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Monthly Macro: Policy Downshift

Posted on January 7, 2014

“…it is worth remembering that in addition to prolonged, low interest rates there is plenty of Fed stimulus left.” – Scott Minerd, Guggenheim Investments

Our Monthly Macro is a recurring post that appears on the first Tuesday of every month and recaps the high level macro developments of the previous month. We highlight the global themes that we believe are the most important and discuss why they matter for investors. This month’s piece will focus on the long-awaited Fed taper, Washington’s budget deal and the skyrocketing stock market.


The Wait Is Over

Few would disagree that highly accommodative monetary policy cut short the tail risk associated with the subprime mortgage crisis five years ago and the subsequent Eurozone debt crisis in 2011. While it is impossible to quantify, we surely would have suffered a deeper and more prolonged global economic downturn had it not been for a the proactive policies of the US Federal Reserve, the Bank of England, the European Central Bank and the Bank of Japan. The Federal Reserve provided crucial bridge capital that allowed highly stressed financial institutions to get through the financial crisis, and its policies have kept a lid on debt service burdens allowing many borrowers to recapitalize and improve their balance sheets over the past five years. Additionally, the perceived “Bernanke put” has bolstered risk appetites and led to a great inflation in asset prices, particularly stocks.

While other central banks appear to have no plans to take their foot off the accelerator, the Federal Reserve has finally reached a turning point and has begun backing off its unprecedented policies. The “taper”, as it’s been called, refers to the Fed’s decision to scale back on its monthly asset purchases (aka, quantitative easing). The taper was first signaled by Bernanke in the 2nd quarter and has been the subject of exhaustive discussion and speculation ever since. But the wait is finally over. At its December meeting, the FOMC announced that it would reduce its monthly purchases of mortgage-backed securities from $40 to $35 billion, and its purchases of longer-dated Treasuries from $45 to $40 billion beginning in January. If the FOMC decides to reduce its pace of purchases by the same $10 billion at each meeting from here on out quantitative easing could be a thing of the past by year end. This will, of course, be dependent on the labor market continuing to improve against a backdrop of tame but consistent inflationary pressures.

WHY IT MATTERS: The Fed’s quantitative easing programs have bolstered asset prices consistently, but at a diminishing rate, over the past five years. At this point in the game the uncertainty of the future consequences of the policy probably outweighed the ongoing benefits of keeping it in pace. It was time to taper. In contrast to the Taper Tantrum that we saw in the markets when the shift was first hinted at earlier in 2013, financial markets took the Fed’s December announcement in stride. This is encouraging as it suggests that capital market performance might be making a shift back to dependency on fundamentals rather than schizophrenically trying to position for the next policy announcement.

Fiscal Headwind Subsides

In contrast to the tailwind of monetary policy, fiscal policy has been a headwind to confidence, economic growth and asset prices in recent years. In the summer of 2011 the budget and debt ceiling standoff in congress led to a US credit rating downgrade exacerbating the deepening sovereign debt crisis in Europe. Then, in 2012, it was the fiscal cliff and sequester followed by the temporary government shut down and threat of default in the fall of 2013. If it weren’t such a serious issue, the dysfunctional bickering amongst grown men (our elected leaders no less) would almost be comical.

In what appears to be more of a cease-fire than a productive compromise, Capitol Hill actually produced a budget deal in December that will fund the government for the next two years. The plan doesn’t really change the current fiscal path. While the goal in 2011 was to come up with $4 trillion in deficit reduction over ten year, lawmakers scaled their ambition back by 99.4% and came up with just $23 billion in savings. What’s more, spending will actually increase over the next several years while the lion’s share of the deficit savings will come in 2022 and 2023 (as if this deal will still be relevant a decade from now).

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WHY IT MATTERS: We obviously are not very fond of the impotency of this alleged “deal”, but the reason it matters is that it takes the budget debate off the table for a couple years. Congress has been governing from a constant state of crisis recently, and not having to worry about spending agreement deadlines and posturing for the public will allow our leaders (hopefully) to focus on real substance behind closed doors while allowing financial markets to focus on things that matter more to the fundamentals. While this news doesn’t do anything about the debt limit which we are scheduled to bump up against in February, it signals that perhaps even that won’t be as big a deal as it has in the past. For now Congress seems more concerned with avoiding another economy-damaging standoff than getting what they want in the near term.

Stocks To The Moon

Last month concluded an incredibly strong year for the stock market. The US outshined the rest of the world, returning roughly 30% for the year. Other developed markets as measured by the MSCI EAFE index were also strong, but lagged the US with an 18% performance. Emerging markets, meanwhile, were a major disappointment posting a 6% decline for the year. Record setting levels of major stock indices have led many to question whether or not the stock market is in a bubble, particularly in light of the excessive stimulus being offered by the Fed. We have written about this issue in our last couple posts (here and here).

It may come as a surprise to many investors that large returns similar to the ones we saw last year are not all that uncommon in the stock market. The table below, re-created from a chart we saw published by JP Morgan, groups all the annual returns for the S&P 500 (and Dow prior to 1928) since 1987. What this table shows is that despite being considered extraordinary by most investors, a 20%+ year in the stock market happens nearly a third of the time. We have seen less of these years over the past decade than we saw in the 90’s which is perhaps why 2013’s stock market advance was so surprising, if not outright alarming, to many investors.

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WHY IT MATTERS: For the first time in five years we are seeing real, tangible confidence returning to the market. In the near term the optimism might be slightly overdone, but this psychological trend could end up becoming a self-fulfilling prophecy in the economy and markets in 2014. For us, 2013 was an extremely frustrating year given the fact that our clients did not participate in the strong gains captured by long-only stock portfolios. Our Diversification 2.0 methodology diversifies assets across stocks, commodities, bonds, absolute return strategies and gold/currencies. This diversification, while prudent over the long-term, detracted from our results in 2013 as commodities and gold fell sharply while bonds declined marginally. Within our equity portfolios we were also diversified across regions and had exposure to emerging market stocks which created a sharp lag vs domestic equity benchmarks. It’s years like the last one that are tough for anyone employing the “endowment style” of investing, but we continue to believe the long-term benefits of this portfolio construction will pay off via better risk-adjusted returns over time.


david_headshot_bw.jpgAuthor 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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