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Did the Fed make a mistake? – “A Few Minutes with Marcia”

Welcome back to A Few Minutes with Marcia. My name is Marcia Clark, senior research analyst at Warren Street Wealth Advisors.

Today we’re going to spend a few minutes considering the pros and cons of the Federal Reserve Open Market Committee holding short-term interest rates steady at its June meeting. Most of my comments today are based on the FOMC announcement published on June 19, the press conference with Chairman Jerome Powell shortly thereafter, and remarks by Federal Reserve Governor Lael Brainard on June 21st.

Watch:

 

On June 19, the Federal Reserve Open Market Committee announced its decision to keep short-term interest rates unchanged at 2.25%-2.5%. Did they make a mistake?

To answer this question, let’s put ourselves in the shoes of the Fed and attempt to base our opinion on the available data. The Fed should reduce rates if they see the economy struggling. Is that what they see?

During a speech in Cincinnati on June 21st, Fed Governor Lael Brainard stated his assessment that the most likely path for the economy remains solid. He noted strength in consumer spending and consumer confidence, as well as unemployment at a 50-year low.

He did note a few areas of concern: cautious business investment due to policy uncertainty, slow growth overseas, and muted inflation.

  • Mr. Brainard said: “The downside risks, if they materialize, could weigh on economic activity. Basic principles of risk management in a low neutral rate environment with compressed conventional policy space would argue for softening the expected path of policy when risks shift to the downside.” But what does he mean by ‘compressed conventional policy space’?

The Fed has limited room to maneuver because interest rates are already low, and inflation and employment have not responded to changes in interest rates as predictably as they have in the past. 

  • On the plus side, this means the labor market can strengthen a lot without an acceleration in inflation
  • On the other hand, this low sensitivity along with already low interest rates gives the Fed less ability to buffer the economy in a downturn

 

If the Fed doesn’t get their interest rate call right, the economy could begin to spiral too far up or too far down.

Let’s take a deeper look at why low interest rates present a challenge for the Fed.

  • In the past, the Federal Reserve has cut interest rates 4 to 5 percentage points in order to combat past recessions
  • The chart on slide 6 shows the current Fed Funds rate sitting at less than half where it was before the last two recessions. 
  • Clearly there is less room to run if a recession hits

 

The chart also shows GDP beginning to stabilize at the end of 2016. With GDP on a more steady path, back in 2017 the Fed started raising short-term interest rates toward a more normal level in order to have some ‘dry powder’ for the next recession.

How did we get to this delicate balance point?

In December 2018, the Fed said more rate hikes were appropriate given the strengthening economy. The stock market reacted badly as at the same time trade talks with China were going nowhere and portions of the Treasury yield curve were inverted. Recession fears were on everyone’s mind.

In March 2019, Federal Reserve officials reassure markets that they will be “patient” with increasing short-term interest rates. To quote the FOMC statement after the March meeting: “the case for raising rates has weakened…” Notice that they didn’t say the case for cutting rates has strengthened.

And in June, the FOMC held interest rates steady and stated that the current level of interest rates is consistent with its mission to promote full employment and price stability. In its post-meeting statement, the committee said that the timing and size of future adjustments will be based on economic conditions relative to these two objectives. 

After the announcement, both stocks and bonds reacted positively to the decision, with the stock market indexes touching new highs before falling back a bit at the end of the week. 

Commentators speculated that the markets reacted well because a rate cut could be imminent. Equally likely, however, is that the markets reacted to the lack of a rate hike and prospects that a recession is not around the corner. 

During a press conference after the announcement, Fed chairman Jerome Powell responded to a question by saying that being independent of political pressure or market sentiment has served the country well and would do so in the future. He stated that the FOMC will react to data and trends that are sustainable rather than individual data points that can be volatile

But despite all the evidence, as we approach the end of June an astonishing 100% of futures investors are betting on a rate cut in July. These investors are wrong. 

Why am I so sure they won’t cut rates when commentators and the futures market clearly think differently?

You may have heard the expression ‘pushing on a string’. What this means is that applying force to something with no rigidity won’t have any impact – the string absorbs the force and the force doesn’t go any further. This is the current situation with monetary policy.

