What "Brexit" Means for You

It seems like just yesterday you were receiving one of our team’s proprietary research papers discussing “Grexit,” or the potential Greek exit from the Eurozone. Since then Greece’s troubles have popped up from time to time but have subsided dramatically overall.

Now, the United Kingdom has decided to leave the European Union in a vote dubbed “Brexit,” short for “British exit.” British oddsmakers (who are typically much closer to final vote counts than most polls) had put the chances of Brexit at around 30% leading up to the vote and only 6% at one point yesterday so this morning’s final tally has obviously surprised many investors.

Although surprises of any kind are always startling, we believe it’s important to keep a few things about Brexit in mind as you go about your day.

First, financial markets are prone to overreactions-both negative and positive. For weeks,  the financial markets had been creeping toward the “Bremain,” or “Britain remains” camp, so much of today’s negative market open is unwinding that recent positive momentum. For example, the financial media is making waves about the pound’s directional move from $1.50 last night to around $1.37 this morning, which is admittedly a very large move. But what they fail to mention is that the pound had been climbing from $1.40 since mid-June as investors increasingly assumed Bremain would prevail. After accounting for where we were just a few weeks ago, the move doesn’t seem quite so dramatic.

Second, nothing different in the UK will happen for quite a length of time. UK Prime Minister David Cameron announced he is stepping down in October and his successor will carry out the negotiations to leave the EU. That negotiation process won’t happen immediately. The negotiations themselves will take place over an extended period of time. Although there was a legal procedure written into the governing Treaty of Lisbon for how to handle the departure of a member country, it was never truly meant to be necessary.  This lack of procedural clarity will undoubtedly extend the departure process.

Third, although this is the first exit of a European Union member state in its relatively short history, it should be noted that the UK never committed to full EU membership to begin with. The UK did not relinquish its monetary independence to Brussels in the way that the other EU member countries did (Germany, France, Italy, Spain, Portugal, etc.). Retaining the pound sterling allowed the UK to determine its own monetary future while simultaneously benefiting from access to the EU’s “single market”.

While Britons undoubtedly received ample benefits for their membership (like open access to all of Europe for London’s financial district), voters apparently felt that the monetary and social costs of membership (unconstrained immigration policies, for example) were just too high. When push comes to shove, it seems that people (and nations) still act in their own perceived self-interest.

Finally, the near-term impact on our domestic stock markets is likely to be exaggerated relative to the actual impact on the US economy. The US and the UK are strong economic, military and, some would say, cultural, partners. This relationship is unlikely to change simply because the UK’s relationship with mainland Europe has changed.

Similarly, the EU is our largest trading partner and that relationship is unlikely to be altered in the near future. While the final ramifications of Brexit will become more clear into the future, the abiding impact will likely be more political in nature than economic. In addition, the UK will likely remain an important trading partner with France, Germany, and many other large EU nations regardless of how the Brits align themselves politically.

We have been managing money for over two decades and have seen our share of “Brexit-like” events. If we thought the Brexit vote was going to be a life-changing event, your portfolios would have been positioned dramatically differently in advance of the vote itself.

Grexit, interest rate hikes, China’s slowdown, recession concerns and now Brexit have been the “crisis du jour” in the market in the past year or two. Somehow, one after another, the market has shrugged off these short-term concerns. As long as the companies we own keep earning, Brexit will be just another bump in the road.

Best regards,
Patrick R. McDowell, CFP®, AIF®

Market Volatility, Talking Heads & the Chinese NFL

As always, we’re honored and privileged to serve as your Fee-Only Registered Investment Advisor. We will be closely monitoring markets and ready to act should we feel it necessary. We thank you for the trust you have placed in us and will continue to work hard on your behalf.

I’ve obviously borrowed Margaret’s style of headlining her columns with a series of seemingly unrelated people, events, and songs. Today’s Client Memo will be a bit longer than usual because, well, there’s more to talk about.

