All Eyes on the Fed

Now that the Federal Reserve’s asset purchase program is coming to an end, the focus of financial markets is shifting quickly to the Fed’s policy in 2015. Members of the Fed have already announced their intention to raise short term interest rates as soon as they are convinced the economy has achieved sufficient strength and momentum to weather such a rate hike. A lively debate has begun within and outside the Fed as to when the interest rate normalization process should commence, how aggressively it will proceed, and what impact this will have on the U.S. economy and financial markets.

What is at stake is the continuation of the five year economic expansion and stock bull market. Pessimists argue that early and aggressive rate increases would break the U.S. economy, possibly foment a recession, and cause a significant stock market retreat. Other Fed watchers are concerned with the opposite outcome; the Fed will proceed too slowly and cautiously, thereby permitting a buildup of inflation and the formation of asset bubbles. Optimists, on the other hand, have confidence that the Fed can lift rates gradually to a long-term norm without disrupting the economy and the stock market. Marietta falls into the latter camp in our response to the key questions of the debate:

1. When do we expect the Fed to begin raising rates?

Members of the Fed itself disagree on an appropriate start date. Kansas City Fed President Esther George has stated that the U.S. economy is already strong enough to withstand higher interest rates. Conversely, Charles Evans, Chicago Fed President, thinks that economic conditions will not be suitable until at least 2017. The key viewpoint will almost surely be that of Fed Chair Janet Yellen, who has expressed that a probable date would be six months following the end of tapering, but with the assumption that the economy would continue to strengthen into 2015. We consider April 2015 to be the most probable start date. This is based on our six month forecast for GDP of approximately 3%, inflation below 2%, and unemployment below 6%. During this period we expect a growing consensus within the Fed supporting Chair Yellen’s prediction that economic circumstances would justify taking action at that time.

2. How aggressive do we expect the Fed to be in implementing rate increases? 

We expect that economic growth will be strong enough and inflation sufficiently tame to support a gradual increase in the Federal Funds Rate to about 1% by the end of 2015. This prediction assumes that the Fed will want to be cautious and, if necessary, err on the side of being too slow rather than being too aggressive. We consider Chair Yellen to be especially dovish. This pace would also be consistent with precedent: in each of the last three rate raising periods following recession and accommodative low rates (1984, 1994, 2004), the Fed started with a .25% rate raise and proceeded cautiously.

3. What is the likely consequence for the U.S. bond market?

We expect the yield on the benchmark 10-year U.S. Treasury to rise from its current 2.5% yield to 3% or slightly above by the end of 2015. This modest rise would be consistent with the two most recent periods (1994, 2004) when prior Fed policy normalizations started. We think such an increase in the benchmark yield would be consistent with approximately 3% GDP growth and the perception that the Fed was proceeding with caution. Nevertheless, this rise in yields would probably result in a slightly negative total return from now through 2015 for many bond mutual funds.

4. What is the outlook for the U.S. stock market? 

From now until April 2015, as the debate over Fed policy becomes more feverish, market volatility will probably increase. We think the market will hold and possibly advance into year-end based on continued strength in the economy and corporate profits. Further, investors will be reluctant to take gains, and performance oriented hedge funds will feel pressure to achieve competitive performance. A correction, however, becomes more likely in early 2015. As the first rate hike approaches, anxiety could cause market weakness. In subsequent months, additional rate hikes could intensify economic uncertainty and exacerbate a market downturn. Nevertheless, we think that by the end of 2015 the market will recover and hit new highs as it becomes increasingly apparent that the economy has not been damaged and corporate profits continue to rise.

A historical perspective supports our outlook. J.P. Morgan has examined the last six Fed policy normalizations and has drawn attention to two observations. The first is that there was a clear market weakness averaging -4% over the three to four months following the first rate increase.  The second is that in five of the six occasions, the stock market made a new cyclical high within twelve months. We agree with their conclusion that “any potential dip due to policy uncertainty should be bought into.”