Imagine pushing a sofa across your carpeted living room versus pushing a mattress across the same room.

Once the feet of the sofa get out of the dent they made in the carpet, the sofa will move fairly easily. That’s because the sofa is rigid – when you apply force at one end, the sofa moves away from the force.

But a mattress is much more resistant to shifting. That’s because much of the force you apply is absorbed by the cushioning already in the mattress. The mattress will often bend before it will move. The force doesn’t go anywhere or accomplish anything.

The current U.S. economy is like the mattress in this example. The U.S. economy has plenty of available capital and interest rates are already low. Reducing the Fed Funds target from 2.375% to 2.00% is unlikely to accomplish much other than encouraging unwise borrowing and ultimately sparking inflation.

Yes, bad things can happen to our economy and the Fed needs to guard against a recession. But a recession overseas is much more likely than in the U.S., and no U.S. recession has ever been caused by a recession overseas. Dropping interest rates to ease market concerns or satisfy political sentiment is not the Fed’s mandate and would be counterproductive.

Barring some catastrophic political event or natural disaster, the U.S. economy is unlikely to falter between now and mid-July. 

Recognizing the Fed’s dual mandate of stable prices and full employment are both being met at the current level of short-term interest rates, right now the downside risk of lowering rates outweighs the potential stimulus benefit. The FOMC should keep the Fed Funds rate steady when they meet in July.

This has been ‘A Few Minutes with Marcia’. I hope you are a bit clearer on how to assess the likelihood of Fed policy decisions going forward. As always, comments and questions are welcome!

Sources:

 

Marcia Clark, CFA, MBA
Senior Research Analyst
Warren Street Wealth Advisors

Warren Street Wealth Advisors, a Registered Investment Advisor. The information contained herein does not involve the rendering of personalized investment advice but is limited to the dissemination of general information. A professional advisor should be consulted before implementing any of the strategies or options presented. Any investments discussed carry unique risks and should be carefully considered and reviewed by you and your financial professional. Past performance may not be indicative of future results. All investment strategies have the potential for profit or loss. 

 

DISCLOSURES

Investment Advisor Representative, Warren Street Wealth Advisors, LLC., a Registered Investment Advisor

The information presented here represents opinions and is not meant as personal or actionable advice to any individual, corporation, or other entity. Any investments discussed carry unique risks and should be carefully considered and reviewed by you and your financial professional. Nothing in this document is a solicitation to buy or sell any securities, or an attempt to furnish personal investment advice. Warren Street Wealth Advisors may own securities referenced in this document. Due to the static nature of content, securities held may change over time and current trades may be contrary to outdated publications.

Form ADV available upon request 714-876-6200

March 2019 Market Commentary

Key Takeaways

    • The rally in U.S. stocks slowed in March but still posted the best 1st quarter in recent memory at 13.65%, though stock markets remain volatile as investors seem to overreact to fears of the Fed increasing interest rates too much or not increasing rates at all
    • A slightly better-than-expected jobs report for March helped calm fears about mixed economic data in the U.S., supporting the Fed’s decision to keep short-term interest rates low for the foreseeable future
    • The OECD lowered its forecast for European GDP growth to a paltry 1.0% in 2019 and 1.2% in 2020; German government bonds fell into negative territory after the ECB reported weak manufacturing data
    • Overall, improved labor conditions, lower headline inflation, and accommodative monetary policy should help support real income growth and household spending in most developed countries

 

  • Conclusion: Recent market swings seem driven more by fear than by fundamentals. Economic data isn’t great, but the data doesn’t support a forecast for a global recession; U.S. markets are likely to hang on to gains until or unless weakness in the economy becomes more clear.

 

 

Is the U.S. economy getting better? Or getting worse?

The S&P 500 had its best 1st quarter return in recent memory, yet the Federal Reserve Bank kept interest rates low to avoid derailing the economy. Which of these forward-looking indicators is correct? To answer this question, let’s start at the beginning. You may have learned in school that GDP – the primary measure of economic strength – is simply the value of all goods and services sold in a country over a given period of time. In essence, GDP represents the value of business transactions. These transactions flow into company financial statements and impact the ability of these companies to pay dividends or launch new ventures. This increased cash flow is recognized by investors, who become willing to pay more for shares of those businesses in the stock market, pushing stock prices up. If the economy is up, stock prices are up too.

