“This place is a mess.” – Nancy Pelosi, Minority Leader of the US House of Representatives
We have been, and continue to be, in a policy-driven market environment. Sure, from time to time a piece of fundamental data will poke its head above the fray and garner some attention, but even then its only importance seems to be whether or not it will lead to a change in policy. While the focus has largely been on the Federal Reserve’s monetary policy, Washington’s fiscal policy has also been hugely influential. This is the dual-headed monster that has been governing financial markets since the financial crisis, and we believe it will continue to play a lead role between now and the end of the year.
The Federal Reserve’s loose monetary policy is currently two pronged, consisting of low short-term interest rates and $85 billion of monthly asset purchases known as quantitative easing, or “QE”. By keeping interest rates low and adding liquidity into the financial markets via its asset purchases, the Fed hopes to lighten the burden on debtors, encourage more borrowing and push investment capital into riskier asset classes. These are the means by which it hopes to achieve higher spending-induced economic growth. Eventually, as the thinking goes, the economy should reach escape velocity allowing the Fed to reverse these loose policies. The first thing to go will be its QE program, followed by an eventual hiking of short-term interest rates.
As we are all aware, the Fed has signaled that it expects to begin reducing its asset purchases at some point either this year or early next. Over the past several months market participants developed a consensus expectation that this so-called “tapering” would be initiated at the FOMC’s mid-September meeting. Bernanke and he comrades, however, have explicitly stated time and again that their decision to taper is not set in stone and will be dependent on the incoming economic data. It should come as no surprise, then, that in last week’s meeting the FOMC voted to keep its QE program intact with no changes. This threw markets for a loop and sent stocks, bonds and gold all skyrocketing into the close of the trading session. A headline on Yahoo Finance that afternoon said it best: Bernanke Confuses Wall Street By Sticking Exactly To His Plan.
In the post committee press conference Bernanke offered some explanation for the Fed’s decision to stand pat on its asset purchases. He mentioned “tightening of financial conditions” in reference to the recent rise in long-term interest rates while simultaneously downgrading his outlook for the economy. The Fed adjusted its projected range of 2013 GDP growth down from 2.3-2.6% to 2.0-2.3% while also pulling down its 2014 forecast by roughly half a percent. Ultimately, says Bernanke, “the Committee decided to await more evidence that progress will be sustained before adjusting the pace of its purchases.”
We believe the committee needs to see some evidence that housing is remaining resilient in the midst of higher mortgage rates, and that the recent downshift in job growth is a temporary hiccup in what otherwise has been a gradual but steady recovery. By not tapering in last week’s meeting the Fed has proven that it really will remain data-dependent rather than seeking to meet the market’s expectations at every turn. This, in our opinion, pushes the prospect of the first taper out to at least the December meeting, if not early next year, despite the fact that many pundits are already projecting that it will come in October. Regardless of what the future holds, we are back into a situation where every piece of economic data is being dissected to determine its impact on the coming tapering.
Fiscal policy has been less of a consistent factor in financial markets. Rather, it has reared its ugly head off and on over the past several years causing brief periods of uncertainty and dysfunction for investors. Two summers ago a vicious battle over the debt ceiling led to a credit downgrade and nearly resulted in a temporary government shut down. Then, late last year Congress spent weeks wrangling over the mountain of tax increases and spending cuts known as the Fiscal Cliff before kicking the can down the road at the 11th hour. Well, get ready folks because here we go again.
This coming Monday, the 30th, is the last day of fiscal year 2013. To avoid a government shutdown on Tuesday the 1st Congress must pass a resolution that authorizes continued spending past that date. The Republican controlled House passed such a resolution this past Friday that would extend the government’s ability to operate through December 15th, at which point another resolution would need to be passed. However, the House’s resolution was as good as dead before the ink even dried as it included a provision, championed by a contingent of tea party representatives, to defund Obamacare. This has little to no chance of passing in the Democrat-controlled Senate where tea party representatives are now being referred to as anarchists, and even if it did President Obama would clearly veto it. As it currently stands the bill will likely be stripped of its Obamacare provision and sent back to the House as a clean spending bill with just a day or two left before the looming deadline.
The amount of political posturing on both sides of the aisle is exhausting. Senate Democrats are clearly not intending to budge on Obamacare, and the tea party contingent in the House appears to be willing to force the government into a shutdown over the issue. Of course a lot of posturing is just that, and some sort of deal will almost certainly be struck behind closed doors prior to a technical shut down next Tuesday. Even if the situation is not resolved, a temporary government shutdown would not be the end of the world. Only “non-essential” government services would be suspended, and we’ve actually had 17 technical shutdowns in the last 40 odd years without any lasting damage to the economy.
But the budget debate is just the beginning. Sometime in the second half of October the US government will run out of money to pay its bills, regardless of whether or not a resolution has been passed to authorize the spending. As such, the national debt limit will once again need to be increased in order to allow the Treasury to borrow the funds needed to operate the government. This will present yet another opportunity for a deeply divided partisan battle over spending, entitlements, taxes and the national debt, and the threat of a US default will once again come into view creating uncertainty and dysfunction in capital markets.
This dual-headed monster of monetary and fiscal policy will continue to hold markets in its grip between now and year-end. What type of master it will be is largely up to the policy makers themselves. The net effect on the economy and asset prices does not have to be a negative one, and in fact there is an opportunity for functional, common sense policy decisions to have quite a positive impact. Ben Bernanke and his decision-making committee at the Federal Reserve are proceeding with great care with a bias towards a gradual reversal of their asset purchases and zero interest rate policy. This is a positive thing in our view, and the guessing game of projecting exactly when and in what quantities this will occur is an exercise in futility. The important thing to know is that monetary policy is and will remain accommodative for some time, but the Fed’s intention is to begin letting up on the gas sooner rather than later. The fiscal side of the equation is far more chaotic and dysfunctional, but in many ways feels far less uncertain if you can rise above the fray and remain focused on the big picture. Any changes, if any, to Obamacare, tax policy, entitlements and future spending are likely to be marginal at best, although even the slightest win will be championed as a major victory by either side. Ultimately, the two chambers will have to come together on a continuing resolution to keep the doors open, and the debt ceiling will have to be raised at some point next month to avoid a default. The alternatives are simply unacceptable to either side, so the path we take to get to that final conclusion is a moot point from a longer term perspective.
As investors, it’s important to stay the course on a well-defined strategy through periods like this rather than letting the emotion of the moment sway us off course. We don’t pretend to know exactly how and when the markets will react to the policy decisions coming in the near future, or if the market may just shrug them off as the same old tune that we’ve grown accustomed to over the past several years. Our goal, through our Diversification 2.0 framework and MarketVANE, is to build durable portfolios that can weather the storms and grow steadily in more normal market environments. Along these lines, we will be staying the course while watching our models closely for any signs that we need to adjust our exposures in the weeks ahead.
Author David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.
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