Market Update for June 26, 2017
Market Update for June 26, 2017

Market Update for June 26, 2017

 

By:

J. Reed Murphy
J. Reed Murphy
CIMA®

President
Chief Investment Officer

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Market Update for June 26, 2017

The Fed Balance Sheet Reduction, Bond Exposure and Irrational Investing

MARKET RECAP

It was a muted week for equites across the board with the three major global indices finishing the week relatively flat. Uncertainty over Washington’s new healthcare and tax policy caused trepidation.

Volatility remains extremely low as the markets were mixed. MLPs fell 1.04% over the week as WTI crude oil made new yearly lows. U.S. fixed income finished slightly up on the week as interest rates sit at just 2.14%.

Exhibit #1

This upcoming week there will be several big economic news announcements, including durable goods orders, which are expected to decline. This could be a major source of discussion prior to the release of confidence, GDP and personal income and spending data later in the week.

And, life wouldn’t be normal without a few political headlines.

 
As we move from the spring into summer, many allergy sensitivities are behind us, but what about our interest rate sensitivity? The Fed decided to raise interest rates recently and after a week off from Reed Between the Lines, we revisit the recent decision along with a bigger Fed announcement.
RBTL

 

INTEREST RATE SENSITIVITY ON THE RISE?

On June 14th the Fed raised its fed funds target rate by 25bps (0.25%) to its stated range of 1% to 1.25%. This move was highly expected. Bigger news was what we telegraphed in our June 12th edition of RBTL: the Fed declared it would reduce its balance sheet, which currently stands at approximately $4.5 trillion up from $1 trillion. This is mostly due to quantitative easing programs after the Great Recession were implemented to reestablish confidence in the markets, suppress interest rates and foster economic growth through increased spending. See this link for a chart of the growth in the balance sheet.

According to Fed studies, the increased balance sheet, which drives up demand for bonds and suppresses interest rates, may have manufactured lower interest rates by up to 1%. With the U.S. 10-year Treasury at 2.14%, that is significant. A smaller balance sheet would give the Fed greater flexibility to respond to future crises.

Why is this important for investors? Without going into all potential ramifications, rising interest rates may be negative for fixed income investors. Reading between the lines, we do not believe there will be an immediate or significant hike in interest rates. The Fed is expected to start reducing its balance sheet perhaps this year by approximately $10 billion per month initially and growing up to $50 billion per month in future quarters. At this expected rate, and with all things being equal and no adjustments, it would take approximately six years to get the balance sheet down to pre-recession levels. Nonetheless, investors should monitor their interest rate sensitivity.

SHOULD I INDEX MY BOND EXPOSURES DURING THIS PERIOD?

While a complete answer requires knowing one’s specific situation, many investors will find that active bond managers handily beat their passive brethren.

Exhibit #2

One reason is that it is nearly impossible to index the entire bond market. For example, one popular total bond market index fund has over 17,000 holdings. Yes, 17,000! A recent study by PIMCO shows that approximately 80% of active managers in the largest fixed-income sectors have outperformed their benchmark over the past five years, after fees. This translates into better results for investors even in periods of rising rates.

ON THE LIGHTER SIDE

I have attached a link to an excellent summary of a timeless 1995 presentation by Charlie Munger, Warren Buffet’s partner. If you ever wondered how and why people (and investors) are irrational, this is a must-watch animated video. It’s worth reading between the lines. If you aren’t into fascinating psychology and want to escape reality for a while, then my movie recommendation of the week is Wonder Woman. I took my daughter to this and we both left inspired by the deeper messages about human connection.


 
Tags:  Active Managers, Bond Exposure, Fed Balance Sheet, Fixed Income Sector, Great Recession, Interest Rate Hike, Interest Rates, Investing, Investing Behavior, Investors, June, 2017, Market Behavior, Market Commentary, Market Trends, News and Markets, Reed Between the Lines, The Fed

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