have broad implications across the global landscape. Several signals have been offered by the American Central Bank in the past few weeks to prepare the marketplace for the impending reduction of their involvement, highlighting the delicate nature of this endeavor.

The Institution faces a daunting challenge in trying to scale back a program that has largely been credited with fueling a dramatic rise in asset prices, without interrupting the current rally in equity markets.  Although the U.S. economy has shown itself to be growing at a moderate pace, a measure of uncertainty lingers within investors as to whether this growth is robust enough to compensate for the paring back of the Bank’s historically unprecedented accommodative monetary policies.

As the depths of the ‘Great Recession’ threatened to pull the global economy into depression, the U.S. Central Bank undertook a herculean effort to bring the country back from the precipice of disaster. The tangible result of these efforts has been a deluge of liquidity forced upon the marketplace, which has given birth to a tremendous rally in share prices of companies listed around the globe, and helped to repair much of the damage inflicted by the crisis. The dramatic expansion of the Fed’s balance sheet, since the inception of these programs, has culminated in the most recent iteration of these efforts—an open-ended program of quantitative easing, comprised of the purchase of $45 billion per month in longer dated U.S. Treasury debt and $40 billion of agency mortgage-backed securities, undertaken in September of last year, that has brought the aggregate amount of assets acquired by the Bank to more than $3 trillion.

5.17.13_Pressier_WindsOfChange

The chart above depicts the increase in the size of the Fed’s balance sheet (white line) versus the S&P 500 Index (yellow line).

As the economic recovery has gained momentum in the United States, with notable improvements seen in both the labor and housing markets, concern has been voiced that the flood of liquidity flowing from Washington should be tapered, lest it potentially result in the creation of artificial asset bubbles, which in turn could present risks to price stability.

The first broach of the possibility of the Fed varying the additions it is making to its balance sheet came in a press release from the Federal Open Market Committee on May 1 which stated that, “The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes.” This statement was followed by the May 11th publication of an article authored by Jon Hilsenrath of the Wall Street Journal, who is widely considered to be a de facto mouthpiece for the Central Bank, “officials say they plan to reduce the amount of bonds they buy in careful and potentially halting steps, varying their purchases as their confidence about the job market and inflation evolves. The timing on when to start is still being debated” (Wall Street Journal). Comments issued on Thursday by the President of the San Francisco Fed, John William’s, referred once again to the possibility of the Central Bank’s program being scaled back, potentially sooner than many market participants anticipate, “It’s clear that the labor market has improved since September.  We could reduce somewhat the pace of our securities purchases, perhaps as early as this summer” (Bloomberg News).

Though the Fed has stated that it will continue its accommodative monetary policies until the unemployment rate in the United States has been reduced from its current rate of 7.5% to a target of 6.5%, it appears that the pace of this accommodation may change in the near term.  While the consensus among market participants is for this gradual reduction in quantitative easing to begin sometime this year, no one is sure of the scale or the exact timing.  As the Central Bank has played such an integral role in helping to engineer the current rally in equities, it will be imperative to closely monitor the deftness with which they handle the extrication of their involvement.

Fed Likely to Remain Accommodative in the Near Term

Magnotta@AmyLMagnotta, CFA, Brinker Capital

Equity market investors expressed concern last week after the release of the minutes from the latest FOMC meeting suggested that the Federal Reserve is considering slowing down the pace of the current quantitative easing (QE) program. The Fed is currently purchasing $85 billion of U.S. Treasury and Agency mortgage-backed securities per month.

The Fed has changed its stance on when policy would potentially move to a tightening bias, from emphasizing a calendar date to basing it on economic data. The Fed has stated that it would not raise short-term rates until the unemployment rate fell to 6.5% as long as inflation is not expected to rise above 2.5%. With inflation currently running well below their threshold and with the unemployment rate elevated at 7.9%, it is likely the Fed is more focused on bringing down the employment rate, potentially at the expense of higher inflation.

With short-term interest rates already at the zero bound, the asset purchases are attempting to promote the same result as additional cuts to the fed funds rate. Even if the Fed tapers off their asset purchases in the next few months, any QE is still easing. They would just be taking their foot off of the accelerator. We feel that economic growth should remain tepid in the first half of the year and not strong enough to bring down the unemployment rate significantly, so the Fed is likely to keep their accommodative stance. In addition, the key members of the FOMC – Bernanke, Yellen and Dudley – all lean to the dovish side with respect to monetary policy.

Before actual tightening occurs, the Fed will first have to end QE. When the Fed stops asset purchases, it would be in the context of an improving economy. An improving economy is typically a positive for asset prices. As ISI Group shows in the following charts, equity prices have eventually increased in past episodes of policy tightening.

The Fed raised interest rates from 1.00% to 5.25% from June 2004 to June 2006. After a modest correction, equity prices moved up substantially.

The Fed raised interest rates from 1.00% to 5.25% from June 2004 to June 2006. After a modest correction, equity prices moved up substantially.

The Fed tightened in more aggressive increments during the 1994-1995 period. The equity markets moves sideways for a period of time, and then ultimately moved higher.

The Fed tightened in more aggressive increments during the 1994-1995 period. The equity markets moves sideways for a period of time, and then ultimately moved higher.

Balancing Act

Joe PreisserJoe Preisser, Brinker Capital

Concern lurched back into the market place last week, as the specter of an eventual withdrawal of the extraordinary measures the U.S. Central Bank has employed since the financial crisis, served to temporarily rattle markets around the globe. Although stocks rebounded smartly as the week drew to a close, from what had been the largest two-day selloff seen since November, the increase in volatility is noteworthy as it spread quickly across asset classes, highlighting the uncertainty that lingers below the surface.

