What the Fed's game of chicken means for your money
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Version 0 of 1. Can a meeting of Federal Reserve policymakers at which nothing much happens – at which interest rates remain unchanged – still be significant for investors? You betcha, and here’s why. This wasn’t an ordinary Fed meeting, something to which Leo Grohowski, chief investment officer at BNY Wealth Management, can testify. “We did a call for our clients and had 300 people on the line, and I can’t remember even doing a call of this kind for a regularly scheduled Fed meeting before. This time, we felt compelled to do so,” because the meeting was seen as such a turning point in the Fed’s policymaking. And so it proved, even though the Fed’s chairman, Janet Yellen, announced up front that that the Fed wasn’t going to raise interest rates. To be frank, that didn’t come as much of a shock. This “will they, won’t they” debate has swung back and forth for months. With China showing clear signs of a slowing economy, the “won’ts” are once more ascendant. More than half of economists surveyed in most polls in the days leading up to the two-day meeting calculated that the members of the Fed’s policymaking committee would continue to play it safe in light of the uncertainty added to the picture by the turmoil in China. As is often the case with the Fed’s pronouncements, what mattered wasn’t in the headline but in the details – and how investors react to the news. The announcement was triply dovish, pundits have noted. Not only did the Fed fail to boost rates, but it accompanied its decision with “dovish” language, such as the belief that volatility in the emerging markets and the economic uncertainty in regions like China may well “put further downward pressure on inflation in the near term”. Then, too, the Fed cut its forecasts for US economic growth in 2016 and 2017. In response, the stock market bounced around late Thursday afternoon and Friday, as investors and traders tried to make sense of all the news and data points – and the absence of the key factor, a rate hike – only to turn south Friday morning and post much larger losses. Unsurprisingly, the Fed’s announcement was the cue for Treasury bonds to stage a big relief rally. But regardless of what the financial markets are doing in the short term, investors shouldn’t be either panicking or celebrating. They do, however, need to ponder their strategy, and find a way to cope with the uncertainty that the Fed’s inaction and decision to postpone making the critical decision has left behind. The biggest disappointment, for many investors and Fed watchers, was the lack of guidance and transparency in the announcement. The result? “A lot of uncertainty; more so than in recent memory,” groused Brian Rehling, co-head of global fixed income strategy at Wells Fargo Investment Institute, on a conference call with clients on Thursday afternoon. He admitted that he was “somewhat disappointed” by the lack of forward guidance with respect to the Fed’s strategy, in light of the context in which the central back is operating. That makes it tougher for professional investors. “Markets are clamoring for certainty,” agreed Rick Rieder, chief investment officer of fundamental fixed income at BlackRock. “Certainty,” he argued, “relieves markets more than does keeping rates low for an extended period of time.” Ironically, individual investors – unlike the folks at BlackRock and Wells Fargo, who must shoulder the burden of managing other people’s money – may have an easier job of navigating the weeks that lie between now and the next crucial date in the Fed’s calendar: the meeting scheduled for 15 and 16 December. That is, as long as they stay calm and focus on their long-term goals and ignore the short-term volatility, which most pundits say is likely to increase. What to do? Firstly, shun cash. “Cash returns will stay below inflation,” Rehling argues, and with interest rate hikes on hold for the next few months (and some of that already priced in anyway), it’s better to find a safe corner of the bond market in which to park your cash than it is to try and time the Fed and wait for higher rates. So, what’s safe and what’s not, in bonds? Well, high yield securities, aka junk bonds, remain a tricky area, in the eyes of many. The market “has changed – it is 41% larger than it was five years ago, and individuals own a lot more of it,” says Rehling. That alone is going to make it more volatile and potentially more perilous; activist investor Carl Icahn, who has been actively shorting junk bonds, is only one of a number of investors to believe that investors’ hunger for yield during the years that the Fed has kept interest rates at record low levels has created a de facto bubble in that market. On the other hand, investment-grade bonds – those issued by companies with solid credit ratings – and municipal bonds with slightly less than pristine credit scores look appealing, offering attractive enough yields without having been on the receiving end of the same kind of torrent of cash in recent years. BNY Mellon’s Grohowski says his team spent Thursday afternoon snapping up appealing bonds in this category, including municipal bonds with single-A ratings. “You have to have the mindset that you’ll own them to the time they mature,” he says. The upside? Owning a bond to maturity makes it easier to ride out or even ignore the inevitable volatility storms and pocket the stream of income it generates, while recouping the capital at the end of the bond’s lifetime. The same kind of guidelines apply to the stock market. The Fed’s policy of keeping yields near zero has caused investors to bid up the prices of some kinds of stocks, to levels that may exceed their valuations. “People have bought income funds and other products that promised enhanced yields and those owned a lot of utility stocks, preferred stocks, and stocks with high dividend yields,” says Grohowski, noting that investors may fare better looking at companies with more modest dividend payment rates – say, 3% or 4% – that are doing a good job at generating cash and thus might be able to increase that payout. (And if they don’t do so voluntarily, he points out, activist investors like Carl Icahn will step in to exert some pressure.) It might also – finally – be time for some alternative investment vehicles to come into their own, such as absolute return funds, long/short hedged funds or managed futures funds. In an environment where the stock market has been roaring higher, these offerings have performed poorly on both an absolute and relative basis, but may do better when compared to a flat and/or volatile market environment. Just don’t expect miracles. The Fed’s decision to stay on hold – and the resultant lingering uncertainty – added to the ongoing global turmoil represent headwinds for investors, and so, too, does the fact that corporate earnings have been “as flat as a pancake” so far this year. Even if earnings show some improvement when the second quarter wraps up in a few weeks, that may not be enough to spark a stock market rally. Now, settle back, and start preparing for another round of Fed mania, just in time for Christmas. |