Changes on the Horizon - The Federal Reserve's Quandary
October 30, 2013
As Ben Bernanke’s stent at the helm of the Federal Reserve comes to an end, the central bank finds itself at a crossroads, to “taper” or not to “taper.” Since September 10, 2008, the Fed has seen its balance sheet balloon from just over $925 billion to $3.839 trillion and counting as of October 23, 2013, according to data released by the Federal Reserve. This is the culmination of three consecutive quantitative easing (QE) programs, the most recent of which has seen the Fed attempt to stimulate economic growth by purchasing $85 billion of long-dated treasury securities and mortgage-backed securities on a monthly basis. Many, including some of those within the Federal Reserve, view the quantitative easing bond buying programs as reckless and ineffective. Speaking in front of the Economic Club of New York on October 17, 2013, Dallas Fed President Richard Fisher warned of a “tipping point” in quantitative easing. Saying with each additional dollar of asset purchases, the Fed gets closer to the point of being “an agent of financial recklessness.”
We have seen the effects of the prolonged asset purchases within the markets, particularly in equities and housing. As of this writing, the S&P 500 is up over 23% year to date. A strong correlation can be drawn between quantitative easing and the rise in equities, as the below chart depicts.
As QE has helped asset prices to rise, the economic-specific benefits of QE have been questionable. Many economists contend that we are simply in a “muddle through” economy here in the U.S., and while the overall economic data has been largely positive, it has not been as strong as the Fed or economists would like. This lends credence to the idea that money printing will boost asset prices more than the overall economy.
Political squabbling in Washington has also not helped matters. The recent government shutdown will likely have a noticeable effect on U.S. economic growth for 2013. Due to these economic and fiscal issues, it is my opinion that the Federal Reserve will not begin to taper until early next year, once there is greater clarity on budget developments out of Washington. In the meantime, continued quantitative easing will do little to change the dichotomy between asset prices (positive) and overall economic growth (lukewarm). This leads me to believe there are two possible outcomes once QE tapering begins: 1) Asset prices will fall, or 2) there will be a period of unusually strong growth. Of these two options, I feel the most likely will be a drop in asset prices until this divergence is reigned in. Though we may possibly be facing some turbulent times ahead, dwell on this quote from famed investor Warren Buffett:
“Look at market fluctuations as your friend rather than your enemy; Profit from folly rather than participate in it.”
The views expressed by Joseph Eschleman are his own and do not necessarily reflect the opinions of Wells Fargo Advisors or its affiliates. CAR# 1013-06232
Thoughts on Investing in Today's Volatile Market
March 8, 2013
Q: Why are investors plunging into stock-based mutual funds today?
A: The academic would state that this is a net result of increased consumer confidence in the economy, coupled with ultra low interest rates which render alternative asset classes very unpopular and unproductive.
However, the above answer can be taken one step further, adding that average retail investors seemingly are afraid of being left behind. As the economy expands and the equity markets improve, the average retail investor becomes more willing to invest capital at higher and higher prices. However, as the economy contracts and the equity markets weaken, these same investors become less willing to invest, liquidating equities at low prices and sitting on cash or investing in “safe haven” securities such as U.S. Treasuries, which offer little to no yield. This thought and behavior process is akin to buying high and selling low, exactly the opposite of what should be done, and serves to reinforce the importance of these three quotes:
“Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria. The time of maximum pessimism is the best time to buy and the time of maximum optimism is the best time to sell.”
- Sir John Templeton, February 1994
“To buy when others are despondently selling and to sell when others are avidly buying requires the greatest fortitude and pays the greatest ultimate rewards.”
- Sir John Templeton, August 1958
"The way to make money on Wall Street . . .is to calculate what the common people are going to do, and then go and do just the opposite."
