Federal Reserve Approaches A Key Decision Point

At times it is best to be invested and sit tight, not second-guessing your decision, as the calls for a bear market mount. The market this year has been one of those times, and investors who have stayed the course are being rewarded. Sitting on hands is one of the hardest things for an investor to do, as Warren Buffett has noted.

Seasoned market prognosticators have been publishing on the imminent demise of the bull market for many months, as highlighted in our article The Relentless Market and Missed Calls. They have not been right thus far, but that doesn’t mean they will never be right. But we feel they will have to wait a little longer.

Fundamentals

In our prior market outlook writings, including Market Outlook 2017, we have emphasized what we believe are fundamental underpinnings supporting a stock market – Earnings, Economy and Monetary Policy.

Earnings growth has been strong, with the first quarter earnings growth of 14% for S&P 500 companies showing momentum that has not been witnessed since 2011 – over 5 years ago.

The Economy remains steady at around 2% GDP growth level, though recent economic reports, particularly on retail sales, have been less than robust.

However, on the Federal Reserve’s Monetary Policy front, a material change has occurred over the past month.

Monetary Policy

Recessions typically occur during a period of interest rate tightenings when imbalances in the economy are not read in a timely manner to align with policy adjustments thus precipitating a slowdown. A rapid rate of tightening has more than once sent an economy into a recession.

In the mid-June meeting, the Federal Open Markets Committee ((FOMC)) kept its tightening pace by raising interest rates to 1%-1.25% band and projecting one more increase this year. This was an expected course of action. In addition, the Committee provided more specifics in reducing the size of the balance sheet, which holds Treasuries, agency debt, and mortgage-backed securities, resulting from the gargantuan effort to boost the economy in the aftermath of The Great Recession. The balance sheet normalization program is expected to begin sometime later in 2017, contingent on economic performance, with a planned reduction of up to $10 billion monthly during the first 3-month period. The cap will increase in increments every 3-months, till it reaches a drawdown of $50 billion monthly, at which time the cap remains constant till the Federal Reserve deems it is time for a change or termination of the program. The normalization is achieved through not reinvesting the principal that is paid back on its holdings.