Easy, right? All the dominoes line up and we understand how the market works…or maybe not?

Here is the conundrum: stock prices are a ‘leading economic indicator’ because investors buy today expecting gains in the future. Interest rates are also leading indicators because investors need to forecast future interest rates – which typically move up and down with economic activity – before they’re willing to tie up their money for 10 or 20 years. Stock and bond prices don’t usually go up together.

Source: https://www.pimco.com/en-us/resources/education/everything-you-need-to-know-about-bonds

If interest rates go up, prices of existing fixed-rate bonds go down in order to compete with new bonds issued with higher coupon (interest) rates. But rising interest rates usually indicate more demand for funds, which is often associated with a strong economy, which means more profits, and consequently higher stock prices.

The upshot of all this is when stock prices go up, bond prices are usually flat or negative. Conversely, when stock prices go down, bond prices are usually positive as investors sell volatile stocks and seek safer assets such as government bonds.

Source: https://stockcharts.com/h-perf/ui

As you can see from the chart above, bond prices as represented by the long-term Treasury ETF (ticker ‘TLT’ – blue line) usually go up when stock prices go down (represented by the Dow Jones Industrial Average – black line), and vice versa. This effect was particularly dramatic during the 4th quarter of 2018.

Despite the strong start for stocks in 2019, if you look back 6-months from October to March, bonds have been among the best performing asset classes. Bonds may not be sexy, but they sure are welcome when markets get rough! But wait – look at the red box in February and March. Bond and stock prices are moving together. Why??

The charts below from the Bureau of Economic Analysis may hold some of the answers. In a nutshell, the problem is Change. And I don’t mean the kind of change you find in your sofa cushions…

Chart 1: The U.S. economy is growing, but slower than in recent quarters.

 

Consumer spending takes a breath after spiking in April

Chart 2: Disposable income is increasing, but consumer spending is down.

Chart 3: Companies are adding value to GDP, but at a slower pace than previously.

The economic data is okay, but clearly slowing from the strong levels of 2017-2018. Does ‘slowing’ economic activity mean a recession is around the corner? I don’t think so, and many commentators are coming around to this view. What’s really moving the market, then? In addition to economic fundamentals, the stock market seems to be overreacting to the possibility of interest rates going up…or going down. Does being afraid of both situations make any sense? Probably not.

If the Fed increases rates too aggressively, they could indeed stall the economy. But we should take comfort in the persistent ‘data dependent’ stance of the Fed. They have no intention of being aggressive with interest rate hikes, so the stock market should probably find something else to worry about. In fact, institutional investors seem to agree that short-term rates are going nowhere any time soon. Federal Funds futures contracts are predicting the Fed will decrease rates by the end of 2019, though the Fed’s own ‘dot plot’ shows a possibility of one rate increase by the end of the year.

Source: https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html

Source: https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20190320.pdf

The Fed is also cautious about raising short-term rates too quickly and causing the Treasury yield curve to become ‘inverted’. An inverted yield curve is one where short-term interest rates are higher than longer term rates. This isn’t normal! Investors and lenders usually require higher rates to lock up their money for a longer period of time. An inverted curve is usually driven by…here’s that word again…Change.

The yield curve can invert under three basic scenarios:

 

  • The Fed is aggressively increasing short-term interest rates to cool down an overheated economy

 

  • Investors are demanding less return for longer maturities because they believe inflation, and consequently future interest rates, will be lower than they are currently

 

  • Differing supply and demand pressures on the short and long portions of the yield curve, sometimes driven by interest rate differentials between the U.S. and other developed countries

 

 

 

An inverted yield curve has preceded many recessions in the past few decades, which is why it makes people uncomfortable. But the inversion has happened as much as 2 years before the recession, so I’m not sure that the curve is actually predicting anything. It’s more helpful to analyze the economic situation driving the curve shape, rather than drawing conclusions from the curve alone. You might take comfort in knowing that post-inversion recessions have only happened when the 10-year Treasury yield was at least 0.50% below the Fed Funds rate, which we’re nowhere near. Right now my money is on Option #3 – a supply demand imbalance, not an imminent recession. Nonetheless, the current Treasury curve is slightly inverted between the 1 year and 5 year maturities and the Fed doesn’t want it to get worse and spook investors.

