We attended the 32nd Annual Monetary and Trade Conference recently held in Philadelphia by the Global Interdependence Center. The topic “Monetary Policy in Transition: Implications for Growth, Markets and the Dollar” brought forth various perspectives about the Federal Reserve and its options going forward. Presenters included economists, academics, investment professionals and former members of the Federal Reserve. One of the presenters was William Poole, Ph.D., now a senior fellow at the Cato Institute; he retired as president and CEO of the Federal Reserve Bank of St. Louis in March 2008 after ten years in that role. During that time he also served on the Federal Open Market Committee (FOMC), which made his perspective more intriguing to us. We are sharing his comments because he offers some constructive ideas to reduce knee-jerk reactions of markets, although he is the first to admit that the Fed will not follow his recommendations.
In discussing how the Fed can return to its pre-crisis operating mode with a balance sheet reduced from $4.5 trillion to $1.5 trillion, Poole believes that the first thing the FOMC should do is to admit that real, nonmonetary factors are hindering a full economic recovery. He cited the reservations of businesses about making fixed investments, not because they have financial constraints, but rather on concerns about the regulatory constraints that may reduce their return on capital so much that they would be unable to cover their costs. This has been particularly acute in the energy sector, with stalled permits to build liquid natural gas export facilities which could be a real driver of future jobs and U.S. economic growth.
Poole would like to see the Fed’s policy actions confined to regularly scheduled meetings, except in extreme cases; let the market know that changes to the federal funds rate will be made in increments of 0.25%; a commitment to complete the tapering program; and a commitment to let the Fed’s portfolio “run off” starting in 2015 by stopping all reinvestments of interest and maturing principal. In his view, the least disruptive thing the Fed can do is to reduce its Treasury holdings to $1.5 trillion within five years. He would also have the Fed stop all forward guidance “before it causes more trouble” and spend more time emphasizing the uncertainty and chance of errors in government projections.
Our bond managers expect the Fed to keep interest rates at current levels until next year. In January, the U.S. Treasury began to offer two-year floating rate notes (FRNs) that have rate adjustments on a weekly basis, and pay slightly more than a three month Treasury Bill. FRNs are the first new type of debt security offered by the Treasury since inflation protected TIPS were introduced in 1997. This gives another defensive option for our taxable bond managers to use as they focus on managing the interest rate sensitivity of their portfolios.
Our Outlook for Equities for the Remainder of 2014
We remain optimistic. The first quarter was held back by weather-related issues in the U.S., and we view the second quarter as the transition between skepticism and realism, with better market conditions expected during the second half of the year. Investors remain unconvinced that the economy is improving. The opportunities within equities continue to grow with new companies joining the public markets as Initial Public Offering (IPOs). The first quarter saw $47.2 billion of new stock issuance by companies globally; up 98% from a year earlier. Of that, the U.S. had 64 companies raising $10.6 billion of capital – the busiest first quarter since 2000. It is interesting to note that company formation has been strongest in the non-U.S. markets, with $36.6 billion or 77.5% raised outside of the U.S.
While this gives our micro-cap and small cap managers new sources of opportunities, they are not all success stories like GrubHub Inc. (online takeout food ordering), which was up 31% on its first day of trading. King Digital (Candy Crush Saga mobile game) dropped 20% within days of its IPO. These rapidly growing companies can crash and burn. The equity market pulled back in early April, which prompted several companies to postpone their IPOs.
The technology sector is also being roiled by M&A activity, with investors concerned that too much cash is leading to a spending frenzy. As an example, Facebook’s stock price declined after announcing its $2 billion acquisition of Oculus VR (3D headsets) in late March, weeks after announcing its acquisition of WhatsApp for $19 billion. On the other hand, it was recently reported that Apple, Inc., which has been averse to acquisitions, has stockpiled $159 billion of the $1.64 trillion in cash held by non-financial American companies. The top three cash hoarders were Apple, Google and Microsoft.
There are signs that capital spending is picking up. BMW, which was the top-selling luxury automaker in 2013, announced its plans to expand its South Carolina facility, which will make it their largest production facility of its 28 plants worldwide. On March 28th, the company celebrated the 20th anniversary of making cars in the U.S. Mercedes-Benz is also expanding its production at its Alabama plant. These are just two examples of non-U.S. companies contributing to the U.S. economy.
March employment numbers showed that the private sector had regained its footing, finally passing the peak numbers of January 2008, yet still behind where we should be. Recent data from the Commerce Department indicates that corporate profits are at peak levels not seen in at least 85 years. Capital to fund advances in science and biotechnology are coming less from government and more from private donors, creating an innovation cycle that is more targeted and ambitious than what we have seen in the past. We recommend the article by William J. Broad, “Billionaires With Big Ideas Are Privatizing American Science” which appeared in the March 16, 2014 edition of The New York Times.
An original article authored by the Investment Research Group of Wescott Financial Advisory Group LLC
© Copyright 2014, Wescott Financial Advisory Group LLC All Rights Reserved