Volatility

Charts of the stock market going back 20, 30 or 40 years are reassuring because they depict a gradual rise in the value of US businesses. This represents the long term benefits of investing. We always say to focus on the long term, but the long term is of course made up of many short terms. Zoom in to any given year and the results appear much more chaotic. In 1987, the “flash crash” caused equities to drop 20% in a day but somehow stocks still finished the year in the black. More recently, in August of 2015, the Dow opened 1,000 points down on the way to a roughly flat year. Talk about volatility.

This amount of volatility is obviously troubling. No one likes seeing their accounts lose value, much less in a seemingly indiscriminate way, like a boxer taking punches on the ropes and hoping for the round to end. But in periods of tremendous volatility we often benefit from taking a breath and reminding ourselves why we own what we own to begin with. On average, stocks are likely to outperform just about every alternative over the next decade and beyond, just as they did in previous decades. Pullbacks and corrections remind us that there really are no free lunches. As investors, these are the days we must endure to experience the long term benefits of owning little pieces of America and the world.

Sentiment

We make it a point to not watch financial television whenever markets are way up or way down. It simply affects perception too much. When things look good, prosperity is around every bend. When things appear troubled, the sky is falling. Financial television is designed to grab your attention and trigger a response. There are often so many people on camera at once it looks like the intro to “The Brady Bunch”, except this bunch is yelling into the cameras instead of smiling like Alice. Everything about it is telling you as a viewer that you need to “Do something!” And the average lay investor, also known as a “retail investor,” has done just that.

The average retail investor’s sentiment is at a low not seen since the financial crisis and is a telling feature of the market’s recent selloff, which by most accounts has been triggered by retail investors and not institutional managers. I saw a headline recently that said the number of Google searches of the phrase “sell stocks” is at a high since 2008. This further emphasizes the retail investor’s fear, as most institutional asset managers probably aren’t typing open-ended questions into Google to determine their best course of action. Simply put, the average retail investor is scared.

Rhetoric associated with Presidential election years can increase the perception that things are negative. Every candidate has an incentive to paint the country with a grim brush. Ironically, a US Passport is still worth its weight in gold and then some in most corners of the world. Additionally, people all over the world without access to financial institutions continue to hold much of their life savings in $100 bills. Throwing away the television (or, less drastically, muting it) will help regulate our emotions in the face of negative market sentiment.

Smart Money

With Average Joes heading for the hills, what’s the “smart money” doing? It’s actually gaining confidence in US equities. The American Association of Individual Investors recent data points out that despite the average retail investor’s bearishness, institutional managers (including hedge funds) are increasingly optimistic. We think this “Average Joe selloff” is based on a number of factors, but most importantly is the rapid, emotional nature of the selloff that ignores the fundamental strength of US corporations and the US economy.

The Economy

The market isn’t the economy and the economy isn’t the market. The market represents how Corporate America is faring, not Main Street. They’re related, of course, no doubt about it. We all live in the same world and it would be tough for corporations to prosper indefinitely if Main Street isn’t experiencing some good days as well. But Corporate America has vastly outpaced the average American in recovering from the financial crisis. In fact, large corporations are contributing more to US GDP than at any time in history.

The US economy, despite the doomsday prophecies by Presidential candidates and financial media headlines, continues to put one foot in front of the other. Growth here at home hasn’t been speedy by any means, but it has been reassuringly consistent. Joachim Fels of PIMCO recently reiterated their view of the “Triple B” economic expansion: growth that is Bumpy, Below-par and Brittle. We couldn’t agree more with this outlook. We’ve called it the “Low and Slow” recovery. We see this trend continuing for the foreseeable future.

Despite recessionary fears that seemed to have popped up in the last few weeks, domestic unemployment continues to trickle downwards. People are quitting their jobs at levels not seen since before the financial crisis. While slightly counterintuitive, “quits” are seen as a sign of strong confidence in the labor market as people rarely quit their job unless they feel they have a better one lined up or their prospects are better on the open market. Restaurants are serving more customers every month, which is a positive sign of the average consumer’s mindset because eating out is very quickly dropped when expectations of the future look grim.