Source: Morningstar.com

It doesn’t make much sense for investors to be afraid of interest rates going up and also afraid of interest rates going down. But that seems to be the case at the moment and is a key driver of recent volatility in the U.S. stock market. Let’s be ‘data dependent’ for a minute and draw our own conclusions based on what we can see in the global economic landscape:

  1. The Fed is being cautious about raising or lowering interest rates because economic data doesn’t point strongly either up or down and they don’t want to spook the financial markets
  2. Though corporate earnings forecasts are lower than 2018, the majority of S&P 500 companies reporting slower earnings projections for the 1st quarter of 2019 have experienced positive stock price movement; S&P 500 gains year-to-date have been felt broadly across many sectors
  3. U.S. manufacturing output slipped to its lowest level in 2 years, despite trade tensions between the U.S. and China moderating somewhat rather than getting worse
  4. Challenges persist overseas, particularly in Europe, as trade tariffs hit European and Asian businesses harder than the U.S.; factory output in the Eurozone fell in March at the fastest pace in 6 years
  5. Manufacturing data in China, the second largest economy in the world, was stronger than expected in March; the Chinese economy is expected to slow to a still robust 6% GDP growth in 2019 and beyond
  6. European markets are stabilizing as the U.K. Parliament seems to be making progress identifying a viable ‘Brexit’ strategy; economic disaster in Europe due to stalled trade with Britain seems unlikely
  7. Trade tariffs aside, improved labor conditions, lower headline inflation, and accommodative monetary policy should help support real income growth and household spending in most developed countries
  8. Emerging economies are avoiding much of the global slowdown as many smaller countries benefit from strong capital investment, improving income growth, and economic and political reforms in recent years

What conclusions can we draw from all this data?

The economic data is certainly mixed, but most indicators point to slower growth in 2019, not a recession. From what we can see today, global economies, and consequently financial markets, should stay in modestly positive territory for the near term. We can sleep well at night knowing the ship is headed in the right direction…for now.

 

ASSET CLASS and SECTOR RETURNS as of MARCH 2019

Source: Morningstar Direct

Source: S&P Dow Jones Indices

Marcia Clark, CFA, MBA
Senior Research Analyst
Warren Street Wealth Advisors

Warren Street Wealth Advisors, a Registered Investment Advisor. The information contained herein does not involve the rendering of personalized investment advice but is limited to the dissemination of general information. A professional advisor should be consulted before implementing any of the strategies or options presented. Any investments discussed carry unique risks and should be carefully considered and reviewed by you and your financial professional. Past performance may not be indicative of future results. All investment strategies have the potential for profit or loss. 

DISCLOSURES

Investment Advisor Representative, Warren Street Wealth Advisors, LLC., a Registered Investment Advisor

 

The information presented here represents opinions and is not meant as personal or actionable advice to any individual, corporation, or other entity. Any investments discussed carry unique risks and should be carefully considered and reviewed by you and your financial professional. Nothing in this document is a solicitation to buy or sell any securities, or an attempt to furnish personal investment advice. Warren Street Wealth Advisors may own securities referenced in this document. Due to the static nature of content, securities held may change over time and current trades may be contrary to outdated publications.

Form ADV available upon request 714-876-6200

 

When a Windfall Comes Your Way

When a Windfall Comes Your Way

What do you do with big money?

Getting rich quick can be liberating, but it can also be frustrating. Sudden wealth can help you address retirement saving or college funding anxieties, and it may also give you the opportunity to live and work on your terms. On the other hand, you’ll pay more taxes, attract more attention, and maybe even contend with jealousy or envy. You may also deal with grief or stress, as a lump sum may be linked to a death, a divorce, or a pension payout decision.

