October 2017

Congress and President Woodrow Wilson created the Federal Reserve (Fed) 104 years ago to provide and oversee a safer, more flexible and more stable monetary and financial system. Since then, the Fed has also been assigned the goal of keeping inflation and unemployment low.

Some question how effective the Fed’s oversight was leading up to the 2007-2009 financial crisis and so-called Great Recession. However, after the crisis started the Fed took bold actions: reducing the overnight interest rate to 0%, expanding its balance sheet by over $3.5 trillion, and buying mortgage backed securities (MBS) for the first time in its history. These actions were intended to restore liquidity and lending in the US as well as to stimulate the economy and lower unemployment. Again, the Fed’s effectiveness has been questioned as some have only recently felt the benefits of economic recovery.

In the second quarter, the Bureau of Economic Analysis (BEA) calculated domestic economic growth accelerating to 3.1%. Excluding volatility from hurricanes and wildfires, the US economy is expected to continue growing faster than 2% for the foreseeable future.

As the economy firmed, the Fed has raised interest rates four times (¼% point each time) from 0% to 1%. By historical standards, this remains a very low interest rate which may continue to stimulate economic activity. While the Fed may raise interest rates another ¼% in December, it does not want to invert the interest rate yield curve by having the overnight rate rising above the ten-year US Treasury bond rate of 2.3%.

The Fed’s other main policy tool is expanding its balance sheet by “printing money”. Since 2007, the Fed’s balance sheet has grown from $915 billion to $4.466 trillion. Starting this quarter, the Fed expects to shrink its balance sheet by $10 billion per month by not reinvesting the principal of some securities as they mature. If the economy remains strong, it may increase this rate eventually to $50 billion per month by the end of 2018.

In order to have enough bonds on the Fed’s balance sheet maturing in three years for this process to continue, the Fed’s excess funds today might be used to buy two to three-year bonds. This action should help contain short-term interest rates.

On the other hand, the Fed will probably buy fewer ten-year bonds. At the same time, the US government should issue more ten and 30-year bonds, leading to rising long-term interest rates.

ECONOMIC OUTLOOK: SYNCHRONIZED GLOBAL ECONOMIC RECOVERY CONTINUES

A media focused on retaining viewership will gravitate to negative news as it gets more attention and better ratings. Recent bad news can be geopolitical (Iran, North Korea, Syria and terrorism), local (Charlottesville), political and policy (Washington) and weather (hurricanes). With all of that bad news, viewers might not realize that negative economic reports have subsided. Fears of Mediterranean states in collapse have been replaced with building cranes appearing through their skylines. Japanese economic stagnation has been replaced with accelerating economic growth and its stock market reaching a 21-year high. As this is positive news, it might not be fully reported.

Other underreported advancements are occurring in: 3-D printing, biotechnology, cloud computing, e-commerce, energy storage, logistics, manufacturing, nanotechnology and smart phones. Each of these can enhance life and productivity. With a perpetual focus on negativity instead of achievements, some investors may even lose sight of a widespread economic recovery.

The stronger US economy, continued low interest rates and excessive money printing in Europe and Japan have strengthened the global economic recovery. European aggregate business and consumer confidence has risen to levels not seen since 2007. Growth in the US and parts of Europe are so strong that some suppliers are having a hard time keeping up with orders.

Global economic growth creates lower unemployment. European unemployment has returned to single digits. As employment tightens, wages should rise. Target has recently announced a minimum wage for all of its employees of $11 by year end. Target plans to increase this to $15 over three years. As employers have a harder time finding competent employees, expect wages in metropolitan areas to increase worldwide.

Tight supplies and wage growth can both contribute to general inflation, which in turn can lead to higher interest rates. Once the European and Japanese central banks observe enough of this, they will likely stop printing money. They should also raise their overnight interest rates from current negative levels up to 0% and beyond to more normal levels.

FINANCIAL MARKET OUTLOOK: EFFECTS OF INFLATION

Past fears of disinflation and deflationary spirals should eventually turn into fears of inflation. Suppliers who cannot keep up with demand, will naturally increase their prices. Companies paying more for supplies and labor will try to raise prices. As it becomes harder to find good workers, employees will ask for raises (i.e. wage inflation). Inflation caused by a stronger economy will help some investments and hurt others.

Interest rates tend to rise with inflation. As this occurs, holders of long-term bonds and companies with large debt burdens may lose money. Heavily debt burdened companies will have to pay their lenders more interest as rates rise.

Holders of long-term US Treasuries may experience a double-digit loss in market value if rates rise 1%. For example, today’s 2.9% 30-year US Treasury bond will be less attractive if the interest rate of competing bonds rises to 3.9%. In order to lure someone into buying the 2.9% bond, its price will have to be lowered by 17.9%.

Stocks in companies that benefit from increased economic growth and inflation could perform very well. Other companies that cannot raise product prices to offset increasing interest, wage and supplier costs may have declining profits and stock prices.

FUTURE CHANGES: WHERE TO INVEST

If interest rates rise, then investors should avoid long-term bonds and other bond like investments. Investments that can move up and down with bond prices include preferred stocks, utility stocks and some levered closed-end funds.

Stocks of companies unable to raise product prices may underperform. These include companies that compete with behemoths less interested in profits. For example, it appears that Amazon is more interested in market share and China is more interested in full employment. Companies that compete with either of these might actually see declining product prices and falling profits.

On the other hand, suppliers to Amazon and China should benefit from their fast growth, while customers of these two can benefit from low prices. Companies benefitting may include select leaders in distribution, logistics and manufacturing and suppliers to technology firms.

Companies benefitting from rising interest rates can include financial intermediaries, some insurance companies and companies with excessive free cash flow.

Companies benefiting from increased consumer discretionary spending should include leaders in entertainment and travel, construction suppliers and firms discovering new medical treatments.

A portfolio with these beneficiaries can still be diversified by geography, industry and market capitalization. Additional exposure to global growth can be gained through owning multinationals and exporters, as well as select international Exchange Traded Funds (ETFs).