- Daniel Drew, notorious stock market speculator, found from notes in his trunk after his death in 1870
We do appear to be in the midst of a bull market that nobody seems to believe in, myself somewhat included. It appears that because the Federal Reserve and Ben Bernanke is currently holding to an extremely accommodative monetary policy, buying a total of $85 billion of agency mortgage-backed securities and longer-term U.S. Treasury securities per month, open-ended, without a tangible mandate on when to terminate this Quantitative Easing III program, on top of maintaining a 0 to 25 basis point target on the federal funds rate for “at least as long as the unemployment rate remains above 6-1/2 percent,” interest rates have clearly been forced down and has caused investors to have to do something with their money other than keeping it in virtually zero-yielding cash or very low-yielding “traditional” bond asset classes.
The old saying "Don't Fight (the Mission of) the Fed" very much holds true today, in my opinion. Apparently, Mr. Bernanke and the Fed see something in the economy that is not readily apparent to the average investor. Even though many investors, both average and institutional, are beginning to question the Fed’s current “cheap money” policy, maybe the only way the Fed can really explain the complexity of today’s economic circumstances is to focus on Bernanke’s ultimate goal, that of higher real economic growth and lower unemployment. Maybe that is as clear as they can be at this time. It seems foolhardy to try and work against the Fed until there is some evidence that Mr. Bernanke is going to be less persistent pursuing further quantitative easing.
However, and most importantly, not even Bernanke knows what the future holds:
“The only function of economic forecasting is to make astrology look respectable.”
- John Kenneth Galbraith, US (Canadian-born) administrator & economist (1908 - 2006)
Being humble about the fact that nobody can predict the future with 100% accuracy, coupled with the spirit of Mr. Galbraith’s quote above, is exactly why we diversify, and exactly why we rebalance.
The views expressed by Joseph Eschleman are his own and do not necessarily reflect the opinion of Wells Fargo Advisors or its affiliates. CAR#0313-01312
How Interest Rate Changes May Affect Your Investments
October 29, 2012
The rise and fall of interest rates is one of the biggest factors influencing the economy, financial markets and our daily lives. It is important to have a basic understanding of how interest rate changes could affect not only your wallet but also your investment portfolio.
Simply put, interest rates help control the flow of money in the economy. Typically the Federal Reserve lowers interest rates to jump-start the economy. Lower interest rates mean consumers may be willing to spend more money as the cost to finance a purchase is relatively inexpensive. This stimulates the economy in a variety of ways, including increased revenues from products sold to the consumers and taxes generated from those sales. Investors, on the other hand, have a different perspective.
Bond Investors: As interest rates fall, the prices of previously issued bonds tend to rise. The new issues are offered at lower, less appealing rates. That makes bonds with higher interest rates much more desirable and that much more in demand. On the other hand, those who plan to hold their bonds to maturity aren’t really affected by falling rates, with the exception of reinvestment risk.
One way issuers may take advantage of falling rates, is by calling their outstanding bonds and issuing new bonds at lower rates. Once the higher interest paying bonds are called, investors looking for a fixed rate of return are faced with lower yielding fixed income alternatives. To offset this risk, it’s important to have a diverse portfolio of fixed income investments with a variety of maturities and call features to withstand fluctuations in rates.
Stock Investors: Falling interest rates tend to have a positive impact on the stock market, especially stocks of growth companies. Companies that tend to borrow money to finance expansions tend to benefit from declining rates. Paying lower rates of interest decreases the cost of the debt, which may positively affect a company’s bottom line. The stock prices of those companies may rise as a result, driving the market in such a way that prices of other stocks may follow suit.
When the Federal Reserve decides to raise interest rates, its goal is usually to slow down an overheating economy. Changes in interest rates tend to affect the economy slowly – it can take as long as 12 to 18 months for the effects of the change to permeate the entire economy. Slowly, as the cost of borrowing increases, banks lend less money and businesses put growth and expansion on hold. Consumers may begin to cut back on spending as the expense of financing a purchase increases. This reverses the effects that lower interest rates had on the economy and, again, investors are affected differently.
Bond investors: In a rising interest rate scenario,the demand for bonds with lower interest rates declines. New bond issues are offered at higher, more appealing rates, driving the price of existing bonds lower.
Stock investors: Rising interest rates can have a positive or negative impact on the stock market. In some cases, rising rates can send jitters through the market, resulting in falling stock prices. In other cases, the stock market may respond favorably.