Windfalls don’t always lead to happy endings. Take the example of Alex and Rhoda Toth, a Florida couple down to their last $25 who hit a lottery jackpot of roughly $13 million in 1990. Their feel-good story ended badly: by 2006, they were bankrupt and facing tax fraud charges. Or Janite Lee, who won $18 million in the Illinois Lottery. Just eight years later, she filed for Chapter 7 bankruptcy; she had $700 to her name and owed $2.5 million to creditors. Windfalls don’t necessarily breed “old money” either – without long-range vision, one generation’s wealth may not transfer to the next. The Williams Group, a California-based wealth coaching firm, recently spent years studying the estate transfers of more than 2,000 high net worth households. It found that 70% of the time, the wealth built by one generation failed to successfully migrate to the next. (1,2)  

What are some wise steps to take when you receive a windfall? What might you do to keep that money in your life and in your family for years to come?

Keep quiet, if you can. If you aren’t in the spotlight, don’t step into it. Who really needs to know about your newfound wealth besides you and your immediate family? The Internal Revenue Service, the financial professionals who you consult or hire, and your attorney. The list needn’t be much longer, and you may want to limit it at that.

What if you can’t? Winning a lottery prize, selling your company, signing a multiyear deal – when your wealth is publicized, expect friends and strangers to come knocking at your door. Be fair, firm, and friendly – and avoid handling the requests, yourself. One generous handout may risk opening the floodgate to others. Let your financial team review appeals for loans, business proposals, and pipe dreams.

Yes, your team. If big money comes your way, you need skilled professionals in your corner – a tax professional, an attorney, and a wealth manager. Ideally, your tax professional is a Certified Public Accountant and tax advisor, your lawyer is an estate planning attorney, and your wealth manager pays attention to tax efficiency.

Think in stages. When a big lump sum enhances your financial standing, you need to think about the immediate future, the near future, and the decades ahead. Many people celebrate their good fortune when they receive sudden wealth and live in the moment, only to wonder years later where that moment went.

In the immediate future, an infusion of wealth may give you some tax dilemmas; it may also require you to reconsider existing beneficiary designations on IRAs, retirement plans, and investment accounts and insurance policies. A will, a trust, an existing estate plan – they may need to be revisited. Resist the temptation to try and grow the newly acquired wealth quickly through aggressive investing.

Now, how about the next few years? Think about what financial independence (or greater financial freedom) means to you. How do you want to spend your time? Should you continue in your present career? Should you stick with your business, or sell or transfer ownership? What kinds of near-term possibilities could this open for you? What are the concrete financial steps that could help you defer or reduce taxes in the next few years? How can risk be sensibly managed as some or all the assets are invested?   

Looking further ahead, tax efficiency can potentially make an enormous difference for that lump sum. You may end up with considerably more money (or considerably less) decades from now due to asset location and other tax factors.

Think about doing nothing for a while. Nothing financially momentous, that is. There’s nothing wrong with that. Sudden, impulsive moves with sudden wealth can backfire.

Welcome the positive financial changes, but don’t change yourself. Remaining true to your morals, ethics, and beliefs will help you stay grounded. Turning to professionals who know how to capably guide that wealth is just as vital.


J Rucci

Justin D. Rucci, CFP®
Wealth Advisor
Warren Street Wealth Advisors

 

 

 

Justin D. Rucci is an Investment Advisor Representative of Warren Street Wealth Advisors, a Registered Investment Advisor. The information contained herein does not involve the rendering of personalized investment advice but is limited to the dissemination of general information. A professional advisor should be consulted before implementing any of the strategies or options presented.

This material was prepared by Marketing Pro, Inc. Any investments discussed carry unique risks and should be carefully considered and reviewed by you and your financial professional. Past performance may not be indicative of future results. All investment strategies have the potential for profit or loss. Changes in investment strategies, contributions or withdrawals may materially alter the performance, strategy, and results of your portfolio. Historical performance results for investment indexes and/or categories, generally do not reflect the deduction of transaction and/or custodial charges or the deduction of an investment-management fee, the incurrence of which would have the effect of decreasing historical performance results. Economic factors, market conditions, and investment strategies will affect the performance of any portfolio and there are no assurances that it will match or outperform any particular benchmark. Nothing in this commentary is a solicitation to buy, or sell, any securities, or an attempt to furnish personal investment advice. We may hold securities referenced in the blog and due to the static nature of the content, those securities held may change over time and trades may be contrary to outdated posts.

