As global equities continue to perform well year-to-date, U.S. equities are showing signs of fatigue. Improving global economic fundamentals continue to propel international equity prices higher with Europe, Asia and Emerging market indices being the best performers.
Interest rates in most sectors of the bond market have fallen modestly year-to-date, which has supported bond prices. Investors seem to have factored out any short term boost from fiscal stimulus in the U.S., as the legislative agenda has stalled on Capitol Hill. Barring any negative surprises from a geopolitical entanglement with a foreign nation and/or an international trade dispute, the economic and investment environments are set to continue to expand at a moderate pace.
Monetary Policy on the Move
In June, the Federal Reserve (the Fed) released details on how it plans to begin tapering the size of its balance sheet. As a reminder, beginning in 2008 the Fed began “quantitative easing”, which was the buying of U.S. Treasury securities as well as agency mortgage-backed securities. The purpose of this action was to stimulate the economy by lowering rates on different parts of the yield curve and to inject more liquidity into the financial system. The basic idea is if there is more money in the system it will generate more economic activity.
The Fed continued to buy these securities for the next six years expanding the assets on its balance sheet from about $800 million to approximately $4.5 trillion in assets. Since then, but with a lag, the European Central Bank and the Bank of Japan have followed suit with their own bond buying schemes. This sort of extraordinary monetary stimulus is entirely unprecedented, especially at this scale.
Why this matters: We, as investors, must take note that the environment is about to change. We do not know exactly when it will begin, but the Fed has indicated that it should begin reducing the assets (bonds) on its balance sheet “later this year”.
Based on the rate at which the Fed plans to taper its balance sheet, it will take approximately five years to reduce it to some semblance of normalcy. However, we cannot predict when and if there will be disruptions to this process.
The Fed also will have to balance the normalization of its overnight borrowing rate (i.e. raising interest rates), at the same time. Therefore, the market will not only be trying to guess when the next rate hike will be, but also by how much the Fed will be reducing its balance sheet. The unintended consequences from this shift in policy are impossible to predict.
It is important to keep in mind that the level of monetary accommodation that is currently in place is extraordinary and that these actions are not designed to restrict economic activity, but to simply remove some of the existing accommodation.
The Environment for Change
The Fed is preparing to move now because economic growth as noted above and in our Spring note continues at a moderate pace. In recent years, the economies of Europe, Japan, and the Emerging markets have all lagged the U.S. The International Monetary Fund’s chief economist, Maurice Obstfeld, was recently quoted saying, “Recent data point to the broadest synchronized upswing the world economy has experienced in the last decade.” Regardless of the economic truth, global stock markets have rallied strongly this year already. Remember that equity markets seek to anticipate future economic gains.
Bumps in the Road
As we all know, politics are dominating the headlines. Until very recently, it was safe to say that the noise in Washington has had little effect on the markets. The war of words with North Korea and the fallout of controversy over the unrest in Charlottesville, Virginia were recent triggers for volatility in the markets. However, neither have succeeded in overshadowing the economic reality on the ground.
If the Trump administration or Congress is able to steer the national conversation towards tax cuts and infrastructure spending, that would be a bullish catalyst for the market. In contrast, if the legislative agenda continues to falter, the administration could also attempt to press its trade policy reforms through, for which it does not need the cooperation of Congress. A move in that direction would likely be viewed as inflationary. We shall have to wait and see.
Equity and bond prices are currently trading at elevated levels when compared to their historical averages. It is not difficult to make the argument that asset prices are expensive and indeed many do. We continue to believe that diversification beyond traditional stock and bond investments is paramount to long term investment success.
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