The Fed Decides: Rates Remain Low As We Watch China

Stock Declines May Be Almost Over, But Fed Communication is Not Helping!!

t’s been a difficult summer for stocks - falling 8% from their May highs and supporting the old market adage, “Sell in May and Go Away!.” This August in particular has been extremely volatile to the downside. In response, the Federal Reserve decided last Thursday to do no harm and keep short-term interest rates low in light of concerns over China’s economy and those of other countries as well. This decision looks to be the right one, but how the Fed is choosing to communicate their future plans is confusing the market.

Despite all of this and contrary to the rest of world, the US economy has continued to strengthen this year and unemployment is approaching the significantly low level of 5%! In similar circumstances, the Fed would normally choose to raise interest rates and keep the economy from growing too fast: low rates bring lower costs of doing business, increased economic activity, more hiring, higher wages, and if left unchecked, an overheated economy growing too fast with destructive inflation and then typically, a recession. The goal of the Fed is to moderate the business cycle and sustain the path of growth.

The Federal Reserve was right to hold off on raising rates, but the plans they have communicated are unclear and contradictory - choosing caution over foreign economies for now, while still confident that they will raise rates by the end of this year which is coming soon! That is a difficult position to reconcile and gives the market pause that maybe the Fed knows something they don’t - maybe a deeper issue with Chinese bank loans. In any event, Fed Board members will be hitting the lecture circuit in the coming days to clarify their plans, calm the markets, and maintain their credibility.

Though it’s probably a surprise that China is not that important to us directly in terms of trade, their place as the second largest economy in the world can create large ripple effects our way; China is slowing in degrees they don’t want to admit to the world, and at the same time this isn’t really new news. But China’s decision in early August to devalue their currency showed potential weakness to investors causing somewhat of a panic - weakness that has yet to be revealed thus far in hard data from sales to China by Apple or Starbuck’s or Germany. In addition, stocks were historically “expensive”, and so, many investors sold quickly.

Hopefully, the decision to keeps rate low here (and in the UK) and of easy money policies in Europe, Japan and China will give stocks another leg up. The risk afterwards will then be as has happened in recent history, that the Fed will wait too long to raise interest rates - the economy, jobs, inflation, and possibly stocks will continue to rise until in a future year, interest rates will need to be raised so quickly, that like a sudden push on the brakes jolts a car slower, a recession may result.

In the medium term, there is a lot that is positive for stocks going forward due to multiple central bank support. In the near term, however, there is a risk of further declines due to new information from China and the true impact on our and everyone’s economies.

Recommendations are for:

● Investment below target stock %’s as downside volatility is still expected in the near-term

● “Buy on the Dips” in the coming weeks to position for the traditionally strong end-of-year period for stocks

● Focus on US, European and Japanese stocks

● Focus on healthcare, technology and consumer products companies as these are the industries with the most attractive valuations

● In anticipation of higher interest rates, maintain bond strategies with shorter-than-average, high-quality bonds designed to be reinvested at higher yields, along with bonds with yields that will float up as rates move higher.

In closing, it’s probably fair to say that all of the above analysis (as well as the bullet point lists below - read at your own option) may be overthinking the current state of the markets. Historically, stock markets have fallen 10% every 18 months for whatever reason at that particular time, and this may be another example of that - although this time “feels” more substantive. In particular, August and September tend to be the weakest months for stocks, and the 4th Quarter of calendar years tends to be the beginning of better times. We’ve been the beneficiary of very low volatility in the past 4 years, and so an 8% correction is very stressful. Stock prices are also consistent with the higher levels seen near the end of bull markets, and so are more vulnerable to corrections such as this.

We’ll just keep our eyes out as best we can on the economic data to both gauge how economies are actually performing (versus how the stock market may be performing, which can be completely different) and how new data reflects the direction US and global growth is heading. We’ll be watching 3rd Quarter corporate earnings very closely as well beginning in mid-October, as stock performance at the end of the day needs to come from companies making profits. We view the current volatility in the market providing us with eventual buying opportunities, especially in light of the Fed holding rates where they are and a lot of the rest of the world beginning to do what we’ve done since 2008.

Nate Cultice, CFP, FSA

Castle Wealth Planning

Santa Barbara, CA

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RISKS TO THE STOCK MARKET (Related to the Federal Reserve and China):

● Near-Term: The Federal Reserve was unexpectedly negative in their printed release last week, in sharp contrast to Chairwoman Yellin’s Q&A remarks of the same day. In addition, it’s hard to reconcile their concerns over China and emerging markets with a confidence that they will indeed raise rates very soon. Over this past weekend, the Fed has tried to walk back some of the negativity seeing how the stock markets were a bit spooked after the announcement. However, the above contradiction keeps getting repeated and continually concerns investors. The market sensed (or senses) that the Fed knows something they aren’t telling us, and that there’s another shoe to drop. This seems unlikely, but due to the potential and the continued volatility in the market (which could also be caused further by this fear), it makes sense to keep stock allocations below long-term averages, and wait and see.

