Fed Note – December 18, 2013

December
18

Written by: Jon McGraw

The Federal Reserve Open Market Committee completed their final meeting of 2013 today, and while some economists called for the closely-watched tapering decision to be put off until 2014, a $10 billion/month program was announced (with tapered amounts evenly split between agency MBS and Treasuries, so monthly purchases in the amounts of $35 bil. for the former and $40 bil. for the latter will continue).

No doubt, we’re sure you are as tired of hearing about and discussing tapering as we are, so this provides a bit of closure to the question, although there is a long road ahead. Probabilities for this happening had risen over the past week, although there were plenty of well-regarded economists who called for it to begin in January or March of next year.

Why the change?

The economy continues to be growing at a ‘moderate’ pace, according to the committee. However, since October, better labor numbers and improved capex spending added a few points in the positive category, while flattened housing figures offset that somewhat. Also, inflation remains quite low and below the committee’s target, which they are quite sensitive to (given Ben Bernanke’s focus on this area).

The Fed might also have been weighing whether or not to lower the unemployment target (from 6.5% down to 5.5-6.0%, which it did not end up doing). The minutes from the October meeting alluded to discussion about the topic, of which FOMC members appear split between potential forward guidance language effects promoting ongoing accommodation and perhaps a credibility issue with making changes in the target mid-stream. The second component of today’s news release was an acknowledgement by the committee that it could ‘likely be appropriate’ to keep rates at zero ‘well past the time’ that this target is hit—which came as somewhat of a surprise—but perhaps a nod to the debate just mentioned and current low inflation numbers.

Removing the news headlines and opinions strewn about, the critical lens from which to make assessments is back to basics: through the Fed’s dual mandates of maximum employment and price stability. Along that end, unemployment is still higher than desired (far below ‘maximum employment’) and inflation is not yet problematic (as measured by their conventional metrics, like CPI, PPI and the Fed’s preferred PCE, as well as through nuanced ones like wage growth, etc.). Therefore, despite the tapering of the stimulus, there is still ample stimulus as they continue to operate on the side of accommodation as opposed to pulling off the gas too early and risking a sputtering of the engine.

At the same time, QE is a dramatic emergency measure, and one could argue whether this policy continues to be as appropriate several years after the depth of the financial crisis. Naturally, the longer this goes on and the more positive and sustainable the underlying economic data looks, the greater the counter-argument against stimulus. In fact, there is already a sizable contingent that disputes the effectiveness of the QE program as a whole, other than the fact that low rates for a longer period of time continues to provide a headwind to conditions and temper the impact of less predictable tailwinds that might surface (fluctuations in sentiment, spikes in gasoline prices, etc.).

We bring this back full-circle to what this means for us in an asset allocation context. Risk assets are higher on the news, which reflects the stronger underlying economic conditions, while bond rates ticked upward.

  • Fixed income: Continued stimulus and easy policy means lower bond yields for longer (although the rate ‘spring’ has been getting increasingly compressed and tapering only releases some of the tension). As/if economic growth improves, it is fair to expect higher rates. This could be quite damaging to conventional fixed income portfolios and why we’re elected to keep our durations short.
  • Equities: As economic growth continues, this translates to both improved company revenues/earnings as well as a positive feedback loop as consumers feel increasingly comfortable about forward-looking prospects—so they increase their own spending. It would not be surprising to see continued strength vs. fixed income while accepting the occasional bouts of volatility we expect from this asset class.
  • Real estate tends to experience fits and starts as rate increases can rattle many income-oriented investments and cast uncertainty into anything affected by ‘carry’ (as funding costs rise and other alternatives can become more/less attractive). However, valuations appear to reflect this reality and, longer-term, fundamental REIT performance tends to be driven by more specific economic factors like tenant demand.
  • Commodities performance is generally difficult to put into a simple box (what asset class isn’t), which explains much of its diversification characteristics. Specific supply/demand characteristics aside, stronger economic growth could serve to boost industrial metals like copper but act as a headwind to contracts like precious metals that thrive in crisis.

Happy Santa Claus rally – for at least a day!