Oil

The energy market’s downturn has played a major role in the volatility we’ve seen recently. Countless headlines cite “Oil and China” as causes of the recent selloff. Part of that explanation makes sense. A hefty chunk of the S&P 500 are energy companies who have seen their shares hit hard based on the belief that we’re in for a long energy downturn. Fair enough. But the other side of the coin isn’t being represented at all. Just like the country as a whole, which is still a net importer, most Americans are energy consumers and not producers. Every week energy prices stay low is another week Americans get to fuel up at a steep discount to anything they’ve experienced in recent memory. If you’re a millionaire this subtle tax break probably doesn’t make you feel that much better, but if you’re the average American this is a huge windfall.

How far will energy prices, and specifically oil, fall? Who knows. It’s a fool’s errand to call a bottom but we do know that most energy producers are not profitable at today’s prices. Eventually, be it weeks, months, or even years, economics will come back into play and producers will be forced to shut down production. This in turn will lead to lower supply and therefore higher prices. This cycle has played out many times in the energy business. Hence the old oilman’s adage: “The cure for low oil prices is low oil prices.”

China

Panicking over China slowing down is like panicking over baldness. As human beings we tend to be “all or nothing” in terms of our responses to positive or negative long term trends. It’s what causes markets to fluctuate from wildly optimistic to wildly pessimistic. It’s what makes it difficult for politicians to close the budget deficit and start shrinking the national debt. It’s what makes it hard to cut out french fries and exercise regularly. The consequences are so far into the future that it’s hard to endure pain today in order to fix a problem 10, 20 or 30 years away.

Chinese stock market woes are constantly in the headlines. If the Chinese stock market was representative of the overall economy, it should cause concern. But it’s not. China’s market is really in its infancy in terms of having a sophisticated investor base, professional managers, etc. Chinese companies are more often funded with debt rather than equity, which further diminishes the stock market’s importance. Consider one more fact: whereas 40%+ of American households are invested in the US stock market, only 4% of Chinese households invest in their market.

With the NFL postseason upon us, I thought a football analogy might be fitting. The United States is home to roughly 320 million people and 32 NFL teams, so there’s about one NFL team for every 10 million Americans. Now imagine that China somehow became fascinated with American football and decided that they would start a Chinese NFL. Assuming they have as many Chinese NFL teams per person as we do here at home, there would be roughly 135 teams! DirecTV might even have trouble carrying that many games, not to mention all the extra playoff games needed to crown a champion from a field that large. One hundred thirty-five teams, representing varying geographic regions, just like we have here. What do Pittsburgh and Miami have in common, after all? How about Seattle and Houston? Buffalo and New Orleans? One hundred thirty-five teams with a packed stadium every weekend and all the ancillary food, beverages, hotels, souvenirs, etc. that go along with a major sports franchise.

We don’t think there’s any hope of a Chinese NFL in the near future, but the visualization is helpful to demonstrate just how big and diverse China really is. It’s hard to start or stop a train that big on a dime and therefore fears of a Chinese collapse aren’t warranted. Yes, their growth is slowing. But slowing growth doesn’t mean impending doom. Despite their naive attempts at “managing” their stock market, Beijing has done an admirable job guiding their economy through its first slowdown in decades. An economy that big simply cannot grow at 10% per year forever.

In the same way we want to invest in companies whose management act like owners, it’s instructive to see what people who have “skin in the game” are saying about China. Starbucks CEO Howard Schultz recently acknowledged that China is in a transition period, but still plans on opening 500 stores a year there. Apple CEO Tim Cook, who sells quite a few iPhones in China, recently said ”Frankly, if I were to shut off my Web and shut off the TV and just look at how many customers are coming into our stores and coming online, I wouldn’t know there was any economic issue at all in China.” General Motors President Dan Ammann similarly said “Last year, 2015, we posted another year of record sales in China…We’re getting back to a more maturing kind of growth rate there.”

AWM’s Response

While we don’t want to be “heroes” and dive in front of irrational sellers, we do believe that more businesses on our “wish list” are increasingly attractive at today’s prices. Over the next few weeks we will be picking up some of these companies either by using existing cash or by swapping out companies with less attractive prospects from these levels. We may also simply add to existing positions where the risk/reward seems to be most favorable.

