The VIX Also Rises

The Fed & Monetary Policy
In a widely expected move today, the Federal Reserve announced its decision to continue the process of “tapering” its purchases of Treasury and Mortgage-Backed Securities (MBS). Some had speculated that the Fed might pause given the upheaval in emerging markets over the past few days. We did not agree. We thought a pause by the Fed would have sent the wrong message to the markets. Moreover, the yield on the 10-year Treasury has decreased significantly since the beginning of the year from over 3% to about 2.72% today. Why would the Fed reverse course when the objective of monetary easing is already happening? So, the volatility in emerging and domestic markets notwithstanding, we think the Fed will stick to its present course for now. This is not to say, however, that more intense volatility in the future cannot, or will not, lead to a reversal of Fed tapering later this year. In fact, we think the odds of this scenario are disturbingly high.

The VIX Also Rises
The recent volatility we are seeing in the capital markets is the inevitable result of Fed “tapering”, in our opinion. As the Fed suppressed interest rates for years through the purchase of long-term bonds (while at the same time keeping the short-end of the curve near zero through a low Fed Funds rate), investors flocked to international markets in search of higher returns on their money. Naturally, a lot of the money flowed into emerging markets, which offer the prospect of higher growth almost by definition. Unsurprisingly, the tapering announcement by the Fed in December has led to a mass exodus of capital from the emerging markets and into safe-haven currencies such as the US dollar and Japanese Yen. This process has been exacerbated by recent evidence of slower growth rates in China. Central banks across the emerging-markets complex are now taking steps to defend their currencies and reduce capital flight. Last night, the Turkish central bank raised its overnight interest rate by 4.25% to 12% in an effort to slow or halt the capital outflows.

The Fed walks a delicate line as it seeks to normalize policy. The easy part of the QE process is over. The hard part is always removing the stimulus. Nobody ever wants to take away the punch bowl. In a nutshell, jittery markets are likely to be the norm rather than the exception in 2014.

State of the Union
In his SOTU address last night, President Obama spent a fair amount of time talking about the growing income and wealth disparity in the US. “Today, after four years of economic growth, corporate profits and stock prices have rarely been higher, and those at the top have never done better. But average wages have barely budged. Inequality has deepened. Upward mobility has stalled. The cold, hard fact is that even in the midst of recovery, too many Americans are working more than ever just to get by; let alone to get ahead. And too many still aren’t working at all.”

Faithful readers of our Market Commentary know that we have been warning of the dangers of a widening income gap for quite some time. We have said that the economy will only achieve “escape velocity” if and when the benefits of the recovery become more balanced. It is important to note that this statement is in no way an expression of political ideology, but rather it represents a firm belief that economic growth will be much more robust and stable when a larger extent of our productive capacity is being utilized. The more people working, earning income and spending, the greater the economic benefits. The masses move the needle, not the 1% at the top. President Obama may have put it best when he said, “Tonight I ask every business leader in America to join us and do the same because we are stronger when America fields a full team.”

The continued weakness in the labor market – to include low rates of labor participation, high rates of underemployment, high rates of long-term unemployed, and weak income growth – lends credence to the President’s claim that we are running nowhere close to our full potential. It should be noted that, unfortunately, some of the deterioration in the labor market is structural in nature. This means that retiring baby boomers are causing an unavoidable decline in the labor participation rate, which will act as somewhat of a drag on economic growth for many years to come. To counter this drag, we believe Congress must implement comprehensive immigration policy that encourages the growth of a young and productive labor force in the US. We believe this is one area of general agreement among the political parties, and so we remain optimistic about some near-term progress on this front.

None of these developments addressed above changes our defensive posture. The Fed’s program of quantitative easing, along with aggressive action by central banks across the globe, has created a situation whereby assets have been valued using factors other than the present value of future cash flows. Getting back to valuing investments based on fundamentals will likely turn out to be a rocky road. Keep your seatbelts on.