Although some investors will greet the next phase of the economic cycle with apprehension, we consider a normalization of rates to be healthy. We emphasize that our views are based on certain assumptions, one of which is an absence of a surprise geopolitical development that significantly alters economic and market forecasts. We consequently think that it is especially important to remain vigilant and flexible in what could well prove to be challenging conditions ahead.

Federal Reserve Supports Marietta's Positive Outlook for U.S. Economy and Stock Market

On March 21, the Federal Reserve Open Market Committee reiterated its positive year-end forecast for U.S. economic growth in 2014 and 2015. In a subsequent press conference, Fed Chair Janet Yellen stated that weak U.S. economic data in January and February was due primarily to bad weather and would pick up in coming months. She emphasized that "the Committee's views are largely unchanged" since December and confirmed the Fed's prior prediction of 2.8-3.0% GDP growth and 1.5-1.6% inflation in 2014. With this promising outlook, the Fed expects to continue its tapering policy to completion in September. It will proceed to raise its base short-term interest rate after a pause if inflation and employment data continue favorably.

Marietta's January 3 Outlook emphasized the importance of economic acceleration and corporate profit growth in extending the 5-year bull market through 2014. The 29.6% surge in the S&P 500 index in 2013 was driven in part by a 10.8% increase in S&P 500 corporate earnings but even more by an increase in the market's P/E valuation. This "multiple expansion" has resulted in a rise in the Index's current P/E ratio on trailing 12-month earnings to 16.5, which is above the last 10-year average of 14.7 We consider the market to be fully valued rather than overvalued, but we think a further advance should be fueled by earnings growth rather than multiple expansion. Hence, our bullish view relies on our favorable 2014 forecast of 3.0% GDP growth and a rise of 7-9% in corporate earnings.

We are encouraged by the 4th quarter corporate earnings reports released during the 1st quarter. According to Howard Silverblatt at Standard & Poor's, 64% of S&P 500 companies reported earnings above Wall Street estimates and an additional 11% met expectations. He also indicates that company research analysts are currently estimating an increase of 12.1% in aggregate operating profits for all of 2014. Assuming the S&P 500's P/E valuation remains constant through 2014, this increase in profits would reward investors with another year of double-digit returns. We think this scenario is reasonable because the market's valuation multiple is unlikely to contract as long as the expected return on money-market funds and bond alternatives remain unattractive.

A concern for some investors is that the Fed's statement is actually negative for the stock market because it hastens the date of an increase in historically low 0-0.25% short-term interest rates. We are not persuaded. The Fed has clearly indicated that it will not raise rates until it is convinced that economic growth has achieved healthy, sustainable growth, which in turn will increase investor confidence in further profit growth. Our view is that investors will not become excessively alarmed as long as inflation and interest rates remain below long-term norms of 2% and 4% respectively.

The Positive Case for U.S. Stocks in 2014

Our assessment of the U.S. economy and stock market conditions leads us to conclude that the 4+ year bull market in stocks, which includes an S&P 500 surge of 25% in 2013 through December 16 and a 160% gain since March 2009, will continue through 2014. We predict an advance of 7-9% in the S&P 500, which would be in-line with a 7-9% jump in corporate profits. A double-digit increase is possible if the “multiple expansion” of 2013 extends into next year. Corrections are a normal characteristic of bull markets, and some believe that the current market is overdue for a 10%+ setback, but we would view such a correction as a buying opportunity unless there is a change in the following favorable economic and market conditions:

• We expect U.S. GDP growth to increase 3% in 2014, which is in line with the Federal Reserve’s forecast and a December 5 Bloomberg survey of economists. This economic growth will likely result in corporate profit growth of 7-9%. Thomson Reuters Baseline reports that the consensus projection is 8%.
• Fundamental to our upbeat economic forecast is low inflation and a continuation of the Federal Reserve’s accommodative policy that includes near zero short term interest rates until at least 2015.
• The market remains fairly valued despite the significant gains in 2013. The current S&P 500 P/E ratio of 16.4% is only slightly above the long-term norm of about 15%.
• A major stock market development in 2013 was that stock prices rose over 20% when corporate profits grew less than 5%. The “multiple expansion” which resulted is characteristic of a maturing bull market and may well extend into 2014. This would raise the 2014 market advance into double-digits.
• Money market funds and bonds remain relatively unattractive. Money market funds yield at or near zero and are likely to remain low due to Fed policy. Bond yields are historically low and Federal Reserve tapering is expected to result in higher bond yields (and lower bond prices).
• Data compiled by Strategas indicates that the 4+ year bull market through this November has resulted in an outflow of $370 billion from stock mutual funds, whereas they report an inflow of $985 billion into bond mutual funds. Improving economic conditions and a rising stock market could convince investors to reverse these flows. A “Great Rotation” could occur in 2014 as investors shift from bonds to stocks.
• Stock markets have a history of climbing a wall of worry. A November 26 Merrill Lynch report on investor sentiment indicates that confidence remains at the same level as at the depths of the bear market in early 2009. Some skeptics argue that the market is now in a bubble condition, which we think untenable when there is such a high level of pessimism.
• Corporate cash balances remain very high. Improving economic conditions may induce corporate managements to increase dividends, stock buybacks, and merger and acquisition activity, all of which are positive for stock prices.

A relevant consideration in our market forecast is that the level of risk in the U.S. market is reduced from prior years. The possibility of a relapse into recession is diminishing as foreign economies expand and geopolitical tensions moderate. Investor concern with dysfunction in Washington has declined significantly over the past two years, with neither political party willing to appear obstructionist as a general election approaches.

We view the upcoming, widely anticipated reduction in the Federal Reserve’s bond buying program (tapering) as a threat to the U.S. market. The fear is that tapering will force rates up to such an extent that it will choke off the housing industry, discourage consumers, and trigger a possible recession in an economy that has yet to restore full health. We think this is unlikely because the Federal Reserve is highly sensitive to declining growth and would adjust its policy if this outcome seems possible.

Despite the fundamental economic and market positives, there is a nagging suspicion held by many investors that something ominous is on the horizon. This view is often based on an awareness that the average duration of past bull markets is about 5 years and the current bull market is approaching this point. Markets do not operate on a preset clock and we encourage investors to base their strategies on empirical conditions. Underlying economic fundamentals are much more reliable predictors of market tops, and they are currently propitious.

Global Economic Revisions

The sharp decline in global stock markets last week was in large part attributed by the financial media to economic warnings issued by the Federal Reserve and the International Monetary Fund (IMF). The reports spawned a rash of recession forecasts as markets tumbled. A closer look at the press releases of these institutions, however, reveals a far less ominous outlook of continued albeit more modest growth. 

Financial markets were well aware before last week that the U.S. and European economies were weakening and that there was a rising risk of further deterioration. It was the Fed’s language that startled investors. Their September 21 policy statement asserted that “there are significant downside risks to the economic outlook, including strains in global financial markets. ”This was a sterner warning than the Fed’s August 9 alert that “downside risks to the economic outlook have increased.” 

Investors evidently overlooked the positive growth forecast in the Fed’s statement: “The Committee continues to expect some pickup in the pace of recovery over coming quarters” and anticipates a gradual reduction in unemployment. Indeed, three members of the ten-member Committee believed the economy was not in imminent peril and voted against the Fed’s new “operation twist” policy on the grounds that they “did not support additional accommodation at this time.” 

In its semi-annual global economic report released last week, the IMF alarmed investors with the opening statement: “The global economy is in a dangerous new phase. Global activity has weakened and become even more uneven, confidence has fallen sharply recently, and downside risks are growing.” In the introduction, Executive Counsellor Olivier Blanchard pointed out that “fear of the unknown is high” and concluded: “In light of the weak baseline and high downside risks, strong policy action is of the essence.” 