In addition, rising interest rates may affect certain industry groups more than others. For instance, growth companies often find it necessary to borrow money in order to expand. Rising interest rates increase the cost of their debt, which in turn decreases profit. As a result, the prices of their stocks may fall.
If you’re interested in learning more about what changing interest rates mean for you, a Financial Advisor can help you better understand the effects interest rates may have on your portfolio.
Stocks offer long-term growth potential, but may fluctuate more and provide less current income than other investments. Bonds offer a fixed rate of return and investment principal if held to maturity. In addition to market and interest rate risk, bonds are also subject to default risk, the risk that companies or individuals will be unable to make the required payments on their debt obligations.
This article was written by Wells Fargo Advisors and provided courtesy of Joseph F. Eschleman, CIMA® Managing Director - Investment Officer in Sacramento, CA at (916) 491-6327
Investments in securities and insurance products are: NOT FDIC-INSURED/NOT BANK-GUARANTEED/MAY LOSE VALUE
Wells Fargo Advisors, LLC, Member SIPC, is a registered broker-dealer and a separate non-bank affiliate of Wells Fargo & Company.
©2011 Wells Fargo Advisors, LLC. All rights reserved.
0811-0569 [87089-v1] 8/11 e6707
15 Positive Aspects Regarding the Financial Markets and Economy
October 15, 2012
In recent weeks and months, the stock market and U.S. and global economy have been surrounded by increasingly negative sentiment. Investors are constantly bombarded with news surrounding the recession in Europe, the potential break-up of the European Union, slowing growth in China, the looming fiscal cliff, and lack of jobs growth, to name just a few of the headlines raising concerns. With all this negativity, it is no wonder why many investors appear to be skittish. But when we pull back and take a macro view we may begin to see a different story.
Found below are what I consider fifteen reasons to be positive about the future, not only about the financial markets, but also about the U.S. economy. While these points are not often discussed, nor reported on, I believe they are key issues that substantiate the sustainability of this economic recovery.
- The European Union (EU) is far from "the brink" and is moving slowly toward a fiscal and a political union to match its monetary union (the Euro).
- The macro choice is to create more fiscal union, or tear down monetary union. I believe we will see the former, and not the latter.
- Another important question is will the stronger parts (read: Germany) of the EU write a check to the weaker parts?
- Understanding that Germany is stubborn, the country is stuck between a rock and a hard place.
- If they don't write the check, Germany is hurt the MOST of any EU nation.
- When backs are truly against the wall, checks tend to get written and common ground is found.
2. Stocks have doubled in the last three years (!) - S&P 500 bottomed at 666.
- The stock market, in my opinion, is in a period where it is “digesting” these major gains.
- So far in 2012, the U.S. stock market, as measured by the S&P 500, is up more than 12% - what is so bad about that?
3. Very loose global monetary policy.
- Find me a major federal bank in the world who is not easing. Stimulative and loose monetary policy is occurring not just in the U.S. and Europe anymore, it is truly global.
- Some are calling it a "reflation party".
- China, India, U.S. - 75% of global growth will occur in these three countries in 2012 according to a Nomura Global Economics report.
4. The U.S. banking system is extremely healthy and is strong and much better capitalized than just a few years ago.
5. Credit card delinquencies - much improved.
- We are in a post-credit bust world where deleveraging (both voluntary and forced) has become the norm.
- Shorter-term, this deleveraging is a headwind to growth (When the consumer deleverages, they generally don't spend as much at the mall.). However, longer-term, it is very healthy in my view.
- It is also very important to understand that economies generally do not recover evenly.
7. Interest rates are LOW.
- 30-year mortgages are at all-time historic lows. Borrowing money cheaply frees up the consumer’s cash flow to be spent in other areas.
8. Inflation is low.
9. U.S. corporate earnings growth continues.
- U.S. corporate fundamentals are very good.
- Important to note that the U.S. economy and stock market growth are not necessarily strongly correlated.
- Corporate America, via increases in efficiency and continued cost-cutting, has largely kept up earnings gains and growth.
- It is important to note that P/E ratios and stock multiples have begun to rise and expand, for the first time since the “Great Recession”.
