March Madness is in full swing with over 60 games having already been played. People all over the world fill out their brackets in hopes that they can predict the future, including the surprise upsets that turn an “also ran” bracket into a money winner. Those who filled out their brackets by working from the Championship game backwards and opting for favorites like Kentucky, Wisconsin, Duke, and Villanova are feeling rather confident right now. In the world of finance, investors are attempting to do the same thing when it comes to the Federal Reserve Bank’s interest policy. The favorites in this game are the consensus opinions regarding when and how the Fed Funds Rate is going to increase, and that has been June and is now starting to get pushed back to September. Instead of analyzing coaches, rosters and game stats, investors are studying Fed statements, inflation data, dollar strength, unemployment figures and economic measures such as GDP.
The trading days in March brought many ups and downs, just like the tournament has. On the first trading day of March, the NASDAQ closed above 5,000 for the first time in 15 years. The S&P 500 closed that day at 2109, but on Friday March 6th the Bureau of Labor and Statistics reported strong gains in employment. The unemployment rate fell from 5.7% to 5.5%, and investors speculated that such positive data would cause a Fed rate hike sooner than later, sending markets into a steady decline for several trading sessions. By March 11th, the S&P 500 had shed 3% of its value. Add March to the long list of months in which a -3% slide was followed by a recovery back to better than breakeven, only to be followed by another sell off.
On March 12th, February retail sales showed a decrease of 0.60% and then a trading rally followed, possibly representing speculation that the Fed might keep rates lower as consumption is such an integral component of GDP. Much chatter continued up to the March 17th Fed meeting followed by a press conference the next day when Chairperson Janet Yellen elaborated on the Fed’s decision to drop the word “patient” from its forward guidance regarding interest rate moves. Yellen would also elaborate on the impact that a strong dollar has on exports as well as the lack of significant wage inflation. Let’s remember that the Fed will act on rates when they are reasonably confident in the employment outlook as well as the inflation outlook. Right now the Fed has expressed a view that they expect inflation to normalize over the medium term; however, weak wage inflation data and current headline inflation would not cause a move today. As it stands, headline inflation stands at 0.33%, well below the Fed’s 2% target as can be seen in the chart below.
All in all, the Fed’s statement was more dovish than expected, leading many to believe the first rate hike might result from the September meeting as opposed to the meeting in June. The Fed also lowered its growth forecasts by 0.30% for 2015 GDP to a range from 2.3% to 2.7%. It’s also worth noting that there’s a minority of Federal Reserve Board members who think the first rate hike should be pushed back to 2016. Bond yields were sent lower over the course of the month in response to the Fed meeting, with longer maturity bonds and some global sectors benefiting the most.
Abroad, major players such as the European Central Bank (ECB) and the Bank of Japan (BoJ) continue to follow the American playbook. The ECB started its version of Quantitative Easing (QE) on March 10th, and the “green shoots” of recovery can be seen in certain parts of the region. The Eurozone saw positive data reported in the Purchasers Manufacturing Index (PMI) half-way through March, however there are still troubling signs. For example, in the United Kingdom inflation reports hit “0” for the first time ever, as reported by the Office for National Statistics. Greece continues to be an area of concern as does a shriveling Euro. If there was ever a year to buy fine French wine, it might be 2015, of course only in terms of currency exchange (who knows what the grapes will be like this year). The chart below shows us that the US dollar has not been this strong versus the Euro since the early 2000’s.
European stocks have rallied strongly year-to-date. Germany’s DAX index is up nearly 26% year-to-date, and currency hedged investment in European stocks have shown even stronger results. While we can’t expect the European version of QE to come off exactly like our own did, we think the results should be similar. To be sure, Japan hopes the results will be similar, and emerging markets economies such as India have also cut rates in hopes of similar results.
The US is well into its economic recovery, albeit a slow one, with much smaller annual GDP readings compared to previous recoveries. A shift in economic growth to those countries and regions that have followed the playbook is very possible. But, one of the most important series of events that will influence global economics will be the US’s journey to normalized rates over the medium term. So much of global business, and economic investment decisions are tied to US interest rates. Interest rates impact the valuation formulas that are involved with nearly all investment decisions. When you value an investment, an asset class or business you have to compare your assumed or expected investment return to the risk-free rate, which has long been the US Treasury Bill. As soon as you change the yield on the T-Bill, you change the outcome of the formula, and the only thing you are guaranteed of is volatility in capital markets.
So the outcome is somewhat “known.” Interest rate policy should and will normalize at some point.
But the real world always seems to deliver surprises. What player might deliver the surprise that upsets all of our expectations? Oil? Conflicts in the Middle East or Russia? A faltering China? Another Ebola outbreak? Political gridlock on Capitol Hill? We’ve already seen a large number of S&P 500 companies issue forward guidance forecasting weaker earnings to come, some of that in part due to the strong dollar, which hurts exports, as we have discussed previously.
It’s become more and more clear that traders are trying to time the Fed’s actions and the nature of their policy. We have seen increased volatility around the release of economic data, Fed statements, and similar headlines. Many think we’ve become too “data-dependent”. One may be tempted to try and time that volatility, however it’s impossible to do so without mistake or with any semblance of consistency. We’ve explored the subject of volatility in recent newsletters, and we continue to give the issue more attention. In fact, our forecasts for higher volatility have been validated by recent market activity. We will continue to manage this higher volatility environment with multiple layers of risk management in both the design and in the day-to-day operation of our portfolios.