A Post-Quantitative Easing World
In December 2008, the Federal Reserve cut its target interest rate to historic lows in an effort to help revive the U.S. economy, which had struggled due to the global financial crisis.
Additionally, over the course of the past six years the Fed has engaged in three distinct quantitative easing programs aimed at stimulating economic growth. These programs have lasted much longer than originally anticipated and are only recently beginning to conclude. Current Fed Chair Janet Yellen announced the end of the third and presumably final round of quantitative easing in October 2014. U.S. equity markets have reached all-time highs while recovering from a recession that began over six years ago. However, while equity markets have experienced significant gains over that time, the recovery of the U.S. economy has lagged. What will now happen as the largest buyer of U.S. debt since 2008 is set to leave the market?
Effect of the Fed’s Monetary Policy
We may not be far enough removed from quantitative easing to formulate a final opinion of the Fed’s bond-buying program and aggressive monetary policy; however it is abundantly clear that some efforts succeeded while others failed. While accomplishing some of its goals – removing subprime mortgages from banks’ balance sheets, stabilizing the U.S. economy, keeping interest rates low enough to revive the housing markets and stimulate economic growth – the Fed’s policies had far less of a positive impact in other areas.
Quantitative easing did not lead to a significant increase of economic output or hiring. Though the unemployment rate has declined to 5.9%, much of the decrease can be attributed to individuals leaving the workforce as evidenced by the declining labor force participation rate. Quantitative easing also did not achieve the Fed’s goal of making credit more available. Banks, receiving billions of dollars of cash through the Fed’s bond repurchase programs, remained wary of new regulation, consumer credit standards, and overall economic uncertainty. Consequently, many banks have been reluctant to lend to consumers and instead have used this cash for dividend payouts to shareholders and stock buybacks. Without increased lending, the expansion of the money supply has been limited and inflation has been kept at bay.
Some Fed officials are not ruling out future quantitative easing if circumstances call for such measures. As global growth rates decline (both in developed and emerging markets) and geopolitical tensions increase in many parts of the world, the Bank of Japan is resorting to quantitative easing to help solidify its economy (beginning in 2015), and there is overwhelming consensus that the European Central Bank will soon follow suit, which poses a threat to the U.S. economy. Nevertheless, with U.S. GDP growth expected to be over 3%, it is the Fed’s belief that the current economy has sufficient underlying strength to support ongoing growth.
Structuring Your Portfolio Post-QE
While the end of QE does indicate that the U.S. economy and job market are expanding, albeit at a moderate pace, the Fed has detailed its commitment to keep interest rates near zero for a considerable time after the conclusion of the Fed’s bond-purchasing program. It is the Fed’s goal to be accommodative until the U.S. economy can sustain itself and grow on its own. Despite economic worries, the Fed cautions that investors should be prepared for the possibility that it will raise interest rates sooner than anticipated should U.S. economic performance exceed expectations. However, history has shown that when yields are below 5%, rising rates lead to an increase in stock prices. It is when rates exceed 5% that they become a headwind and lead to negative stock performance. Most Fed watchers believe it is unrealistic that a rate increase will take place before mid-2015. Nevertheless, whenever the rate increase does occur it will be the first since 2006, and there are many effective strategies that can be implemented in a portfolio to prepare for this event.
As short duration bonds are less sensitive to movements in interest rates, they will protect a portfolio when it is expected that rates will rise, but the timing is unknown. As these shorter duration bonds mature, the proceeds can be tactically allocated depending on the standing rate environment and how the market is reacting to any Fed policy changes.
Normal bond prices have an inverse relationship with interest rates. However, with floating rate loans the opposite is true: loan prices move in tandem with changing rates. Thus, floating rate loans adjust at regular intervals to reflect changes in short-term interest rates, allowing for a lower degree of sensitivity to changes in interest rates when compared to fixed-rate bonds.
If economic activity were to increase rapidly after the stimulus is removed, there could be significant inflationary pressures. Monetary policy works with a lag, and changes in interest rates usually take a few quarters to impact the economy. Given how close we are to the Fed’s long-term target on inflation and unemployment, and how far away we are from the Fed’s long-term target on the federal funds rate, the Fed could be reactionary in raising interest rates to curb the excess inflation.
Real assets, which can include real estate, commodities and infrastructure, have tended to perform well in inflationary periods. In the real estate sector, rising interest rates typically coincide with increasing commercial rents as the costs of higher rates are passed on to lessees. Given that rising interest rate periods typically occur with expanding economies, the resulting demand for energy would boost commodity prices. Infrastructure can provide a steady stream of income and capital appreciation as most infrastructure projects are essential services and tend to perform well regardless of economic cycle.
Finally, the conclusion of quantitative easing creates a terrific opportunity for active fund managers. Expansionary monetary policy tends to buoy markets as a whole, causing securities to deviate less from their benchmark index. In this new market environment, experienced managers with the resources and track record to efficiently analyze the fundamentals of individual securities will have a better opportunity to outperform than they have had since before the global financial crisis. If you have any questions relating to this newsletter article or your investment portfolio, please contact an Andersen Tax investment consultant.