Tag: Federal Reserve

A Client Asks: What’s the Benefit of Inflation?

One of our retired clients sent us the following question recently:

“I can’t understand the FED condoning and promoting any inflation rate. To me inflation means that the value of money is simply depreciating at the inflation rate. Further, any investment paying less than the inflation rate is losing money. A quick review of CD rates and government bonds show it is a rare one that even approaches the promoted 2.25% rate. It seems to me to be a de-facto admission of wanting to screw conservative investors and forcing them into riskier investments… Where is there any benefit to the financial well-being of the ordinary citizens?”

I suspect that there are a lot of people who feel the same way. It’s a good question. Who wants ever rising prices?

Here’s how I addressed his question:

Let me answer your inflation question first. My personal opinion is that 0% inflation is ideal, and I suspect that you agree. However, lots of people see “modest” rates of inflation (say 2%) as healthy because it indicates a growing economy. Here’s a quote from an article you may want to read:

Rising prices reflect a growing economy. Prices typically rise for one of two reasons: either there’s a sudden shortage of supply, or demand goes up. Supply shocks—like a disruption in the flow of oil from Libya—are usually bad news, because prices rise with no corresponding increase in economic activity. That’s like a tax that takes money out of people’s pockets without providing any benefit in return. But when prices rise because demand increases, that means consumers are spending more money, economic activity is picking up, and hiring is likely to increase.

A case can be made that in a dynamic economy you can never get perfect stability (e.g. perfectly stable prices), so it’s better for there to be more demand than supply – driving prices up – rather than less demand than supply – causing prices to fall (deflation). Of course we have to realize that “prices” here includes the price of labor as well as goods and services. That’s why people can command raises in a growing economy – because employers have to bid up for a limited supply of labor. On the other hand, wages grow stagnant or even decline when there are more workers available than jobs available.

But for retirees on a fixed income, inflation is mostly a negative. Your pension is fixed. Social Security is indexed for inflation, but those “official” inflation numbers don’t take food and fuel costs into consideration, and those tend to go up faster than the “official” rate. The stock market also benefits from modest inflation.

Which gets us to the Federal Reserve, which has kept interest rates near zero for quite a while. It’s doing this to encourage business borrowing, which in turn is supposed to lead to economic expansion.  However, the actual effect has been muted because other government policies have been detrimental to private enterprise. In effect you have seen the results of two government policies in conflict. It’s really a testimony to the resilience of private industry that the economy is doing as well as it is.

The effect on conservative investors (the ones who prefer CDs or government bonds to stocks) has been negative. It’s absolutely true that after inflation and taxes the saver is losing purchasing power in today’s low interest rate environment. The FED is not doing this to intentionally hurt conservative investors, but that’s been part of the collateral damage. The artificially low rates will not last forever and the Fed has indicated they want to raise rates. They key question is when, and by how much?

Municipal Bond Risk

Municipal bonds are found in the portfolios of many higher income investors.  They have experienced great returns over the last 30 years.  Part of that has come from interest payments and part has come from bonds price appreciation.  Remember, falling interest rates (and we have seen interest rates fall since 1980) leads to higher bond prices.

The problem for bond investors is that rising interest rates have the opposite effect: bonds go down in price when rates go up.  And today’s low rates are largely being engineered by Federal Reserve policy of low, low rates to spur a slow-growth economy with high unemployment.  When the Fed stops easing, we can expect rates to rise, and perhaps rise rapidly.

Here’s Morgan Stanley’s take:

Investors in the $3.7 trillion municipal market will probably face negative returns in 2014 following declines this year, the first back-to-back annual losses since at least the 1980s, according to Morgan Stanley.
The company’s base-case scenario for city and state debt in 2014 calls for a loss of 1.7 percent to 4.1 percent, Michael Zezas, the bank’s chief muni strategist, said in a report released today. A year ago, he correctly predicted that munis would lose money in 2013 as yields rose from the lowest since the 1960s.

In addition, we have seen a rash of municipal bankruptcies which causes investors to be concerned about getting their money bank if a city defaults on its obligations as Detroit is set to do.

For investors who have accumulated large municipal bond positions either as individual bonds or as bond mutual funds, caution is the watchword.

Market commentary as we begin the fourth quarter of 2013

As the third quarter of 2013 came to a close, focus turned to Washington with the government shutdown and the looming November 1 debt limit.  As we write this, it remains to be seen how the competing factions will come to a resolution or if they’ll just end up kicking the can down the road, as they have done so many times in the past, without making any real compromises on the underlying issues.  From 1976 to 1996, the government shut down 17 times, spanning a total of 110 days.  Historically, government shutdowns have had no detectable long term effect on the markets.  The last, and longest, shutdown doesn’t appear to have hurt the economy.  That was mid-December 1995 until early January 1996, a three-week shutdown under President Clinton.  The year before the shutdown, real GDP grew 2.3{030251e622a83165372097b752b1e1477acc3e16319689a4bdeb1497eb0fac93}.  In the fourth quarter of 1995 it grew at an annual rate of 2.9{030251e622a83165372097b752b1e1477acc3e16319689a4bdeb1497eb0fac93} and then during the first quarter of 1996 it grew at an annual rate of 2.6{030251e622a83165372097b752b1e1477acc3e16319689a4bdeb1497eb0fac93}.  This was despite the shutdown and the East Coast Blizzard in January 1996, which was then followed by large floods.

