Regime Change

After last year’s stunning performance, investors spent the first quarter asking the age old question: “Now what?” At first they seemed to regret their year-end exuberance, selling the market down nearly 6 percent from the New Year’s Eve high. Then, regaining their confidence, they pushed the market up to new highs only to see the rally fade again, then recover, and then fade yet again. The result was a range bound market that left many investors feeling like they were running hard just to stand still.

After the dust settled, large cap stocks gained 1.8 percent on the quarter while small company stocks gained 1.1 percent. Developed international markets returned a modest 0.8 percent and emerging market stocks fell 0.4 percent. Confirming the power of diversification, the biggest winners in the quarter were real estate invest­ment trusts (+8.5%) and commodities (+7.0%), two sectors that disappointed during the great stock rally of 2013. Interestingly, investment grade bonds matched returns with large cap stocks, gaining 1.8 percent.

Meanwhile, back at the Fed…

The first quarter brought regime change at the Federal Reserve, in terms of both policy and leadership. In January, the Fed started its program of “tapering” bond purchases by $10 billion. Then, on February 3, Janet Yellen was sworn in as the new chair of the Federal Reserve Board of Governors. She is a very impressive individual and has all the qualifications necessary to succeed in her new role. Here is a quick summary of her resume taken from Wikipedia:

  • 2010–2013         Vice Chair, Board of Governors, Federal Reserve System

  • 2004–2010         President and CEO, Federal Reserve Bank of San Francisco

  • 1997–1999         Chair, President's Council of Economic Advisers

  • 1994–1997         Member, Board of Governors of the Federal Reserve System

  • 1985–present    Professor, Haas School of Business, UC Berkeley

  • 1980–1985         Associate Professor, Haas School of Business, UC Berkeley

  • 1978–1980         Lecturer, London School of Economics and Political Science

  • 1977–1978         Economist, Board of Governors of the Federal Reserve System

  • 1971–1976         Assistant Professor, Department of Economics, Harvard University

  • 1974                     Research Fellow, Massachusetts Institute of Technology

Hopefully, Yellen will live up to her resume. She will certainly be tested—and soon. The big question everyone wants answered is how this tapering thing is going to play out. Unfortunately, nobody knows, including Janet Yellen. She faces a huge challenge as she figures out what to do with the massively bloated balance sheet she inherited from her predecessor. Of course, as Vice-Chair she was complicit in the bloating, but extricating us from QE now rests squarely on her shoulders. Ben Bernanke may have shown a prescient sense of timing when he decided to exit as Fed Chairman.

How big is the bloat?

The Fed’s balance sheet is so enormous it almost defies description. With $4.2 trillion in assets, the Fed now vies with the People’s Bank of China as the largest central bank in the world. But size is only one part of the story. The Fed’s growth rate is even more staggering. Since early September 2008, the Fed’s balance sheet has more than quadrupled, growing at an average annual rate of 31.6 percent.

The Fed is now the largest owner of U.S. government debt, excluding the Social Security trust fund, the federal civil service retire­ment and disabil­ity fund and the military retirement fund. Remem­ber when we used to worry about what would happen if China stopped buying our bonds? Now we need to carefully consider what might happen when the Fed stops buying bonds later this year.

Some fear that the Fed will drive interest rates higher as they pull back from the Treasury bond market, reducing liquidity and stifling economic growth. That would be a problem, but a bigger concern for me is that unwinding QE might actually coincide with a burst of liquidity just when the economy least needs it. The details of how this could work are beyond the scope of this discussion, but evidence is starting to accumulate.

In the first quarter of 2014, commercial and industrial loans grew at the fastest pace since Q4 2007. Loan growth was similar in 2011/2012 only to fade. It could fade again, but I don’t think it will. Broad economic activity is much stronger this time around which should fuel increased demand for loans, which in turn will drive the money supply higher. Suffice it to say, we need to keep a careful eye on inflation. It hasn’t been a problem for a long time, but that could change if liquidity expands aggressively and the Fed maintains a complacent attitude.

Steve Merrell is a CERTIFIED FINANCIAL PLANNER (CFP) practitioner in Monterey, CA and is a co-founder and financial advisor of Monterey Private Wealth.  Monterey Private Wealth is a fee-only investment advisory firm, which serves the communities of Pleasanton, Dublin, Blackhawk, Danville, San Ramon, Livermore, the greater San Francisco Bay Area, Monterey, Carmel, and the greater Monterey County Area.