Quick Market Update
December 19, 2013
Marshall Stuckey, CFA
Senior Fixed Income Portfolio Manager
John Lynch, CFA
Regional Chief Investment Officer
In this Quick Market Update:
FOMC begins to taper; budget deal passes Senate
The Federal Open Market Committee (FOMC) surprised markets again yesterday by announcing that it will trim its bond purchases by $10 billion starting in January.
Outgoing Chairman Bernanke indicated that this pace of tapering is likely to continue, but will depend on the committee’s outlook for inflation and the labor market.
In another surprise, after four years of partisan wrangling, Congress passed a budget deal.
These surprises provide some answers to lingering policy uncertainties. Policy clarity may boost investor confidence and strengthen U.S. economic prospects, likely benefitting U.S. equity markets.
In September, markets expected the Federal Reserve (Fed) to begin tapering the pace of its bond-buying activity. It did not. Then yesterday, the FOMC surprised markets again. This time, most analysts were not expecting any action, but the Fed decided to trim its pace of bond buying by a cumulative $10 billion starting in January. The Fed will reduce its purchases of Treasuries and mortgage-backed securities by $5 billion each. There were several reasons why pundits did not expect the FOMC’s announcement:
Despite a decline in the unemployment rate to 7.0 percent, other variables associated with domestic employment, such as average hourly earnings and labor participation rates, suggested only minimal improvement in the labor market. In the past two months, the U.S. has seen a welcome jump in the growth of non-farm payrolls, as the economy has added approximately 200,000 new jobs each month. However, in previous meetings, some FOMC members have made it clear that they would like to see more evidence that these growth numbers can be maintained with some consistency.
This was Chairman Ben Bernanke’s last meeting as Fed chairman. Many pundits suggested that the FOMC would wait for his likely successor, Janet Yellen, to be in the driver’s seat before announcing any major changes to the bond-buying program.
December is typically an illiquid month in capital markets so it was assumed unlikely that the Fed would risk a disruption to capital markets by announcing the imminent start of tapering.
Indeed, the FOMC has presented the market with several surprises since Chairman Bernanke first mentioned the idea of tapering in May. Additionally, many market observers did not think tapering would be announced until there was greater clarity on budget/debt ceiling issues. (Ironically, the budget issue was resolved with the Senate passage of a budget deal just hours after Bernanke’s press conference).
Despite these factors, the FOMC decided to begin the process of tapering, citing further “progress toward maximum employment and the improvement in the outlook for labor market conditions.” While the announcement is significant, the fact that the FOMC is buying $10 billion less in securities will not change the landscape much for investors, especially bond market participants. The move has largely been priced into interest rate levels for some time.
While the announcement of reduced bond buying may be deemed a hawkish development, doves certainly have something to cheer. The FOMC made a slight but notable adjustment to its forward guidance, saying, “It likely will be appropriate to maintain the current target range of the federal funds rate well past the time that the unemployment rate declines below 6.5 percent.” Employment markets and overall economic growth may be much improved, but the second part of the FOMC’s official mandate—inflation—has been surprising to the downside for some time. This affords the FOMC considerable flexibility in continuing to maintain an extremely accommodative policy regime. In fact, most FOMC members believe the fed funds rate will remain below one percent through the end of 2015. The front end of the bond market yield curve will continue to exhibit value in a “lower for longer” environment.
10-Year Treasury Yield Rises as Economy Adds Jobs at Steady Pace
Source: FactSet, 12/19/13
Overall, the equity markets seemed to like Wednesday’s news from the Fed, while bond markets slid just slightly. A mild tapering, coupled with an acknowledgment by the FOMC that economic growth is improving, may be a signal to equity markets and non-Treasury bond market sectors, like high-yield corporate bonds, that the monetary backdrop is still supportive. Monetary policy changes are evolving at a snail’s pace while economic growth is moving in the right direction. In addition, many mortgage-backed securities (MBS) investors have fretted about the reduction in MBS buying. However, a small $5 billion reduction in MBS purchases will do little to disrupt the favorable supply and demand dynamic that has been a hallmark of the market for some time.
The FOMC is not the only group in Washington capable of surprising markets
After four years of failed attempts, Congress finally passed a budget. The most recent fiscal debacle in October, which included a partial government shutdown, resulted in the establishment of a bipartisan committee tasked with developing a federal budget by December 13. The committee, headed by Senator Patty Murray and Representative Paul Ryan, unexpectedly delivered a deal three days ahead of schedule.
The compromise would set 2014 spending at $1.012 trillion and $1.014 trillion in 2015, up from the $986 billion provided in 2013.
To offset the $62 billion in spending increases over the next two years, the deal calls for approximately $85 billion in new “revenues.” Though this deal does not raise taxes, the new “fees” will come from a combination of airline travel costs, rates charged by the Pension Benefit Guarantee Corporation, larger contributions from federal employees for retirement benefits, and a two-year extension of the two percent cut in Medicare (through 2023). As a result, the deal actually cuts the U.S. budget deficit by approximately $23 billion over the next decade.