Just like the Federal Reserve has begun “normalizing” interest rates, Arbor Wealth has begun the process of “normalizing” our bond holdings. As a firm that would probably be characterized as conservative by many, we have traditionally held many more individual bonds in client accounts than we have recently. This has been for a number of reasons, but mainly because we were wary of the bond market’s reaction to the Federal Reserve’s December rate hike. Those fears have obviously been subdued by the recent equity market volatility, but our desire to hold more individual bonds remains intact. It’s not ideal to buy bonds during a correction because their security tends to be at a premium (like generators during hurricanes) but we believe we will be able to work these into client portfolios successfully over the near future.

In closing, the world is still spinning. People are still doing everything they did three weeks ago. And while the New Year cheer might have worn off a bit sooner than it otherwise would have, 2016 still holds promise for investors who can take the good with the bad and stay the course.

Best regards,
Patrick R. McDowell, CFP®, AIF®

A Tale of Two Inflations (Or Charles Dickens Meets Janet Yellen)

With the U.S. currently experiencing very low levels of inflation, why does it still feel like things cost more every year?

In simple terms, inflation (or lack thereof) is the natural result of a never-ending competition between the value of money and the value of the goods and services that money can buy. If there’s a static amount of money and a static amount of goods and services, we don’t usually see much inflation, because buyers and sellers find a natural balance. When more people want a particular product than there is to go around, the price typically rises.  The available money competes (bids) to buy those goods. When this happens on an individual product level, we call the process “supply and demand”, but when it happens across an entire economy, we simply call it “inflation”.

Inflation (as opposed to “deflation”, or falling prices) has been a fixture of the financial world for centuries, because throughout most of history the demand for goods and services (and the amount of money available) has outweighed the supply of those goods and services. This makes sense as it is easier to create new people and new money than it is to create new land and new natural resources. Additionally, the modern fractional reserve banking system that we now take for granted is itself inherently inflationary; early bankers realized that depositors were unlikely to demand their money back all at once and bankers could therefore earn extra money by lending out a portion of those funds, thus effectively putting more money to work in the economy than actually existed. The inner workings of the banking system are a hoot, aren't they?

Modern day inflation dynamics are obviously more complicated than they were in the Renaissance era, but for our purposes the key to understanding today’s domestic inflation is determining whether money is being hoarded or being put to work.  The latter theme resonates throughout history. When the Spanish brought home and spent massive amounts of silver from the prolific “silver mountain” mines of Potosi in the mid 1500’s, it triggered a wave of inflation that lasted a century. More recently, the post WWI German Weimar Republic printed so much money that people had to wheelbarrow cash to the grocery store to get a few days’ worth of food. This type of inflation is the one most of us are familiar with and it is relatively easy to understand. If there is more and more of one thing (money) actively trying to purchase a stable amount of another good or service (food, in the German example), something has to give.

Many investors and market participants anticipated dramatic levels of inflation since the beginning of the Federal Reserve’s Quantitative Easing program, a policy that is now being emulated around the world. The Federal Reserve purchased massive amounts of bonds from banks, effectively putting lots of new money into the banking system with the expectation that those dollars would eventually be lent out and circulated. Yet domestic inflation has barely budged an inch. How can creating more money in one instance lead to rampant inflation while in another it doesn’t move the needle? The main reason is that once the new money was created, it was effectively stuffed under the mattress by banks. Had the federal government, in lieu of the Federal Reserve’s asset purchases (QE), spent the same amount of money on public works projects, those dollars would likely have found their way into the real economy and presumably would have caused the inflation that many expected.  

So with inflation at a very tame level, why does it still seem like everything costs more every day? The answer depends on who you ask.

Ask a Millennial how inflation is impacting them and you might hear “I hadn’t really noticed.” Ask a retiree on a fixed income how inflation is impacting them and you’ll likely get a resounding “a lot!” Just like the saying, “you are what you eat,” your inflation is what you buy.