10. Sentiment - people seem to hate equities right now.
- Equities are underowned; bonds and cash are overowned.
- As Warren Buffet says, it is best to buy an asset when it is underowned and unloved, and sell when it is overowned and popular.
- The S&P 500 dividend yield is 35bps (.35%) higher than the 10 year Treasury bond as of September 4, 2012!
- Corporate profits are being used for dividend increases and for stock buybacks. Levels of this activity are high, and there is clearly room to increase further.
12. Housing is not deteriorating anymore.
- There is tangible healing taking place, both nationally and also here in California.
13. Labor is improving
- Hours worked and average hourly earnings both higher.
- The U.S. unemployment rate has dropped from 10.0% in October of 2009 to 8.3% in July of 2012 – still more work to be done, but also tangible improvement.
14. Election - who knows who will win in November, but somebody will!
- The market tends to hate uncertainty, and after November 6th, this uncertainty will be gone!
15. Demographics - we are a young country
In my opinion, the bottom line is that we are in the middle of a boring “muddle through” recovery. Understanding that the 1.5 - 2.0% growth we are getting is both irregular and is not great, it is certainly not bad either. The positives listed above should, in my view, provide credence to my belief that this recovery, while weak, should continue.
- Small to moderate economic tailwind.
A Simple Way to Transfer Wealth
July 5, 2012
Thanks to the 2010 tax-relief legislation, the rules for estate planning are very favorable in 2012. This two-year window of opportunity provides the incentive to act now.
Lifetime gifts can be a simple, effective way to transfer your wealth to other individuals – provided you know the tax rules. Here’s a brief overview of three opportunities you may want to consider that allow you to make transfers without any estate or gift taxes.
Annual exclusion gifts. Did you know you can give up to $13,000 per year to as many people as you like? And you can gift to anyone, not just family members. If you are married, you and your spouse can give $26,000 per beneficiary per year.
Annual exclusion gifts are attractive because they’re simple – no tax reporting is required. They reduce your taxable estate (potentially saving a 35% tax), and there are no lifetime limits, as long as you stay within the annual limits. Gifts to individuals are not taxable income to the beneficiary and do not create any income tax deduction for you.
Lifetime exclusion gifts. With this type of gift, you can make gifts above $13,000 per person per year, without paying gift tax, up to a $5,000,000 lifetime limit (this amount is scheduled to change in 2013). Let’s say you give $100,000 to a family member. The first $13,000 is covered by the annual exclusion; the remaining $87,000 is applied to your lifetime exclusion. If this was your first gift exceeding annual exclusion limits, you would have $4,913,000 of lifetime exclusion remaining.
When making this type of larger gift, you should keep in mind that a gift tax return is required. You must report the gift, but will not owe gift tax. In effect, these lifetime transfers “use up” part of the exclusion that would otherwise be available at death to reduce your estate tax.
The key benefit is that if you transfer assets that appreciate in value, all of the future appreciation is removed from your taxable estate, although the recipient takes on your cost basis and holding period for income tax purposes.
Direct gifts (tuition and medical expenses). There are special rules in place for direct gifts of tuition or medical expenses. You can pay tuition or medical expenses for another person, without limitation. These gifts do not count against the annual exclusion or lifetime gift exclusion. However, you must pay the school or medical provider directly. Funds given to the beneficiary directly will not qualify. And “tuition” means just that – tuition only, not books, supplies, fees or room and board. No specific tax reporting is required, but as a rule you should keep good records. Ultimately, it is your responsibility to be able to prove that your gift qualified under this rule.
Wells Fargo Advisors can help you determine the best gifting strategy that benefits you as well as the individual(s) on the receiving end. Call your Financial Advisor today to discuss your gifting options.
The information in this article reflects federal tax laws in effect for 2011 and 2012, after the enactment of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010.
Wells Fargo Advisors does not render legal or tax advice.
This article was written by Wells Fargo Advisors and provided courtesy of Joseph F. Eschleman, CIMA® in Sacramento, CA at (916) 491-6327.
Investments in securities and insurance products are: NOT FDIC-INSURED/NOT BANK-GUARANTEED/MAY LOSE VALUE.
