It’s All Good for the Quarter!

Remarkable

The only way to see this past quarter is as remarkable. Everything appeared to be up. Intermediate term bonds: up. Short term bonds: up. International bonds: up. U.S. equities: up. International equities: up. Real estate investment trusts: up. Natural gas prices: up. Natural gas pipelines: up. I may have missed a category or two, but the likelihood is that they, too, were up. The point is we have been in an unusual phase since the beginning of this year. The tide seems to have come in and floated all the boats.

The last time we saw markets rising all together was in the mid-1990s. What is most unusual in this case, is that intermediate bonds, both corporate and municipal, rose during this period. With the pressure from the Federal Reserve, from the reduction in bond and mortgage purchases, to the talk about raising the discount rate, bonds were expected to either show no growth or drop in value. The increase was a pleasant surprise that made up for the losses in this investment sector during the last half of 2013.

While stocks did reasonably well in the first quarter of 2014, they outperformed themselves in the second quarter. After the sharp rise in equity values in 2013, a significant rise was not expected this year. The S&P 500, for example, began the quarter at 1873.96 and ended at 1960.23, an increase of 4.6%. Since the beginning of the year, the S&P 500 is up 6.2%, meaning that the first quarter contributed a gain of only 1.6%.

Walking with the FED

The Federal Reserve (FED) has its work cut out going forward.  In January, the FED began to scale back on the purchases of bonds and mortgages. In December of 2013, they purchased about $85 billion of these securities. The July purchases are expected to be about $35 billion. The FED recently announced that, after October, they will no longer make any purchases. Investors were concerned that this pull back would mean a rise in overall interest rates, but the reduction in purchases has apparently had no material impact on bond pricing.

The next hurdle facing the FED will be deciding when to raise the discount rate and by how much. The discount rate is the rate that banks must pay the FED for borrowing money. Since 2009, the FED has been keeping the discount rate at between 0% and 0.25%. In actuality, the rate since then has moved generally in a much narrower range of between 0% and 0.15%. The discount rate is generally used to cool down the economy and control the rate of inflation. The FED has established a range for inflation of between 2% and 2.5%. Up until recently, the inflation rate has fallen below this target. The FED feared that the economy could fall into deflation (where prices are dropping) if the inflation rate didn’t rise. They believe the target inflation rate is important to maintaining economic growth. To go below this rate would mean that the economy is not growing enough.  Above that rate, the economy would be growing too fast and asset values would be depreciating. In a nutshell, the FED has to decide when to raise and lower the discount rate so as not to harm the economy.  

Tricky Business

At the end of the first quarter, the unemploy­ment rate was 6.7%. As we go into the third quarter, the rate has dropped to 6.1%. Job formation is running at almost 300,000 jobs each month, with far fewer new jobless claims. All this leads me to think that the constraint on wages may be ready to recede. There are certainly people in the “employed” category who are working part time that would like full time work. There are also people who are currently “underemployed,” meaning that their current job does not best use their job skills or give them the income they should be receiving.

As the economy gets stronger, fewer people are available to fill job openings that require specific skills. When this happens, employers who need workers raise wages for new hires to motivate employed people to work for their firms. Eventually, wages have to increase for the current work force as well. All of this adds up to an overall increase in wages. With more money available, workers as consumers begin to spend more.

Now, supply and demand take over. If the supply of goods and services do not rise at an appropriate rate, an imbalance occurs. This imbalance leads to higher prices. Higher prices lead to a greater level of inflation. This cycle is okay if it remains somewhat limited, i.e. inflation at a 2% to 2.5% level. If inflation grows too fast, then the value of increased wages is diminished and the cost of goods and services becomes too expensive. This then leads to an overall decline in the economy. The FED must consider all of the above as they contem­plate increases in the discount rate.

When the FED raises the discount rate, the result is not felt in the economy for three months to six months. Therefore, the FED needs to make a decision and act ahead of inflation to avoid economic disruption.

Looking Ahead

The FED has indicated that they will not raise the discount rate until next June. I believe that they will have to act sooner. In all likelihood, by the end of this year or early next year, they will raise the discount rate to 0.50%. Much of this is anticipated by pricing in the market. This will be a definite boon for short-term rates, such as CDs, money market funds and short-duration bonds. The change in the discount rate could move mortgage interest rates up from where they are presently, about 4%, to 4.5% to 5%. This in turn could slow the housing market. The change could also raise interest rates on intermediate high quality bonds, which would negatively impact high yield bonds (also known as junk bonds); real estate investment trusts, because the risk to yield ratio would not be as good; and equities, where dividend rates would likely remain flat. The change would also impact the availability of low cost financing that has been available for the past five years. This could slow down new construction, capital expenditures by corporations, as well as slowing down the number of new hires by businesses. While all of the above is likely, the overall impact may be mild over the long term, as it would result in keeping inflation in check. Timing will be very important!

I also expect that sometime in the next six months, we will see a stock market correction. A correction is where the market loses about 10% of its value. It is like stopping to take a breath of fresh air before continuing a journey. My belief, at this time, is that the equity and real estate markets will be in good shape for the next four to five years. I also think interest rates will rise on intermediate bonds to a point where they will once again be a desirable investment.

Conclusion

This has been a good time to be an investor!

Ed Mallon