● Medium-Term: China’s economy is slowing down, and the government is trying to transform it from an industrial to a services economy like in the US. There are some signs of success here, but this is a difficult shift. China’s banks are not in good shape (not even at the levels of US banks during the 2008 crisis!!), and there has been too much overbuilding over the past decades for any kind of industrial growth to naturally occur. A recession in China causing a global recession (including the US) is a risk, not likely, but a risk. A more plausible risk is that a China slowdown causes a global growth recession - the world continues to grow, but not at the rates expected or that are assumed in stock prices. With stocks already at price levels associated with the latter stages of bull markets, any downgrade to assumed growth will cause stock prices to fall.

● Longer-Term: As referred to in the main commentary, assuming no further issues with growth abroad, there is a risk that the Federal Reserve waits too long to raise rates and cool economic growth. If any one of the above risks were to happen, I view this as the most likely to occur. In very recent history (Stock Market Crash of 1987, failure of Long-Term Capital Management in 1998), the Fed has reversed course on interest rates in the face of market risks. Currently, the Fed wants to begin raising rates, but is pausing due to China and the world. If they wait too long, the high employment rate of the US will spill over into higher wages, higher economic output/demand, and inflationary growth. The Fed would be hard-pressed to help the economy avoid a recession. This is a risk to monitor - currently, it looks like stocks have room to run before this is a concern.

REASONS TO BE OPTIMISTIC ABOUT STOCKS:

● The US economy is currently strong, and the jobs picture continues to get better.

● Oil and gas prices continue to be low in the US, and gas prices are about to reach the post-summer period where they typically fall further!!

● Interest rates are low. When the Fed does decide to raise rates, they have been clear that interest rates will stay lower for longer.

● Europe, Japan, and China are adopting easy money policies, which along with the Fed move, supports economic activity and therefore stocks.

● China may join Japan in doing fiscal spending through construction and works projects.

● Investors have very few places to get returns other than with stocks, increasing their appeal (and support of prices). Bonds continue to offer very low yields.

● China’s economy may not be as bad as the market reaction would indicate. Apple and Starbuck’s for instance still report strong sales in China; Caterpillar (heavy machinery) on the other hand has reported large declines. This is not unexpected, and China has lots of resources to inject into their economy.

● The nuclear deal with Iran may open up numerous opportunities for companies, particularly European firms in the automotive, aerospace and energy sectors.

● Lastly, to the extent that recent stock declines were due in part to hedge fund repositioning of trades, it looks like the wave of selling pressure is nearing an end.

HOW DID WE GET HERE (Since the Financial Crisis of 2008)?:

● The US Federal Reserve understood early on that unprecedented measures were required to come out of the crisis (the UK did as well to a lesser extent). Both the US and UK as a consequence have fared well since the crisis - much better than the rest of the world.

● The Fed dropped short-term interest rates and then adopted successive rounds of Quantitative Easing (QE, not done before on wide scale) to drop long-term rates as well.

● Emerging markets (companies in countries such as Brazil) took advantage of the weak dollar and raised money in $-denominated loans moreso than before.

● China’s economy slows recently from 9% growth to “7%” annually. Most in the financial world assume this truly means 5% growth, as China tries to shift from a manufacturing-based economy to services, like in the US.

● China’s slowdown in building contributes to much lower commodities prices globally (steel, copper, oil, etc.).

● Emerging and developed countries that depend on selling commodities abroad suffer (Brazil, Russia, Australia, Canada, etc., not India, Europe or Japan).

● As the US $ strengthens, this squeezes companies in emerging countries to owe more on their loans while selling commodities for less. If the Fed were to raise interest rates now, the dollar would strengthen further, harming emerging countries.

● Europe and Japan adopt easy money policies to stimulate their economies - China is slow to react.

HOW DID WE GET HERE (In the Short-Term, Since August..)?:

● On August 11, China allowed the yuan to devalue versus the US $ - not by much, but this was unexpected. Devaluation is a step a country takes to make their goods more affordable to the rest of the world, competing in a sense with other countries.

● In the aftermath of the Chinese government attempting to prop up the Chinese stock market for the past couple of months, the devaluation crystallized fears that China was vulnerable and experiencing a slowdown.

● With this happening at the same time as the Fed was likely to begin raising interest rates, my opinion is that a lot of institutional/hedge fund money quickly began to unwind investments and sell what they deemed to be “pricey” stocks.

● These large capital flows and consequent stock sales were likely followed by further sales by computer algorithms selling in reaction to the turbulence as well as mutual funds with historically low levels of cash to meet investor requests for their money.

● It does appear that economic activity, even in the US, fell a bit in August. But up to this point, there has been very little “new” news - China’s slowdown and that of global growth is nothing new. What we’ve seen is a lot of worries, trading and volatility. As the saying goes, “stock markets have predicted 9 of the last 5 recessions.” As data comes in over the coming months, the Fed will judge what is actually happening in the economy (it is just not clear how the Fed feels they’ll have the “new” information they need in the next 3 months in order to confidently raise interest rates, and this is confusing the stock markets).

● European leaders urged the Fed to not raise rates.

● Seeing lower economic activity in August, low inflation, and acknowledging that there still is room for improvement in the US jobs picture (people dropping from the workforce, still no evidence of wage raises), the Fed decides to hold off on raising rates this time.