Is it up-hill from here?Submitted by Trott Brook Financial on February 28th, 2019
In mid-February, we hosted our annual “State of the Markets” breakfast. Once again the weather was crummy. In fact, the snow was bad enough that schools closed locally. That’s the second time in four years we’ve held our event on a day that school was canceled! If you’d like to see our actual presentation, you can find the recording on our website under “events.”
Of all the topics we touched on this year, the one that stands out to me as most important for investors to understand is what’s occurring at the Federal Reserve and, to a lesser extent, other central banks around the world. This is one of those topics that can be very abstract and technical so I’ll try to simplify as much as possible.
Since the 2008 financial crisis, prices of what we call “risk” assets (such as stocks and real estate) have surged to record highs. It has been a great decade to be an investor. What you owned hasn’t mattered all that much because basically everything went up in price. But it’s critical for investors to understand the backdrop of this environment as we look ahead to the next decade.
To use a metaphor, think about the economy as our patient and the Federal Reserve (the Fed) as the doctor.
If we go back to October 2008, the economy (our patient) was flat on its back with hardly a pulse. The financial system was imploding as banks failed and home foreclosures spiked. The stock market was in free-fall and people were losing their jobs. Eventually the Federal Reserve (our doctor) swooped in and decisively administered what is considered the greatest shots of monetary stimulus in history to bring the patient back from near death.
These “shots,” which involved pushing interest rates to zero and injecting money into the financial system, were designed to soften the recession and help the economy heal. They also created the conditions for what has turned out to be a historic rise in stock and real estate prices.
At the most basic level, when interest rates decline, it makes riskier assets look more attractive. For example, if the bank only pays 1% on CDs, someone who normally wouldn’t own stocks might think twice if they can buy something that pays a 3 or 4% dividend. Likewise, putting up with the headaches of owning real estate may seem worth-while if an investor can earn over 5%. The shift of investor money into riskier assets pushes prices up simply because of the increase in demand.
Additionally, low interest rates encourage borrowing. At the risk of over-simplifying, when consumers spend, it stimulates the economy. The result is companies make more money, pay more dividends and their stock prices rise further. You can see how it becomes a sort of virtuous cycle.
The point is, this backdrop of extremely accommodative economic conditions has underlaid what is now the longest bull market in history. The more risk you’ve taken with your investments in recent years, the more you’ve been rewarded.
But 2018 marked a significant turning point. To stick with our metaphor, after being on an unprecedented dose of monetary stimulus for nearly a decade, the Fed has begun the process of weaning the patient off the drugs.
If last year was any indication of how this will play out, it may be tumultuous indeed. Stocks declined for the first time since 2008; although real estate prices rose, they showed consistent signs of slowing; and finally, a number of economic indicators which had been flashing green flipped to yellow by year-end.
It’s important to say this doesn’t mean a huge market decline or recession is imminent. Although the picture is mixed, the economy is still chugging along and the markets have shot back up decisively in 2019.
The key point is the rapid rise in stock and real estate prices over the past ten years have clearly been aided by the unprecedented stimulus measures provided by the Federal Reserve (and other central banks globally). As we speak, that stimulus is gradually being tapered off.
The Fed certainly has the ability to respond to changing economic conditions. They could drive rates back down if we face a recession but here’s the thing, although interest rates have risen, they are still very low. According to JP Morgan, the seventy-year average for the ten-year government bond is 6.03%. At the end of January, the ten-year was at 2.63%. In other words, the Fed could push rates back down but the stimulative effect would likely be modest at best because the base rate is so low already.
At the end-of-the-day, all this really means is investing conditions are likely to be more challenging as we move ahead in the short to medium term. The huge tailwind that has existed for the last decade is largely gone. It’s not the end of the world by any means. Some investors may actually like the fact that bond yields and other fixed instruments like CDs and annuities are paying more. But investors would be well informed to expect more modest returns from stocks and real estate in the short to medium-term. In other words, it’s been downhill for a decade…it might be up-hill from here.
Trott Brook Financial is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.