This budget deal is far from a “Grand Bargain” and doesn’t offer any real long-term fiscal reform measures. Nonetheless, the House passed the bill by a stunningly large measure, 332-94, last Friday, and it has been approved by the Senate this week.
The budget deal does not address an extension of unemployment benefits, an issue that remains critical for many Senate Democrats. Nor does it eliminate the possibility of further political brinksmanship in the months ahead. The debt-ceiling issue remains unresolved and the challenges associated with addressing prescriptive measures for reform in Social Security, Medicare, and other entitlement programs are likely to once again surface as this debate intensifies in the first quarter of 2014.
Passage of this budget into law—the first budget since April 2009—should help boost economic growth in 2014 by eliminating the fiscal drag that weighed on the economy in 2013.
What do these surprises mean for investors?
First, clearly the budget agreement is a positive development for the economy in that it removes an element of uncertainty that had arguably been acting as a headwind to economic growth. It also unwinds some of the spending cuts that automatically kicked in at the beginning of 2013 due to Congress’s inability to reach past budget deals. The result was fiscal tightening that constrained the country’s growth prospects. With the marginal loosening of fiscal policy, the Fed may have felt that it now had leeway to reduce monetary economic stimulus. Our conclusion is that we can expect moderately higher U.S. growth in 2014.
While, in our view, the expectations that the Fed would eventually taper are largely already factored into the market, if economic growth does, indeed, start to accelerate, we may see a further reduction in bond-buying activity. Such circumstances can create opportunities for investors, but also increase portfolio risks.
On the risk side of the equation, understanding what you own in your bond portfolio and how rising interest rates may impact its value should be a priority. Tactically, we are making some shifts inside U.S. investment-grade bonds: upgrading U.S. Treasury securities from Extreme Underweight to Underweight, boosting Treasury Inflation-Protection Securities (TIPS) from Underweight to Neutral, and trimming corporate bonds from Overweight to Neutral. We continue to emphasize reducing interest rate risk with shorter duration exposure and utilizing credit spread opportunities. We suggest you discuss any concerns that you may have with your investment advisor, who can request a portfolio diagnosis from our Fixed Income team.
Market environment changes such as these also can result in other risks. The equity markets reacted very favorably to the Fed announcement and such bullish sentiment can sometimes result in investors switching to a more aggressive investment strategy than may be appropriate for their specific circumstances. We suggest meeting with your financial advisors to discuss the best course of action for you. We believe that using a goals-based approach in which your cash flow, liquidity, and long-term income and portfolio growth needs are taken into consideration likely will place you in a better position to meet those goals over the long-term than taking on more risk for short-term gain.
All data for this Quick Market Update was sourced from Bloomberg Finance, LLP, unless otherwise noted.
Wells Fargo Wealth Management provides products and services through Wells Fargo Bank, N.A. and its various affiliates and subsidiaries.
The information and opinions in this report were prepared by the investment management division within Wells Fargo Wealth Management. Information and opinions have been obtained or derived from sources we consider reliable, but we cannot guarantee their accuracy or completeness. Opinions represent Wells Fargo Wealth Management’s opinion as of the date of this report and are for general information purposes only. Wells Fargo Wealth Management does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.
Asset allocation and diversification do not assure or guarantee better performance and cannot eliminate the risk of investment losses.
Past performance does not indicate future results. The value or income associated with a security may fluctuate. There is always the potential for loss as well as gain. Investments discussed in this presentation are not insured by the Federal Deposit Insurance Corporation and may be unsuitable for some investors depending on their specific investment objectives and financial position.
This report is not an offer to buy or sell, or a solicitation of an offer to buy or sell the securities or strategies mentioned. The investments discussed or recommended in the presentation may be unsuitable for some investors depending on their specific investment objectives and financial position.
Investing in foreign securities presents certain risks that may not be present in domestic securities. For example, investments in foreign and emerging markets present special risks, including currency fluctuation, the potential for diplomatic and potential instability, regulatory and liquidity risks, foreign taxation and differences in auditing and other financial standards.
Fixed income securities are subject to availability and market fluctuation. These securities may be worth less than the original cost upon redemption. Certain high-yield/high-risk bonds carry particular market risks and may experience greater volatility in market value than investment grade corporate bonds. Government bonds and Treasury bills are guaranteed by the U.S. government and, if held to maturity, offer a fixed rate of return and fixed principal value. Interest from certain municipal bonds may be subject to state and/or local taxes and in some instances, the alternative minimum tax.
Indexes represent securities widely held by investors. You cannot invest directly in an index. S&P 500 Index is a capitalization-weighted index calculated on a total-return basis with dividends reinvested. The index includes 500 widely held U.S. market industrial, utility, transportation and financial companies.
Wells Fargo and Company and its affiliates do not provide legal advice. Please consult your legal advisors to determine how this information may apply to your own situation. Whether any planned tax result is realized by you depends on the specific facts of your own situation at the time your taxes are prepared.
© 2013 Wells Fargo Bank, N.A. All rights reserved.