Equities listed in the United States retreated from the five-year highs they had reached early last week following the release of the minutes of the most recent Federal Open Market Committee (FOMC) meeting as the voices of those expressing reservations about continuing the unprecedented efforts of the Central Bank to stimulate the U.S. economy grew louder. The concern of these members of the Committee stems from a fear that the current accommodative monetary policy may lead to “asset bubbles” (Bloomberg News) that would serve to undermine these programs. “A number of participants stated that an ongoing evaluation of the efficacy, costs and risks of asset purchases might well lead the committee to taper, or end, its purchases before it judged that a substantial improvement in the outlook for the labor market had occurred. The minutes stated.” (Wall Street Journal).

Tangible evidence of the unease these words created in the marketplace could be found in the Chicago Board Options Exchange Volatility Index, or VIX, which measures expected market volatility, as it leapt 19% in the aftermath of this statement representing its largest single-day gain since November 2011 (Bloomberg News). The reaction of investors to the mere possibility of the Fed pulling back its historic efforts illustrates the continued dependence of the marketplace on this intervention and highlights the difficulties facing the Central Bank in not derailing the current rally in equities when it eventually pares back its involvement.

A measure of the uncertainty surrounding the timing of the Federal Reserve’s withdrawal of its unprecedented efforts to support the U.S. economy was dispelled by St. Louis Fed President, James Bullard, in an interview he gave late last week. Mr. Bullard, currently a voting member of the FOMC, was quoted by CNBC, “I think policy is much easier than it was last year because the outright purchases are a more potent tool than the ‘Twist’ program was…Fed policy is very easy and is going to stay easy for a long time.”

Reports of statements made by The Chairman of the Federal Reserve, Ben Bernanke, earlier this month, which downplayed the potential creation of dangerous asset bubbles through the Central Bank’s actions, released Friday, helped to further assuage the market’s concerns. “The Fed Chairman brushed off the risks of asset bubbles in response to a presentation on the subject…Among the concerns raised, according to this person, were rising farmland prices, and the growth of mortgage real estate investment trusts. Falling yields on speculative-grade bonds also were mentioned as a potential concern” (Bloomberg News). Although the rhetoric offered by these members of the Federal Reserve in the wake of the release of the minutes of the FOMC was offered to alleviate fears, the text of the meeting has served as a reminder to the marketplace that the asset purchases currently underway, which total $85 billion per month, will be reduced at some point in the future, and as such, has served as a de facto tightening of policy.

Though investors appeared to be appeased by the words of Mr. Bullard as well as those of Mr. Bernanke, the steep selloff that accompanied the mention of a pull back of the Central Bank’s efforts is a reminder of the high-wire act the Fed is facing when it does in fact need to extricate itself from the bond market.

Global Equities Rise on Hopes for End to U. S. Budget Impasse

Joe PreisserJoe Preisser

Optimism cautiously crept back into the marketplace this week, as investors continued to cast wary eyes toward Washington D.C. and the high stakes drama playing out around the looming budgets cuts and tax increases of the, “fiscal cliff”.  Stocks on Wednesday marked a turning point as they reversed earlier losses, and staged a late day rally with indications that policy makers in the United States were moving closer to bridging their differences helping to support share prices.  Although the momentum of late has been positive, indices around the globe remain beholden to news reports discussing the state of negotiations, with any hint of stagnation or progress toward resolution holding the power to move share prices significantly in either direction.  Joseph Tanious, a Global Market Strategist for J.P. Morgan was quoted as saying, “I think we’re going to have these markets that react to every single headline.  I think an agreement will be reached, and I think we’re likely to see a relief rally at the end of it.  But until then, hold on to your seat” (Wall Street Journal).

Through the confusion of this unnecessarily complex dance of politics, it appears as though the two sides are inching closer to common ground.  In a break with his party’s line, senior Republican Representative, Tom Cole of Oklahoma on Tuesday advocated to fellow G.O.P. members that they accept the White House’s proposition to extend tax rates for those making $250,000 or less (New York Times).  With the issue of possible tax increases on the highest income earners among the most contentious of the current debate, it has become apparent that the President may be amenable to adjusting the size of such an increase, potentially creating the conditions for compromise.  If the current tax rates of those Americans making more than $250,000 and $388,000 respectively, which represent the highest brackets, were permitted to expire they would reset to the Clinton era levels of 36% and 39.6%.  The co-chairman of the President’s 2010 deficit-reduction panel, Mr. Erskine Bowles suggested, following a meeting with President Obama this week, that those rates may be permitted to rise to a lower level as part of a broader deal.  According to the Wall Street Journal, “Mr. Bowles said White House officials made clear to him that the rates might not have to increase quite that high, as long as they increased a significant amount and were paired with some limits on tax breaks.”

11.16.12_Preisser_Fiscal_Cliff_Concerns

Equity markets got an additional lift this week from an article published by the Wall Street Journal, in which Jon Hilsenrath, who is widely considered a de facto mouthpiece for the Federal Reserve Bank of the United States, suggested that the Central bank will likely continue their unprecedented monetary easing policies into next year.  Mr. Hilsenrath wrote, “Three months after launching an aggressive push to restart the lumbering U.S. economy, Federal Reserve officials are nearing a decision to continue those efforts into 2013 as the U.S. faces threats from the fiscal cliff at home and fragile economies elsewhere in the world” (Wall Street Journal).  Although volatility will almost certainly surround the remaining days of the “fiscal cliff” negotiations in Washington, if the framework for compromise which has been created is completed, the extrication of this uncertainty coupled with the possibility of additional action by the Federal Reserve will be strongly supportive of equity markets around the globe.