Q2 2017 Commentary - The Times They Are Changin'
The echoes of this Bob Dylan classic from 1964 can be heard through today’s financial markets. After 8 years of extraordinary monetary measures by the U.S. Federal Reserve (the Fed), the times they are a-changin’. The days of quantitative easing (QE) whereby the Fed buys $60 billion in U.S. Treasury obligations and mortgage-backed securities, gone. Interest rate cuts, gone. The path forward in economic parlance…“policy normalization.” The successive rounds of QE since the Great Financial Crisis have resulted in the world’s four largest central banks holding a combined $13 trillion in securities on their balance sheets or roughly 20% of the world’s combined annual gross domestic product (GDP). Policy normalization means central banks now want to slowly and gradually increase interest rates AND reduce the size of their balance sheets by either not reinvesting the interest and principal of their holdings as they mature and/or selling securities into the market. The process of central banks extracting themselves from their radical monetary measures without upsetting the global economic framework will be very difficult to put it mildly. And they are well aware of this. The following excerpt from the most recent annual report of the Bank of International Settlements (BIS), which is commonly known as the central bank of central banks, highlights this very point.
“Policy normalization presents unprecedented challenges, given the current high debt levels and unusual uncertainty. A strategy of gradualism and transparency has clear benefits but is no panacea, as it may also encourage further risk-taking and slow down the build-up of policymakers’ room for manoeuvre.”
The use of the phrase “unprecedented challenges” by the BIS should sound the wake-up call to market participants. The report continues by specifically highlighting some of these challenges.
“In determining the pace of normalization, central banks must indeed strike a delicate balance. On the one hand, there is risk of acting too early and too rapidly. After a series of false dawns in the global economy, questions linger about the durability of this upswing. And the unprecedented period of ultra-low rates heightens uncertainty about reactions in the financial markets and the economy.
“On the other hand, there is a risk of acting too late and too gradually. If central banks fall behind the curve, they may at some point need to tighten more abruptly and intensively to keep the economy from overheating and inflation from overshooting. And even if inflation does not rise, keeping interest rates too low for long could raise financial stability and macroeconomic risks further down the road, as debt continues to pile up and risk-taking in financial markets gather steam. How policymakers address these trade-offs will be critical for the prospects of a sustainable expansion.”
The path to normalization would be easier if the U.S. and global economies were performing better. Unfortunately, U.S. GDP for the first half of 2017 appears to have grown at a sub-2% rate based upon preliminary reports. While this may improve in the second half of the year, there are several potential headwinds that could limit growth, including slowing auto and home sales, which are both significant to the U.S. economy. In addition, as of this writing, Congress cannot seem to agree on the details of comprehensive healthcare or tax reform. If the Fed continues to tighten in the back half of 2017 in the face of an economy struggling to grow above 2% AND tax reform gets delayed until 2018, financial markets may finally start to take notice.
The markets remain quite tranquil as measured by the most recent level of the volatility index (VIX). So the times may be a changin’ but the market doesn’t seem to care, yet. This may be explained in part by the embedded belief of market participants that if economy and/or markets begin to falter, central banks will quickly reverse course on policy and reduce interest rates or even begin more QE if necessary. Whether one agrees or disagrees with Fed policy, in our opinion this belief is well-founded and likely to be proven true given the right set of economic/market conditions.
The current Chair of the Federal Reserve, Janet Yellen, recently made news with the following comment.
“Would I say there will never, ever be another financial crisis? You know probably that would be going too far, but I do think we’re much safer, and I hope that it will not be in our lifetimes and I don’t believe it will be.“
While we certainly hope Chairwomen Yellen is correct in her belief there won’t be another financial crisis in our lifetimes, we prefer to take a more nuanced, cautious view. The world is a complex organism with many levels of interconnectedness that no one person or institution can fully understand or properly model. In such an environment, the prudent approach is to construct well diversified portfolios that participate in the upside if economies and markets continue to grow, while maintaining some exposure to non-correlated assets that offer some downside protection if the path to policy normalization proves more challenging than many expect.
As always, we remain committed to helping you meet your financial objectives. We appreciate the trust you place in us.