Wells Fargo Advisors, LLC, Member SIPC, is a registered broker-dealer and a separate non-bank affiliate of Wells Fargo & Company. ©2012 Wells Fargo Advisors, LLC. All rights reserved. 0312-4868 [87564-v1] 03/12
Joseph's Take on the Current State of the Markets
June 12, 2012
Last week, the U.S. stock market had its largest weekly advance of this year after holding at important support levels. This is an encouraging sign that a lot of bad news has already been factored into current prices. However, the market still faces other tests before current uncertainties are cleared up.
Markets also braced last week for a bailout on Spain which came this past weekend. Spain’s banking sector is in terrible shape, causing their share price to join other European banks at 25 year lows. The official downgrades came long after the stock market had voted with its feet, and it was clear that European leaders had little to add to the debate. There's some talk of a twin track: some European countries pressing on to further integration, some coping with contraction and austerity on their own. Neither makes much sense in my opinion. More importantly, European policymakers have agreed to lend 100 billion euros to help Spain’s troubled financial institutions and provide funds that could be used as a line of credit in case Greek voters choose leaders that could take Greece out of the European currency union.
Monetary Policy: Last week we had both the Fed and ECB state no change in policy was required but that they're both looking at the situation carefully. Well, thank goodness [sic]. Ben Bernanke pointed out the obvious risks of tentative new job creation, Europe, and domestic budgetary pressures and he warned quantitative easing (QE) has diminishing returns. He used "moderate" paced language rather than "modest" and left a clear message that the Fed would ease more if there was a major disruption (i.e. Europe or domestic fiscal cliff issues). He held to the 2% inflation target, which is where he is getting the most flack, on the assumption that monetary growth must feed into higher prices. The trouble is the market does not believe his inflation targets. But in some ways their indifference, especially in the face of weaker economic numbers, is understandable because monetary policy can only overcome so much inertia on fiscal policy – when both the government sector and personal sector deleverage, the economy struggles, which is what we have seen since 2009.
For most of this year it's unequivocally pointing to deflation and inflation expectations have dropped in the last two years. Part of the problem is the "stop/start" approach to monetary policy. This has meant one policy after another which sets a target amount of open market activity but pretty much fails to state what the goals are, so plenty on the means, but not much on the end.
Regarding the European Central Bank (ECB), Mario Draghi talked a good game and told everyone they must redress their imbalances, but he left policy unchanged. The ECB is constitutionally much weaker than it looks. The eurozone appears to be on the cusp of a technical recession, which would argue for rate cuts, bank recapitalizations, and stabilized bond yields. But the ECB does not control these and so only target inflation, which at 2.4% is above the stated goal.
Flow of Funds: The Federal Reserves' quarterly flow of funds is a very good read because it gives all sorts of information on what U.S. households are up to. Two things caught my attention. One, last quarter many analysts pointed to the fact that the government had bought 65% of all treasury securities in 2011 and, beware, when they stop buying, rates would climb. Well it did stop, it dropped to 16% of buyers, but rates didn't climb. That's because households stepped in to buy 20% of issuance as part of their effort to put their balance sheet on a firmer footing.
Second, the composition of household balance sheets continues to change. Net worth increased $2.4 trillion, mainly because risky assets, like mutual funds, equities and pension funds, accounted for 77% of assets and all increased in Q1, 2012. Meanwhile, over on the liabilities side, mortgage debt fell over $1 trillion from its peak and stand at 25% of net worth compared to 27% two years ago. This is possibly why the Fed believes the wealth effect of a rising market is more important than housing. Certainly, households are at least in a better place to support spending should higher levels of confidence return.
China cut rates. It won't have much effect on demand because the fiscal side is what drives the economy. The domestic economy is what counts. Net exports have contributed around 0.2% to a 9% GDP/growth rate. Chinese GDP will probably slip below 8% this year.In summary, the U.S. stock market passed a big test this past week, holding at important support after several central banks cut interest rates in order to boost economic growth. The stock market still faces other tests, including the Greek elections and the next Federal Reserve policy meeting. If the outcomes are positive, the U.S. stock market could be poised for a summer rally.