July 1, 2015
Written by Nathan Erickson, CFA®, CAIA, Chief Investment Officer
Financial news and market activity for the first half of 2015 have been driven by Central Bank Policy — perhaps more than any other time in history. The coverage of quarterly earnings announcements pales in comparison to coverage of Federal Reserve meeting minutes and economic data points, as investors search for some indication of a change in policy. If you are an avid reader of financial publications, the above names are likely familiar, or you may have googled them in the last few months. The chart below illustrates the frequency with which Yellen, Tsipras, and Draghi have trended in digital media from 2005 to present day.
Clearly interest has increased dramatically as all three influence global markets and the economy.
Janet Yellen, Chair of the Board of Governors of the Federal Reserve, may be the most influential person in markets today. The great unknown is when the Federal Reserve will raise the Fed funds rate for the first time since 2006. A higher Fed funds rate increases the cost of borrowing for banks, as banks typically borrow from the Fed to make loans. Historically, raising the Fed funds rate was a means to slow a strong economy and prevent inflation from getting out of control, given that bank lending slows down because banks’ cost of borrowing increases. Today, the market is looking to see if the Fed believes the economy is strong enough to handle a rate increase. At the same time it is concerned that if the economy is not strong enough, slow growth may become even slower. As a result every word Yellen speaks is analyzed in great detail, and every Fed statement is compared line by line to the previous statement, looking for clues of a change in outlook. For the layperson, the Wall Street Journal has created a website which tracks Fed statement changes all the way back to 2007. http://projects.wsj.com/fed-statement-tracker/
Mario Draghi, President of the European Central Bank (ECB), is Janet Yellen’s counterpart in Europe. Like Yellen and Bernanke before her, Draghi’s words have substantial impact, best illustrated in July 2012 when he stated that the ECB was ready to do “whatever it takes” to preserve the Euro. As a result, yields on bonds in European countries have fallen dramatically, reflecting the lower cost of borrowing with the backstop of the ECB supporting their credit, as illustrated in the chart below:
Finally, Alexis Tsipras is the newly elected Prime Minister of Greece since January 2015, and was recently voted by Time Magazine as one of the 100 most influential people globally, despite the fact that the GDP of Greece represents just 0.39% of the world economy. http://www.tradingeconomics.com/greece/gdp
You may be wondering how someone who heads a country with such little economic influence becomes one of the 100 most influential people. Because for the first time Greece, with Tsipras at the helm, presents a risk to Eurozone stability. While Greece leaving the Euro will not in and of itself create substantial problems, the primary concern for the ECB is what the follow-on effect will be on the rest of the Eurozone. As of the writing of this commentary, Greece has shut down the flow of capital as they wait for a referendum on the ECB’s proposals, to occur on July 5th. Although markets have been volatile in response to this action, most economists believe the market is prepared for any outcome in Greece, and current volatility reflects short-term overreaction.
While the title of this commentary is tongue-in-cheek, it reflects the somewhat comical scenario of these three individuals having so much influence on markets. Historically, the economic relationship between data and market outcomes was fairly simple. However in the current environment market participants are uncomfortable relying on history, and instead struggle to decipher how policy makers will respond in light of the data. Where historically data points like strong job growth and increased housing demand meant the economy was strengthening and was bullish for markets, today markets are unsure how the Fed will interpret and act on that data, especially in light of low inflation and low economic growth across the globe. The result is what may be the beginning of a long period of lower returns across all asset classes, as weak economic data leads to Fed inaction and consequently market inaction.
The good news is that the lack of economic activity has prevented excesses from occurring that typically lead to economic crisis. As one economist David Kelly once said, “It’s hard to hurt yourself jumping out of a one-story building.” Equity markets have recovered and appear to be fairly priced, the housing market remains subdued, and regulatory changes have substantially reduced bank participation in economic activity. The bad news is that the lack of economic growth and inflation mean market participants have to re-set their reality to investment returns that are substantially lower than history. Gone are the days of 10% returns in the stock market and 5% returns in the bond market. A more reasonable expectation is 7-8% for stocks and 2-4% for bonds for the next several years, at least until economic growth and inflation return. Perhaps now more than ever investors need to be sensitive to the risks they take and the compensation they receive for those risks.
As financial advisors to our clients, fair compensation for risk taken is one of our primary investment objectives. In the second quarter we made changes in the fixed income and multi-strategy allocations of our portfolios to reduce overall risk and retain the long-term expected return, despite the fact that both stock and bond market expected returns continue to decline. Although the current environment creates challenges in traditional markets, opportunities for investors to earn a reasonable return exist in other areas. Some of the changes we have made this year reflect that, and the work is ongoing as our investment department and investment policy committee continue to evaluate new opportunities.
While we cannot avoid all risks, and we can’t predict Janet Yellen, Mario Draghi, or Alexis Tsipras’s next move, we can build portfolios that have a high probability of success of meeting your objectives in various future outcomes. As always, we appreciate the opportunity to serve you.
To view a downloadable version of the Q3 Market Commentary please click here.