Citations.

1 – bankrate.com/finance/personal-finance/lottery-winners-who-went-broke-1.aspx#slide=1 [5/23/18]
2 – money.cnn.com/2018/09/10/investing/multi-generation-wealth/index.html [9/10/18]

The Retirement Handbook

The Retirement Handbook  (click to download)

Retirement is coming soon, and you should be excited. However, you might have so many questions and concerns about retirement that you’re more nervous than anything else.

We get it.

At Warren Street Wealth Advisors, we’ve helped countless people, from families to business owners, plan for their retirement and reach their financial goals. We put together this Retirement Handbook to help you on your way to a successful retirement.


 

1. Have a Plan

Nothing else on this list matters if you don’t have a personalized financial plan.

Having a plan not only lays out the destination, but it shows you the steps you need to take along the way. It’s your roadmap to a successful retirement.

2. No Seriously, Have a Plan

Having a plan is half the battle. 

You can be tax savvy and an investment genius, but if you don’t have a plan for retirement or any financial goal, chances are you’ll miss the mark.

3. Say “Goodbye” to Debt

Excess debt is the biggest destroyer of retirement dreams. 

If you have excess debt, then formulate a plan to eliminate it as soon as possible. It’s not the end of the world, but it might be time to roll up your sleeves and get to work.

Imagine how rewarding it will be once you have freed yourself from excess debt.

4. Budget it Out

Targeting your annual expenses is key to understanding if you have enough money to retire.

It’s no fun to build a budget. We get it.

However, knowing where your money is going on a monthly basis may help you identify where you can save. Get rid of the stuff you hate and keep more of the things you love. Love your bowling league? Keep it. Hate your cable or phone bill? Shop it around or eliminate it all together.

Not sure where to start with your budget? No problem. Download our retirement toolkit and utilize the Budget Template to help get you started.

5. Build Up Emergency Savings

We’re always optimistic about the future, but sometimes life takes surprising and difficult turns. Wise financial planning means being prepared for those situations.

Having cash available can help you through some of these hard times. Maybe the car breaks down or you need to find a new job. Having six months of cash on hand in a savings account can help out and keep you prepared for life’s ups and downs.

6. Save ’til it Hurts.

401(k). 403(b). 457(b). IRA. SEP. Simple. Deferred Comp. Roth.

Max it out.

Are you putting money aside for the long term? Does your employer have a 401(k) program? Do you have a personal investment account you contribute to?

Whatever it is, make sure you continue to think long-term for that beautiful retirement you’ve been dreaming of.

7. Wait Until Full Retirement Age to Take Social Security

There are all kinds of articles out there about what to do about your Social Security. Let us boil it all down: you don’t have to take it at 62!

When we build a financial plan, we calculate all options for optimizing Social Security, no matter how many times we do it, one thing becomes clear every time: it’s usually best to wait until your full retirement age to take Social Security.

There is also plenty of evidence to support wait until age 70 too as the 32% increase in benefit can be worth the wait. It’s ultimately your decision, and we suggest weighing your options before committing to collecting a 25-30% reduced benefit at age 62.

8. Have a Plan

Yep. Said it again.

If you’re not sure where to start with your financial plan, that’s OK. We can help.


 

Schedule a free consultation to talk through your finances and take the first step toward building a confident retirement.

Warren Street Wealth Advisors LLC. is a Registered Investment Advisor. The information posted here represents opinions and is not meant as personal or actionable advice to any individual, corporation, or other entity. Any investments discussed carry unique risks and should be carefully considered and reviewed by you and your financial professional. Nothing in this commentary is a solicitation to buy, or sell, any securities, or an attempt to furnish personal investment advice. We may hold securities referenced in the blog and due to the static nature of content, those securities held may change over time and trades may be contrary to outdated posts.