For example, if you’re a laptop-toting, cord-cutting (meaning not a cable subscriber), Uber-riding, Netflix-watching, Southwest Airlines-flying Millennial, inflation hasn’t impacted you dramatically. In fact, many products and services utilized by young people (like digital technologies and services, consumer electronics, entertainment, travel, clothing, etc.) are going down in price every year. But few retirees would say their cost of living has seen a similar decrease. Quite to the contrary, retirees are facing dramatically higher inflation than their children and grandchildren. Why? Look at the areas that have seen the most inflation in recent years and you’ll see price increases in necessary items that hit retirees especially hard. Healthcare, pharmaceuticals and food are three major contributors to this “retiree inflation”. 

Trends in "Excess" Health Inflation via the Bureau of Economic Analysis

Although everyone has to eat, groceries tend to make up a larger portion of discretionary income for retirees than younger people. Healthcare and pharmaceutical price increases are the real elephants in the inflation room, though. These price increases have tended to outpace overall inflation for decades. While the gap between healthcare inflation and general inflation is shrinking, healthcare costs are still escalating faster than the broader inflation basket. And barring some major political or social reform, this trend is likely to continue into the near future.

So what’s an investor who is experiencing unofficially high inflation to do?

Arbor Wealth’s belief has been for many years and remains that the best defense against creeping inflation is a solid dividend paying offense. Even if investors don’t currently need dividend income, in years like this one where markets are essentially flat dividends represent a large portion of total return. But buying dividend payers alone isn’t enough. We endeavor to own companies that are growing their dividends sustainably over time. And how do we know if dividend growth is sustainable? There are a number of factors (balance sheet strength, solid and dependable cash flow, limited or manageable debt, etc.) but by far the most important is pricing power. By focusing on businesses with pricing power, or the ability to continually raise prices to combat inflation, we attempt to match price increases that our clients experience as consumers tit-for-tat with price increases as the owners of businesses.

So the next time you’re at a store and see a price increase in your favorite product made by a company you own, take heart in knowing those dollars will come full circle back to you soon enough.

Best regards,
Patrick R. McDowell, CFP®, AIF®

A Fall From Greece

You’ll have to forgive the pun. Greece really has fallen a long way in the last few years. Just in the past couple of days, I’ve seen headlines suggesting a deal between Greece and its creditors was close only to see another headline to the contrary, like an international high-stakes game of “Deal or No Deal”. As news of a potential Grexit (financial-speak for a Greek exit from the Eurozone) continues to make headlines and since a few clients have asked me recently why Greece continues to cause so many problems in the world economy, I thought I’d offer some thoughts.

Why are we talking about Greece and not Portugal or Ireland or Spain? We’re talking about Greece because, in simple terms, the Greek government borrowed a lot more than most other Eurozone nations, didn’t do anything productive with that money and then couldn’t (or wouldn’t, depending on your perspective) pay their bills.

How did this happen? When the European Monetary Union was formed, bond investors began to assume that all European government debt was the same. After all, it was one currency union with one central bank, just like the United States. And since Greek debt paid more than German or French debt, investors bought a lot of it, assuming creditworthiness wasn’t an issue. This drove down the yields (i.e. the interest rate) Greece had to pay on its bonds, making it cheaper and cheaper to borrow more and more money, very much the opposite of how most countries and households operate. If it’s cheaper to borrow, it’s cheaper to spend. And politicians love to spend. If there aren’t any taxes hikes to pay for increased benefits and services, all the better. It’s all free money, or so it seems.

But then came the credit crunch and the deep crack in the Eurozone was revealed. It became very obvious, very quickly, that Greece had next to no hope of ever paying all their creditors back in full. Unlike the United States, where if Delaware or Louisiana were to default on their debt the federal government would step in to foot the bill, nobody was quite sure what would happen if Greece defaulted. Creditors were treating Greece like a member of a well-known family. He comes from a good family, so he must be good for it, right? And if he’s not, then certainly one of his relatives is. But what if the family recently had a falling out and doesn’t want to cover their delinquent cousin’s debt when he defaults? The lender is left holding the bag.

