FAI Investment Outlook 3Q 2015
First Half 2015: S&P 500 stocks provided dividends…and not much else!
Before the markets opened on Monday, June 29th, the S&P 500 was sporting a ho–hum YTD total return (e.g. price change plus dividends) of 3.1%. But the last two trading days of 2Q were bogged down with worries about unmanageable debts in Greece and Puerto Rico; falling prices smacked the total return for stocks in the first six months of the year down to just 1.2%!
Here is the S&P 500 index for the first half of 2015… very choppy and not very productive:
Source: CNN Money
Lately, global financial news has been dominated by two themes: 1) whether Greece, a $237 billion (USD) economy with 25% unemployment, burdened with roughly $415 billion of government debt, might default and exit the Euro Zone; and 2) speculation about when the U.S. Federal Reserve might finally begin boosting short-term interest rates above the “zero bound” for the first time in almost seven years… potentially slowing the U.S. economy and depressing securities prices. So, let’s look at Greece and the Fed.
On June 30th, Greece became the first “advanced economy” to default on loans from the IMF. (Heretofore, the only nations to do so were Cuba and Zimbabwe!) On July 5th, 61% of the Greek electorate voted to reject the latest extension proposal by their European creditors.
The IMF recently projected that even if Greece should accept its creditors’ proposed fiscal reformation, its debt would still be unsustainable 15 years from now! Our best guess is that sooner than later Greece will default massively, exit the Euro Zone, and start over with the Drachma as its currency. HOWEVER, this working assumption has virtually no influence on either our global economic expectations or our portfolio construction... because Greece, despite its hallowed place in world history, is a TINY economy. They are 11 million people producing about 0.4% of the world’s output of goods and services (1.8% of the Euro Zone’s GDP). And, in Democracy’s original home, the government spends almost 60% of its GDP!
It’s important to note that Greece’s sovereign debt is now held mostly by the IMF, the European Central Bank and other European governments. Hence, Europe’s banking system, substantially strengthened since the financial crisis, does not appear vulnerable to a Greek default. Nor do we believe that a “Grexit” would be contagious, as many have suggested. Spain, Portugal, Ireland, and Italy (the usual suspects) have, unlike Greece, made serious adjustments and their economies are growing again. They’ll be happy to stay put.
So, outside of Homer’s picturesque homeland, the consequences of a Greek Euro exit will be but a rounding error in the global economy. Still, it may be in investors’ interest to see her troubles as one of several flashing signs that should focus us on the risks inherent in a highly leveraged world that remains addicted to deficit spending and monetary manipulation.
With that in mind, what about the Federal Reserve Bank’s influence on global interest rates?
The Fed and Bond Prices
The Fed sets the interest rate at which banks make one-day (“overnight”) loans to one another; it is also the rate the central bank charges for overnight loans to the banks it regulates. The overnight rate is also called the “policy rate” and “Fed funds rate.”
Because policy-rate loans are available to all our national banks, Fed moves tend to influence all domestic lending rates… they affect what banks pay for deposits, the rates they charge on mortgages and business loans, as well as the market rate for corporate bonds, Treasuries, etc.
The Fed has kept its policy rate at 0 – 0.25% since December 2008, hoping to stimulate borrowing and spending in the wake of the ’08 financial crisis. For perspective, just a year before that, the rate was 4.25%! So, when the Fed talks, as they have the last few months, about “normalizing” the Fed Funds rate, market pros start to worry about how far rates might rise… and whether rising rates might suppress both economic activity and securities valuations.
The other major policy tool the Fed has luxuriated in since the ‘08 crisis is so-called Quantitative Easing or QE. It is their program of ongoing open-market purchases of bonds. They mainly buy Treasuries and other government-backed issues, usually with money they’ve “printed” for their own use… oh; it’s not totally clandestine– since the amounts fabricated do show up as debt on the Fed’s balance sheet. The Fed’s purchases add to normal market demand for bonds, boosting bond prices (hence reducing their yields). QE policy was used liberally (with over $4 trillion worth of made-up money) in the wake of the financial crisis. It ended just last October.
Ending QE purchases was considered a step toward normalization. The next logical step will be to gradually raise the Policy Rate to something like 1% – 2% above the prevailing inflation rate. In the current environment that could be more than 3% (a long way from 0%!) Investors have two basic concerns about the potential rise in interest rates: 1) the rising cost of borrowing money (whether for consumption or for corporate investment) may well slow the pace of the economy and 2) rising bond yields tend to accompany generally lower P/E ratios for stocks (this is a little too “wonky” to describe in detail on these few pages… but it’s true.)
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