The Federal Reserve finally did what it had been threatening for quite some time. At its December meeting, the FOMC (Federal Open Market Committee) led by Chairwoman Janet Yellen voted to raise interest rates for the first time in over eight years. The new federal funds target range is 0.25% - 0.50% compared to the previous range of zero – 0.25%. As the U.S. economy steadily rebounds from the depths of the great recession the Fed decided it was time to ease up slightly on their stimulus gas pedal. Contrary to the fears of many, the market’s initial response was favorable with all major U.S. equity indexes gaining over 1% on the news. The days that followed witnessed exaggerated price swings as many traders couldn’t decide if the Fed’s action was good news or bad. Nevertheless, the die is cast and the Fed says it intends to slowly bring interest rates up over the course of 2016 and 2017.
In explaining its reasoning behind the decision, the FOMC stated that consumer spending and fixed business investment has been solid and the housing sector continues to improve. On the labor front, the unemployment rate is still dropping and job openings are increasing. Additionally, inflation remains well below 2%, due mostly to falling energy prices and non-energy imports. Risks to the economy remain, especially as it relates to the current state of our international trading partners. One of the biggest concerns has been China, the world’s second largest economy, which is experiencing a sustained decline in its growth rate. In Europe, the ECB (European Central Bank) is actually lowering interest rates at the same time the Federal Reserve is raising rates here at home.
Typically when increasing interest rates, the Fed is deemed to be moving from an accommodative to a restrictive monetary policy in an attempt to slow the economy and prevent runaway inflation. That’s not the case this time. The Federal Reserve considers its current stance to be accommodative as evidenced by the current low interest rate environment and the continuance of its bond buying program. It appears the Fed is simply trying to re-stock its tool kit with available options when next needed. For example, if interest rates are at current levels when we head into the next recession (which will eventually happen) the Fed will have little room to stimulate the economy. They can’t reduce rates below zero. Their challenge has been timing a rate increase without choking off our fragile recovery.
Stocks
In spite of all the doomsayers predicting the end of the world once interest rates reversed course, the broad equity markets delivered an impressive performance during 4Q-15 led by a 7.04% gain in the S&P 500. Even international markets, which have been struggling for a long time, rose during the period. Developed international markets (MSCI EAFE) posted great quarterly returns, up 4.71% and the emerging markets sector (MSCI EM) took a breather from its negative momentum with a slight 0.66% gain during the period. Emerging markets is the sector that has been the most troubled due primarily to the aforementioned slowdown in its largest constituent, China.
As good as the 4th quarter was for stocks, the full year was a different story. Most major equity indexes posted losses in 2015 for the first time since 2008. Looking back, it was year filled with uncertainty and negative surprises and the stock market generally doesn’t like either. The collapse in oil was probably the most significant negative surprise and has had devastating effects on energy companies and their share prices. OPEC appears willing to allow oil to fall to whatever level is necessary to maintain market share and the recent U.S. nuclear deal with Iran will only make the supply situation worse. Additionally, Apple Computer (AAPL), the world’s most valuable company, finished the year down -7.66% (excluding dividends) and as a result was a big drag on the market’s overall performance.
Bonds
Wealthview typically includes short/intermediate term bonds for all but our most aggressive clients. We do this to temper portfolio volatility, provide modest income and to act as a source of liquidity. We are not chasing yield, as to do so would require exposing our clients to more risk than we believe is prudent. If interest rates ever rise to more normal levels we will consider extending our maturities. As one would expect, bond prices fell with an increase in interest rates during the quarter. Remember that bond prices and interest rates have an inverse relationship and typically move in opposite directions. The longer the bond’s maturity, the more exaggerated the price swing needed to compensate for a change in market rates. Our bond benchmark, (Barclays Capital 1-5 Year Government/Credit) fell slightly, down -0.57% for the quarter, and was up about 1% for the full year 2015.
What’s Next?
Initial 4th quarter GDP (gross domestic product) estimates will not be released until later in January but 3rd quarter GDP came in at a 2% annual rate compared with 3.9% for the 2nd quarter. The economy is growing, just not at a rate to brag about. As mentioned previously, the Fed indicated it intends to slowly raise interest rates, something we welcome for two reasons. First, to do so is a sign they believe the economy is on firm footing and that is certainly good news. Second, since bonds are such a significant part of many investors’ holdings, higher interest rates means higher eventual returns from future dollars invested in fixed-income. However, many analysts believe our sub-par growth rate will keep interest rates sub-par for an extended period of time. At the end of the day earnings, interest rates and inflation drive equity valuations. Interest rates and inflation are still low but earnings were flat in 2015, thus the mediocre equity returns. Current estimates are for a rebound in earnings in 2016.
Part of Wealthview’s investment strategy is based on our belief in the impossibility of consistently predicting major inflection points – the most recent example being oil prices. Unfortunately, many investors’ portfolios are structured consistent with these top-down, macro-economic predictions. It might be the result of their own opinions or it might be the opinion of a team of professionals managing their money. Anyone who structures portfolios based on a top-down, macro-economic perspective may be right for a time but it only takes one wrong opinion to reverse years of progress. This predictive type investment strategy contrasts with the way Wealthview manages assets. The most important thing is not being over-weighted in the right sector but being properly diversified so you can participate in all sectors of this great experiment we call free-market capitalism.
As important as being properly diversified is, having a plan is equally significant. It doesn’t matter whether your goals are wealth creation, preservation, utilization or transfer. Everyone needs an intelligent plan to clarify your goals, identify the resources available to fund those goals and monitor your progress toward their attainment. It also helps to have a professional partner to whom you can look for advice and mutual accountability. If you are already fully engaged with our planning services you understand the benefits. If not, we invite you to give it a try, you might like it. In summary, depending on your perspective, the Fed may be accommodating or restricting, but interest rates appear to be headed up, even if ever so slowly. As Bob Dylan likes to sing - “The times they are a-changin”. Yes they are.
Best wishes to you and your family for a safe and prosperous 2016.