While headline news will have short term effects on markets, over the long term, economic conditions and the direction of corporate profits will have the greatest and most long-lasting effects on portfolios.  Economic conditions have been slowly and steadily increasing over the past few years, and now Europe seems to have stabilized and may be beginning to experience modest growth.  China’s new leadership is working to transform that country’s economy from being export-oriented to one that is more focused on increased consumer consumption.  This will have a major impact on the future of global trade.

As we have said for several quarters now, we continue to remain optimistic about stocks and cautious on bonds.  Even though the Federal Reserve has indicated that they will not begin easing until the economy improves, and they have spelled out what they’ll consider improvement, just the mere mention by the Fed of future rate hikes sends bonds tumbling.  As we said last time, we think that the Fed being able to remove itself from the equation of the U.S. recovery is a net positive, not a net negative.  Additionally, we now have the November 1 debt ceiling looming, which could send both stocks and bonds oscillating as politicians and pundits take to the airwaves to bring a little “Halloween cheer” (sarcasm alert).  We think a last-minute deal will be struck to avoid any real damage, aside from the emotional toll imparted upon people who watch the news or the stock markets very closely.

Whatever comes our way, we are always positioning our portfolios to participate in further market gains and to cushion any market declines.  Over the long term the trend is up.  Please call if we can be of any other assistance to you or someone you care about.

Income Investing: Investors No Longer Taking a ‘Fixed’ Approach

While interest rates on bonds have risen slightly from the absolute bottoms, investors looking for income are still not satisfied with the rates that they can get today.  Adding to their concerns is the expectation that when the federal reserve slows “quantitive easing” interest rates will rise to significantly higher levels.  And that means that the bond they buy today will probably go down in value.

As a result, income investors are actually looking at dividend paying stocks to provide the cash flow that they need.  One other advantage of this strategy is that many companies have been raising their dividends regularly, something that bonds don’t do.

Stop worrying about the Federal Reserve

There are lots of people fixated on trying to figure out what the federal reserve is going to do with interest rates and when they are going to do it.  If you are a retail investor, you are not going to beat the professionals in that game, so stop trying.  Instead, let the pros handle it and relax by looking at the view from 30,000 feet.  Here’s what the bond experts at Oppenheimer are telling us in a messge titled Why Fed Watching Is Likely a Waste of Your Time

What to Remember for the Long Haul

For long-term investors, I believe there are essentially five important points to keep in mind.

1) Overall global economic growth is slow but most likely the worst is over. While there may be hiccups every so often, it is unlikely that we will revisit the financial abyss in the near-to-medium term.

2) Real interest rates are quite low. Over any reasonable investment horizon, they are going to go up. That is true irrespective of what the U.S. economy looks like this quarter or who the next Fed chair is.

3) Because interest rates are so low now, the likelihood that returns from any part of the bond market will get you to a comfortable retirement based on their real returns is virtually zero. You most likely have to have a significant portion of savings in assets that provide better real returns, albeit with greater risk.

4) That said, you can’t just put all your money in stocks. There will be future periods of equity underperformance. In order to make sure you don’t panic and go all cash at the worst point in the cycle, have some part of savings devoted to bond or bond-like instruments now. Even if they aren’t generating a lot of income, those investments may provide protection during equity downturns, which is as important.

5) Income, not price appreciation, is typically going to be a significant part of overall returns. Therefore, wherever you can, and whatever risks you are comfortable with, seek out income-generating investment options. As always, past performance does not guarantee future results.

Good advice.

Federal reserve surprise

The highly regarded Art Cashin commented on the announcement coming from the Federal Reserve that it would not begin “tapering” its bond buying this month.

The financial media has joined the trading community in speculating about possible damage to the Fed’s “credibility” from its no taper decision.  The question is based on the process.  In late spring, Mr. Bernanke floated the idea of gradually reducing the Fed’s QE purchases and, ultimately, ending the program – possibly as early as the middle of 2014.  In the following weeks and months, various FOMC members (voting and non-voting) opined on the matter.  The collective impression was that tapering would begin by yearend (and before Mr. Bernanke’s term ends in January).  The media odds-makers generally moved toward September as the likely start. Instead, the FOMC opted to stand pat in September.  Shocked markets around the world reacted violently.   If the Fed was moving toward a delay of tapering, why was there no intervening “guidance”?  Traders now speculate that the FOMC may have made up its mind at the meeting itself.  If so, was there some last minute economic data or development that moved the FOMC away from a decision that was broadly expected by markets around the globe (as demonstrated by the sharp and sudden reactions that followed)?   That could make the Minutes of the meeting very enlightening – unless they are heavily laundered.  We await with great anticipation.

And here’s a brain teaser:
An ancient Roman Puzzle – “Start with five hundred, end with five hundred just five in the middle will be.  Between them shall be a first of numbers and of letters to give ye the name of a great king.”  Who is it?

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