That takes care of how Greece took on so much debt. But Portugal had a lot of debt, as did Spain and Ireland. Why is Greece so different? There are a number of quantitative factors that are at play, but those don’t tell the whole story. For the most part, there was a large deficiency of political courage in Greece and the Greek government simply did not want to pay the piper. Leaders in Portugal, Spain and Ireland stepped up to the plate and told unhappy voters what needed to be done whereas this never happened in Greece and the wound was left to fester. After realizing they were truly out of options the Greek government began to capitulate to austerity, but because their government had failed them so miserably Greece’s delayed austerity was even more punishing than the rest of the Eurozone. Blaming Germany, the European Central Bank and the International Monetary Fund instead of their elected officials, elections were held.

Alexis Tsipras

Enter Alexis Tsipras, the man who has been playing chicken with the world economy. Seeing a path to power, Mr. Tsipras promised the Greek people a future without austerity and simultaneously promised the world Greece would remain in the Eurozone. Quickly after taking office, Mr. Tsipras realized the gravity of the Greek situation and was stuck between a rock (angry Eurozone officials and lenders) and a hard place (angry voters when you’ve promised what you can’t fully deliver).  But he also knew how destructive a Grexit would be to the Eurozone and to the global economy. Since that time, he has held the world hostage by demanding large write-downs of Greece’s debt. As Bob Dylan said, “When you ain’t got nothing, you got nothing to lose.” This very dangerous game has caused markets to doubt the integrity of the entire Eurozone. The rest of the Eurozone, especially the other indebted nations who had taken their painful medicine, understandably balked at this brash young man (who famously never wears ties to meet world leaders) dictating terms to them, the lenders of relief funds, about how things would go.

So where do we go from here?  The fact that the on-again-off-again relationship between Tsipras and Eurozone representatives hasn’t rattled markets dramatically would suggest that many believe a deal is inevitable and baked in the cake. But just because you don’t think a train will come around the bend in the near future doesn’t mean it’s wise to take a nap on the tracks. As always, when thinking about risk we must expect the probable but also be cognizant of the improbable (especially if that improbability would lead to drastic consequences) because even if that event doesn’t happen, that doesn’t make the decision to flirt with its occurrence any wiser.

With both parties playing hardball, the real risk now is that even though a deal is still likely (because trudging along in an imperfect system is still far better for both Greece and the Eurozone than a very messy breakup), every day a deal isn’t struck leads to more uncertainty and a greater chance for miscalculation on either side. While we believe a deal will be struck, we will likely see continued volatility fueled by a lack of clarity as to the direction of the talks.

The bottom line is that the Eurozone needs to retain Greece in the monetary union, not because Greece is an important economy or that a Grexit would cause fundamental economic pain to the other Eurozone countries, but because a Grexit would signal to the world that the European Monetary Union is a misnomer. If a country can choose to leave a monetary union, it isn’t a monetary union at all but rather a fixed-peg currency exchange system. This would be roughly similar to the ramifications of the first legal divorce. Marriage immediately went from “until death do us part” to “I might have some other options.” This is the crisis of confidence and perception the Eurozone is so desperately trying to avoid.

We believe the Eurozone will continue to do what they’ve so successfully done up until this point: kick the can down the road. Until then, I don’t think I’m alone in hoping that Greece once again becomes ancient history.

Best regards,
Patrick R. McDowell, CFP®, AIF®

U.S. Equity Markets: Hot or Cold?

Anyone watching the stock market over the last few weeks could be forgiven for thinking Wall Street has gone mad. Are stocks the genteel Dr. Jekyll or the corrosive Mr. Hyde? The short answer has been a bit of both.

The start of the latest bout of volatility was a very strong U.S. jobs report. Wait, good news caused the markets to throw a fit? Strangely enough, yes. With the economy creating almost 300,000 jobs last month, investors began to increasingly fear that the Federal Reserve would feel confident enough in the strength of the U.S. economic recovery to begin raising interest rates. 

So the economy is getting better and the Federal Reserve wants to raise interest rates. Wouldn't that be good for stocks? Yes…and it depends.

Overall, good news is still good news. A rising tide will continue to lift many boats, even some leaky ones. But rising interest rates affect different industries in different ways, some for the better and some for worse.

If you’re a bank that makes money from borrowing at one interest rate and lending at another, low interest rates have been putting a dent in your profits for years and rising rates are a welcome sight.  However, if you’re a capital intensive business that takes advantage of a low rate environment by borrowing huge sums of money to expand capacity, then rising rates means a higher loan payment in the near future.   Not so good.

