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Market Commentary 03/31/2014

The Beginning of the End of QE3

As we conclude the first quarter of 2014, we want to take this opportunity to address the significance of the Federal Reserve System, the effects of QE3 tapering, and the appointment of Janet Yellen as the new Federal Reserve Chairwoman.  The Federal Reserve System was established after a series of financial panics and bank runs that threatened the financial system in the United States in the early part of the 1900s.  The Federal Reserve Bank (Fed) of the United States operates with a dual mandate: to maintain both stable prices and full employment.  Historically, its main tool has been the purchase and sale of US treasuries and federal agency securities to impact interest rates, specifically the federal fund target rate.

Generally, the formula for the Fed stipulates that interest rates should be raised when inflation or employment rates are high and lowered under opposite conditions.  When this tactic did not have enough of an impact on the 2008 recession, for the first time in history the Fed employed the Quantitative Easing (QE) strategy, which provided a much broader and more aggressive approach than the traditional open market operations.  QE allows the Fed to purchase longer duration treasuries as well as other assets such as mortgage backed securities (MBS).  In November 2008 the Fed announced it would buy $800 billion in bank debt, MBS and Treasury notes to stimulate the struggling economy.  It ended up doing much more than this through their three rounds of quantitative easing, the last of which, QE3, was implemented in September of 2012.

Did the Fed’s QE programs accomplish what this unconventional strategy was intended to do?  Is the economy now able to stand on its own?  The QE programs were specifically designed to lower long term interest rates, increase investment and boost job growth.  To a large degree, the program accomplished those goals.  We see that the unemployment rate climbed from below 5% in 2007 to a peak of 10% in 2009 but then fell back to its current 6.7%.  While we are still far from maximum employment, the US continues to see modest improvement in job growth.  The long term interest rates have also remained low, which is a very important factor for home buyers as well as businesses that are investing in larger scale projects.  This clearly has had a positive impact on the rising home prices over the last few years.  Banks as well as businesses have continued to hold onto cash to a greater degree than hoped, but with rising consumer confidence, we expect that banks will increase their lending and businesses will again start capital spending for plants and equipment.

This quarter Janet Yellen, an accomplished economist familiar with the QE strategy, stepped into the top spot at the Federal Reserve Bank.  As one of her first acts, she started the planned tapering of the well-publicized QE3.  While a reduced need for stimulus should be a positive sign that the economy is improving, any hint of this policy reversal creates more volatility in the overall markets.  One of the markets’ worst fears is that the Fed will cut back on its easy money policies at a time when the economy is just not growing fast enough to counterbalance it.  So not surprisingly, when Yellen announced that this year was the beginning of the end of QE, the markets reacted.  The markets’ response to the January announcement was swift with the US markets hitting their lows of the quarter by early February.  The Federal Open Market Committee (FOMC) tapered back another $10 billion at its March meeting, while slightly downgrading its economic forecast to growth of 2.8 to 3 percent this year, down from 2.8 to 3.2 percent.  When we look at the overall results of the quarter, they were positive, but they came with volatility.  The S&P 500 returned just 1.8% for the first quarter.  The closing low for the first quarter was 1741.89 and the closing high was 1878.04, a range of nearly 8%.

As it appears, the Fed has accomplished its goals to a degree but the economy needs to improve further before they call their strategy a complete success.  The Fed has been very clear that its actions will be gradual and deliberate both in its reduction of quantitative easing and their ultimate decision to increase short term interest rates.  It will continue with a slow reduction of stimulus to the economy, reducing its monthly bond buyback program by $10 billion a month.  It currently stands at $55 billion.  The FOMC also stated that asset purchases are not on a preset course, an indication that the central bank is prepared to slow or speed up the pace of its tapering if necessary and that its unemployment rate target is flexible. 

What does all this mean for you and your investments going forward?  We believe that US companies are going to continue to improve.  Even with major US stock indices hitting record levels, the price increases have come with an improving economic backdrop and healthy corporate balance sheets.  Stronger global growth has also led to record profits.  Inflation has remained a non-factor to this point but is another reason to hold stocks for the long term.  We expect volatility to increase from the very low levels we became used to last year but overall we continue to believe equities will lead other asset classes.

 In June of 2013, after four months of research we analyzed two aspects of the overall bond market.  Rates in our opinion could do two things:  Stay flat or increase.  We restructured the portfolios to reflect both of these outcomes.  We focused on duration, yield, credit spread and types of bonds that perform in a flat or increasing interest rate period.  Our goal was to maintain the everyday need for funding monthly cash flow, protecting the allocation within a diversified portfolio and to prepare for the next phase of adjustment within the bond market no matter how the changes take place.  The bond market is every bit as diverse as the equity market and we have a universe to consider for your portfolio.

We continue to monitor these changes.  We believe they will require more work.  However, even if rates go up in the next year, we would expect to see price declines in some areas of the bond market while others will have much less impact.  There has been much written about how bonds should be avoided in anticipation of the Fed’s tapering and concerns of higher interest rates to come.  We believe rates will eventually rise.  However, we disagree with the blanket statement particularly to avoid bonds.  Bonds continue to serve a purpose within a diversified allocation.  As investors you need to own the appropriate bonds based on the economic environment that exist.  Since we are in a historically low interest rate time period brought on by the Federal Reserve policy, we need to identify what works today and where are we heading. 

As we go into the second quarter of the year, we want to make sure we talk to you about the potential upside as well as the downside volatility going forward.  Diversification remains key in our perspective as well as positioning your portfolio for your needs- both now and in the future.

Thomas L. Menzel, CFP®                                             Shawn J. Jacobson, CFP®, ChFC, MBA    
Asset Manager                                                            Asset Manager
 
 
 
 
 Lauricella, Tom, “Markets Review and Outlook: Moneybeat’s Quarterly Quota” The Wall Street Journal, 1 April  2014; “US Fed Cuts Monthly Bond Buying to $55B a Month” MSN.com, 19 March 2014; HFI Weekly Commentary, HFI Wealth, March 31, 2014; Market  Insight-Quarterly Perspectives, JP Morgan 2Q 2014; Alessi, Christopher and Mohammed Aly Sergie, “The Role of the US Federal Reserve” Council on Foreign Relations, 23 December 2013.


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