The actual growth projections in the IMF forecast are more encouraging. Global GDP growth is expected to be 4.0% in 2011 with an additional 4.0% in 2012. The U.S. will avoid recession with 1.5% growth in 2011 and 1.8% growth in 2012. The Euro Area is projected to slip but remain positive: 1.6% growth this year will slide to 1.1% in 2012. The emerging and developing economies will continue to drive global growth with gains of 6.4% in 2011 and 6.1% in 2012. China and India will maintain their torrid pace with 2012 gains of 9.0% and 7.5%. 

 Supporting these forecasts of continued GDP growth this and next year is the consensus outlook of economists polled by The Economist. The U.S. is expected to grow 1.6% in 2011 followed by a modest rise of 2.0% in 2012. Euro Area growth will remain positive but slump from 1.7% this year to 1.0% next year. The widening gap between the developed and the emerging economies, so pronounced in the IMF forecast, is also reflected in the consensus outlook: China is predicted to slow only modestly from 9.0% to 8.6%, whereas economists foresee India’s GDP will rise from 7.9% to 8.2%. 

 In review, the broadly accepted, probable scenario projected by professional economists is that the U.S. and Euro Area will muddle through with the support of continued strong growth in the emerging economies. Even though the economists do not believe recession is likely, they acknowledge that the global economic outlook has dimmed, the risk of a further deterioration has risen, and a further reduction in estimates may be necessary. All eyes will focus on the policy makers to take decisive action to raise consumer and investor confidence and restore healthy growth.

Fed Watch

In recent Outlooks and blogs, we have emphasized the importance of Federal Reserve policy in influencing the direction of the U.S. stock market and the relative performance of industry sectors and investment styles. In particular, we have pointed out that in 1994 and again in 2004 the Fed reversed accommodative, anti-recession, low-rate policies and raised rates as economic recoveries gathered steam. In both cases, the Fed rate hikes abruptly halted powerful stock market rallies and led to rotational shifts in investor stock preference. We have also noted the negative impact thus far in 2010 on the prior stock market rallies in China, India, and Brazil as governments and central banks tightened credit in an effort to ward off potential inflation and asset bubbles.

To most Fed watchers, the question not whether the Fed will raise rates but when will they raise rates. For months the Fed has indicated its intention to keep rates low for “an extended period” even though the country has emerged from recession and the recovery has strengthened. At the end of 2009, we expected the Fed to raise rates late in the 2nd quarter or early in the 3rd quarter, by which time we anticipated that job growth would be the catalyst to trigger a change in Fed policy. In April, we subsequently pushed back our expectation to November when the Fed acknowledged economic growth, but stated its concern for the sustainability of the recovery and left in place its “extended period” language in statements regarding their interest rate deliberations. A Wall Street Journal survey of economists, disclosed in a May 12 article, finds that the consensus view in early April was for a hike in November, but now 42% expect the Fed to hold off on tightening until at least 2011. The WSJ attributes their shift in opinion to the European debt crisis, which “underscores the fragility of the global financial system and the risk, however small, of outside shocks derailing the recovery.” As a support to this view, on May 14 Chicago Federal Reserve President Charles Evans stated “I think the risks, obviously, with the global situation make things a little bit more uncertain than we were expecting…so, if anything, I am even more comfortable with my assessment that accommodation continues to be important.”

As the WSJ article points out, low inflation under 2% combines with the European turmoil to provide the Fed with room to keep policy on hold. We presume that the Fed prefers to avoid a rate increase in the politically sensitive months leading up to the national elections in November and thus welcomes this breathing space. On the other hand, the Fed is also painfully aware of the criticism of former Fed Chairman Greenspan and the Fed’s “too little, too late” rate raising policy coming out of the last recession, which permitted the creation of the housing bubble. We will monitor closely and comment on developments at the Fed in future blogs.