Rising rates also affect the value of income producing assets in general, regardless of the industry they’re in. For example, if you were thinking about purchasing an apartment to rent out that produces a steady $10,000 a year in income, you might be willing to pay $200,000 for it, which would give you a return of 5%. In today’s zero interest rate environment, no one would turn their nose up at a low-risk 5% return. But if interest rates rose a few percentage points so that a risk-free treasury bond yields 5% and you can’t raise the rent, the apartment’s yield no longer looks so attractive. And if you wanted to sell the apartment you’d probably have to drop the price so that the current yield is well above the risk-free rate to attract a buyer. So a rise in interest rates didn't affect your monthly rent, but it nonetheless affected the value of your asset.

When you apply this type of analysis to stocks and bonds, you can see why a little interest rate hike could rock the boat. High-yielding stocks in industries like utilities, telecommunications and tobacco, just to name a few, have been volatile in recent weeks for this very reason.

Five Year Yields Go Negative - March 2010 to March 2015 Overview

There are a couple of things to keep in mind, though.  The odds of treasuries yielding 5% any time in the near future is very low, and the Federal Reserve is unlikely to ratchet up rates quickly or dramatically anytime soon. For these reasons, coupled with ever-increasing global demand for the yield these companies produce, we believe holding most of these positions for the long term remains a good idea. A small rate increase affects investor perceptions of these companies much more than it affects the companies themselves.

Federal Reserve Chairwoman Janet Yellen is under an intense, global spotlight.  The latest market obsession has been over the use of the word “patient” in Federal Reserve statements about the timeline of rate increases. Reading tea leaves has never been more popular. But with the values of almost all assets affected by interest rates, it’s understandable why so many are so obsessive about analyzing her comments.

The Federal Reserve, by our estimation, would like to raise interest rates in the near future to signal to investors that the economy is returning to a more normal environment and to corporations that the free-money days are winding down, which is a strong positive. The most likely rate increase is a very small one, maybe around 0.25%, or one quarter of one percent. Obviously no one will go broke by tacking on 0.25% to a loan, but with the target rate between 0.00% and 0.25% you can see it is a measured increase.

However, we believe that the Federal Reserve will be very cautious in raising rates even a paltry 0.25% for a number of reasons. 

For one, the rest of the global economy is moving in the exact opposite direction. China just lowered rates. The Bank of Japan’s interest rate is at exactly 0.00%. The European Central Bank just lowered interest rates into negative territory (yes, you read that correctly).  It will be difficult for the U.S. to stray too far from the pack, regardless of the strength of the domestic recovery. The impact of other central bank policies on U.S. policy cannot be overstated. In fact, according to her most recent schedule, Ms. Yellen’s third most time consuming activity is meeting with foreign officials, presumably to coordinate policy plans.

Additionally, the continued strength of the U.S. dollar has increasingly acted as a de facto rate hike, slowing down international profits for U.S. companies. In this context, a rapid and substantial rate hike is hard to imagine.

One thing that we believe the market is not weighing heavily enough are the benefits of U.S. currency strength and a possible interest rate hike. If you’re an investor in Paris or Tokyo, you can leave your savings in a currency that is weakening (which erodes your purchasing power) and in a bank that either yields absolutely nothing or actually costs you money (negative interest rates). Or, you can move your savings to a bank that yields something in the most stable country in the world (the United States), with an appreciating currency (which grows your purchasing power). Not a tough decision, right? We believe international investors will continue to bring capital to the U.S. in the coming months and years for safety and growing yield. It won’t power the ship, but it will be a nice tailwind.

What will the markets do in the short term in response to the potential of a small interest rate increase? As an early American financier once famously said, they will “fluctuate”.  But in the long term, stocks will inevitably follow corporate profitability as they always do. And if the economy continues to improve, as we believe it will, corporations will be the main beneficiaries. So if a rise in interest rates means that things are getting better on the home front, we don’t see that as the end of the world.

Best regards,
Patrick R. McDowell, CFP®, AIF®