Q3 2017 Commentary - Meet The New Boss...Same As The Old Boss
Or so the classic line from the Who’s 1971 hit song “Won’t Get Fooled Again” goes. And who exactly is that boss? Why, none other than global central banks. Since the Great Financial Crisis, the Federal Reserve’s (the Fed) extraordinary monetary policy has been successful in re-liquifying the banking system and, most importantly, elevating valuations of many asset classes. The Fed, or old boss, has now begun the long process of “policy normalization” by raising short-term interest rates and initiating the slow drawdown of their balance sheet. But what about that old adage “Don’t fight the Fed?” If the Fed’s easing of monetary conditions through lowering interest rates and purchasing assets via quantitative easing was good for stocks and bonds, why hasn’t the raising of short-term interest rates and the plan to reduce the size of their balance sheet caused the markets to at least stall, if not fall? Yet the markets remain resilient, continuing to move higher even with the political dysfunction in Washington D.C., growing geopolitical concerns about North Korea, and continuing credit concerns about China. How can this be? There are likely several reasons. First, corporate profits for many U.S. companies remain strong and are continuing to grow. Second, while interest rates on the short-end of the curve have risen, interest rates on the longer-end of the curve, 10 plus years, have stayed relatively flat, remaining very low by historical standards. Third, while the U.S. Fed has begun the difficult process of policy normalization, the European Central Bank and the Bank of Japan, the new bosses, are still engaged in massive quantitative easing programs, having bought more than $1 trillion in assets thus far in 2017. The global central bank liquidity spigot is still on and gushing. And this liquidity continues to find its way into U.S financial markets fueling the relentless buying pressure. The new bosses learned well from the old boss. Pump enough liquidity into the financial system and asset prices will rise (see chart below). Investors have taken notice and “won’t be fooled again” into selling stocks as long as global financial conditions remain very accommodative.
Let’s state the obvious. Stocks, not to mention bonds, are quite expensive by many historical measures. And as was covered in our recent blog post, A Public Service Announcement from Investing Legend Howard Marks, investors are becoming ever more complacent to downside risks. But that does not necessarily translate into stocks are expensive so they must fall now. Anyone who has been in the markets for any length of time knows that valuation is a terrible timing tool. Assets can remain overvalued for much longer than thought possible. In addition, there is the hope amongst investors that significant tax reform will get passed in the coming months. Reducing corporate tax rates would increase the profitability of many U.S. based companies, possibly providing further fuel to the financial market rally. While it is a fool’s errand to try and predict short-term market movements, if the financial markets get through the month of October unscathed, it would not surprise us to see a rally into year-end. Especially if we see legislative progress on tax reform. Our mantra remains, move forward, but with caution. In execution this means staying diversified, including non-correlated assets in the portfolio, while maintaining optionality to increase risk exposure on any correction. While the market may move higher in the near term, it is time to stay sober, alert and with a keen focus on risk mitigation.
As always, we appreciate the trust you place in us. We remain committed to helping you achieve your financial objectives.
Financial Planning Focus
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