Wait For It…

by Charles N. Waterhouse, Vice President & Senior Financial Advisor 

The Federal Reserve surprised the financial markets in September by leaving its current level of economic stimulus in place.  After several months of hinting about reducing the current $85 billion dollars of monthly bond purchases, known as quantitative easing or QE3, the Fed gave investors a head fake, deciding to wait for more solid signs that the economy is strengthening enough to go it alone.

Despite a steadily improving economy, several factors likely compelled the Fed to wait to begin “tapering” its bond buying program.  Comments made by Fed Chairman Ben Bernanke early in the summer caused markets to react, sending yields on the 10-year Treasury to jump more than one percent, increasing mortgage rates at the same time.  This rate increase could slow the improving housing market recovery, risking the strength of the economic recovery.  The Fed also appears concerned about possible upcoming political fights in Washington over government spending and the federal borrowing limit.  These could cause significant headwinds for the fragile economy.  

Over the last few years, the housing market has been repairing itself and now is a significant contributor to the economic recovery.  Four years ago, housing starts registered less than 500,000 annualized units. This year they hit the one million level. 

During the last four months they’ve settled back in the 900,000 range, but that’s still good growth.  We’ve got upside potential, too, as the long-term average is closer to 1.4 million units.  Home values have been improving too. The Case-Schiller index has shown solid increases in the year-over-year value for the past 14 months, settling in at 12% the past 3 months.  The recent increase in mortgage rates could slow this improvement in the housing sector, which could hurt the overall economic recovery, but it’s still too early to tell.

It appears that the White House and Congress are bracing for a fight on government spending, and it could get ugly.  Washington needs to pass legislation to fund the government and increase its debt limit. The recent past indicates the sides are widely divided over how to approach that.  An ongoing fight could spook the markets and send stocks reeling, and cause a pause in the economic recovery. 

The Federal Reserve appears committed to its accommodative stance, keeping interest rates low for the next couple years. But many thought the Fed would start tapering in September, based on prior statements. Even though markets were betting on that move, Chairman Bernanke summed up the Fed’s inaction in his post-meeting press conference, saying “We can’t let market expectations dictate our policy actions.  Our policy actions have to be determined by our best assessment for the economy.”

Solid Stock Performance

While the stock market gave up some ground in August, year-to-date performance through August 31st has been very solid.  The S&P 500 Index of large companies is up 16% for the year, with the S&P 400 Midcap Index and the S&P 600 Small Cap Index increasing 17% and 21%, respectively.  The markets remain fairly valued at these levels, though the uncertainty caused by the factors mentioned above could cause some volatility for the remainder of the year.

International markets have fared less well this year, as the MSCI EAFE Index was up only 8% through August 2013.  Emerging Markets on the other hand have struggled this year, falling more than 10% in the first 8 months of the year.  Weakness in China and Brazil have been partly to blame for this dismal performance, but the latest reports show that growth is returning to China’s manufacturing sector.  Signs of economic growth returned in September, as an index of manufacturing activity rose to a-six month high.

Interest rates are certain to trend upward over the next several years as the economy gets stronger and the Federal Reserve reduces monetary stimulus.  Whether the Fed starts tapering in September or December of this year, they’ll get to the same spot in the end. They are committed to a stronger sustainable economy and more job growth.  Although Chairman Bernanke has admitted the Fed has little power to offset potential harm caused by inaction in Washington, the Fed will continue to accommodate the economic recovery.

Progress has been made on reducing the deficit in recent years, as it has fallen from 10% of GDP in 2009 to below 4% this year.  Estimates show it could fall to 2.1% by 2015.  With this trend, maybe we can avoid the political theatre that rocked the markets back in 2011.  In any event, long-term economic growth is on solid footing and we have strategies in place for managing our clients’ portfolios through these changing times.