Sustained economic growth paired with sub-par inflation furthered the debate during the 3rd quarter about how soon the Federal Reserve will begin raising interest rates. If the Fed acts too soon it risks choking off the economy and if it waits too long it risks higher inflation and market instability. A corollary debate is about how investors should position their portfolios to prepare for that inevitable rate increase. For example, if you thought interest rates were going to be higher a year from now, what changes would you make to your portfolio today to best capitalize on that scenario? And just how much would you be willing to bet on your belief?
The rate being debated is the short-term federal funds rate, the dot on the yield curve over which the Federal Reserve has the most control. However, it cannot control market rates which are determined by forces independent of the Fed’s purview. Case-in-point is the market’s response to the Fed’s announcement last December that it would begin winding down its asset purchases known as QE-3 (Quantitative Easing – Phase 3). Many experts thought a more restrictive monetary bias would result in a substantial increase in interest rates and a corresponding stock market sell-off. Although rates did go up in the immediate aftermath of that announcement, since then, yields have plummeted as geo-political tensions have trumped worries about inflation. The 10-Year U.S. Treasury note is currently yielding 2.50%, down from about 3.00% when the Fed first announced its QE-3 reduction intentions. Additionally, stocks as measured by the S&P 500, gained over 10% from the date of the Federal Open Market Committee (FOMC) announcement through the end of 3Q-14. So much for cause and effect!
A growing economy and accommodative Fed policy propelled stocks to all-time highs during the 3rd quarter. The S&P 500 set a new closing record on September 18, exactly nine months after that infamous FOMC announcement. Unfortunately, those gains wouldn’t hold as worries about conflicts in the Ukraine, Israel and Iraq combined with continued fretting over the prospects for higher interest rates stalled the rally, ending the quarter on a sour note. The notable exception was U.S. large companies (S&P 500) which notched a gain of 1.13% for the period. All other major equity sectors posted losses for the quarter, the worst being a -6.73% return by U.S. small companies (S&P 600). Our bond benchmark (Barclays Capital 1-5 Year Government/Credit Index) treaded water for the quarter down -0.05%. Year-to-date returns were mostly positive, but all over the board, ranging from a gain of 8.34% for U.S. large companies to a loss of -3.72% for U.S. small cap stocks. Short-term bonds posted total returns of 1.01% for the year’s first nine months.
Second quarter GDP came in at an impressive 4.6% annualized, and the outlook for the economy remains favorable. Latest readings on consumer spending are encouraging and underpin a belief that initial 3rd quarter GDP numbers when released in late October will be solid. Since the U.S. consumer makes up 70% of our economy it matters a great deal what these numbers look like. Inflation remains below the Fed’s target range with an August increase of 1.5% in the Personal Consumption Expenditures (PCE) index, the Fed’s favorite inflation gauge. Increased spending and tame inflation make for a tasty economic recipe.
Avoid the Herd
The recent Fed watching scenario is exactly why Wealthview Capital manages portfolios the way we do. We believe the myriad of variables which influence markets’ short-term direction cannot be predicted with any degree of consistency, and by tilting portfolios to profit from those predictions you put at risk the very long-term success on which your financial future hinges. Even if you were right in calling the modest and brief jump in rates it is unlikely you would have been able to predict the subsequent and significant rate drop that followed. Nor would you likely have been able to anticipate the continued rally in stock prices. To position your portfolio for a predicted sell-off in stocks and bonds would have required reducing your exposure to both asset classes and increasing your exposure to cash. If you had acted on that premise last December, you could be utterly exasperated that the Fed’s long-awaited easy money policy was finally ending but the markets did not react the way you anticipated. This is a quintessential example of market timing, the prudence of which we refute.
Successful investing requires thinking and acting different from the herd. The herd is always trying to out-guess the market and is perpetually frustrated when things don’t go as planned. One of the financial industry’s siren songs is that investors must constantly do something to be successful. The herd confuses activity with progress, but they are not the same. By slowing down and taking a deep breath you may realize that you very possibly already have the prudently diversified, properly allocated portfolio needed for your long-term goals.
Maybe the question to ask is not when the Fed is going to raise rates or by how much, but rather, “Is my portfolio optimally structured to offer the best opportunity to achieve my long-term goals in spite of the short-term volatility inherent in the capital markets?”. If you are not sure, give us a call. It’s never too late to re-evaluate your goals and the resources required to fund those goals. Markets will always be in a state of back and forth in the short-term, waxing and waning with the vagaries of the latest economic and political news or predictions. However, we are not investing for the short-term. Remember, successful investing is not complicated, but nothing about it is easy.