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Alan McKnight, MBA, CFP®
July 14, 2015
As the 2nd quarter came to a close, issues with Greece and its potential exit from the European Union weighed heavily on the minds of investors. This, coupled with issues in China and Puerto Rico, has created quite a bit of volatility and has many investors looking over their shoulders and wondering if the gains of the past few years are in jeopardy. Many market strategists predicted that volatility would return to the stock market markets in 2015, and the first half of the year has certainly supported those forecasts.
Despite all three major indices hitting new highs this past quarter, only the NASDAQ finished the first half of 2015 with much of a gain; but it took 15 years to surpass its old high hit way back in 2000! For the 2nd quarter, the Dow was down 0.88%. The S&P 500 was down 0.23%, and the NASDAQ eked out a 1.75% gain.
Bonds have also struggled this year with the 10-year Treasury moving from 2.17% on December 31, 2014 up to 2.35% as of June 30, 2015. The quarterly change was huge with a 41 basis point rise! A great deal of this has been caused by increased consumer spending, lower unemployment rates and a slow but improving economy.
There continues to be talk and debate amongst financial analysts and publications about the remainder of 2015. At Barron’s midyear roundtable, an annual gathering of 10 investment market strategists, they felt that although the market isn’t cheap, they were still optimistic about the remainder of 2015. Some analysts are saying a long over-due correction is imminent. According to CNN Money, the U.S. stock market is long overdue for a big fall, but the solution isn't to exit stocks. Instead, they suggest that there may be opportunities during market dips. They remind investors that stocks often go up after a correction. Corrections do not always mean the bull market is done and can actually be a healthy cleansing process in overall market cycles.
In a contrast, Jeff Reeves at Market Watch claims a market correction is not ‘due’. He suggests that perhaps the most important data point of all for the bears to remember is that rallies do not end simply because they’ve gone on for a few years and are “due” to correct. To support this theory he suggests investors study the bull market of 1987 to 2000, which lasted 4,494 days and saw a roughly 585% increase in the S&P 500. He adds that this is not to discourage investors from thinking critically or skeptically about the numbers. Obviously, it’s simply human nature to wonder when the party is going to end, but he warns against predicting the end just because we’ve had a long run-up, and so would we.
Again this quarter, interest rates and Fed watching continued to feel like a spectator sport for investors. Everyone has been carefully watching the Federal Funds Rate in anticipation of a rate increase.
The Federal Funds Rate is an important benchmark in financial markets. It is the interest rate that the borrowing banks pay to the lending banks to borrow funds. It is negotiated between the two banks, and the weighted average of this rate across all such transactions is the Federal Funds Effective Rate.
According to CNBC on June 23rd, Fed Governor Jerome Powell, a voting member on the policy-setting committee said he sees conditions for an interest rate liftoff as soon as September, and an additional increase in December. Powell added that he believes the dollar and oil prices have broadly stabilized. He estimated the economy will grow at around a 2% pace this year. Powell said he's seen positive signs in the economy, including a pickup in wages and an uptick in the labor participation rate.
The Federal Open Market Committee (FOMC) minutes released on July 8th revealed that only 1 out of 10 board members were willing to raise rates in back in June, but they said they would be willing to be flexible and wait “another meeting or two.”
Here are some common questions about interest rates and how the central bank uses them to try to help the economy:
Exactly what interest rate is the Fed looking to raise?
The reserves that banks are required to hold at the Fed are known as federal funds. The interest rate that banks use for these overnight loans is known as the Federal Funds Rate.
How does the Fed control the Federal Funds Rate?
The decision to change the target Federal Funds Rate is overseen by the members on the FOMC. Centered on the prevailing economic conditions, the committee votes on the desired target interest rate that they believe will help keep the economy running smoothly.
Looking back over the past 40 or so years, the Fed has raised rates interest rates to fight inflation after the Oil Embargo; they raised rates to stave off persistent inflation in the late 1970s and early 1980s; they lowered rates to dampen the effects of the Dot.com crash, and they lowered rates to almost zero during the Great Recession and have been there ever since.
Why does the Fed raise or lower the Federal Funds Rate?
The FOMC’s goal is to use the Federal Funds Rate to prevent unnecessary shocks to the overall economy. Congress gave the Federal Reserve control over the Federal Funds Rate to provide maximum employment, keep inflation low, and provide reasonable long-term interest rates.
How does the Federal Funds Rate affect other interest rates?
While the Federal Funds Rate is only directly applicable to banks that lend to one another, it has become a benchmark for consumer and business loan rates, the prime lending rate and bank deposit rates. Business executives and investors keep a close eye on the Federal Funds Rate and the FOMC’s position on the economy to help them adapt their business plans accordingly.
The prime lending rate, for example, is established by banks and is offered to their best customers. It is used to determine interest rates for a variety of loans, including credit cards, car loans, small business loans, and home equity lines of credit.
We still live in a slow-growth, low inflation world that is likely to keep interest rates low for the immediate future. Currently, 27 of the world’s 34 major central banks are making an effort to suppress interest rates. Investors need to keep a watchful eye on interest rates, but also need to avoid over focusing on rate hikes.
Greece’s Monetary Issues
As of June 30th, Greece was facing great financial fears. If Greece vanished today, the world economy would contract 0.3%, once. Economically, the loss would scarcely be noticed. That's why a Greek financial crisis isn't the same thing as a US or global financial crisis. It isn't big enough to hurt.
How will the Greek issues affect the markets?
After Greece’s fears surfaced, the Dow plummeted 350 points June 29th, its worst day of the year. Some analysts believe the effect may be short-lived: S&P Capital IQ published a 70-year historical analysis of past market shocks that found events like this produce an average decline of 2.4% on the next trading day, which has been recovered in an average of 14 trading days.
As of this writing, European leaders announced that they had reached a deal with Greece.
Ian Williams, an economist and strategist at brokerage Peel Hunt in London said: “That there is relief in the market that some agreement has been reached, but that this is being tempered by the broad understanding that the risk of Greece exiting the Eurozone is by no means off the table yet.”
The success of the deal depends on Greeks swallowing an even-tougher austerity plan than the one they rejected overwhelmingly in a referendum on July 5.
China’s Equity Markets
After years of great returns, the stock market in China had a tumultuous quarter to say the least. China onshore A-share markets have risen approximately 150% and slid as much as 30% in the past few weeks. The economy continued to slow, growing 7% in the 1st quarter, the slowest in six years.
The Shanghai Composite which was a rising star for the last year was off nearly 22% from its peak in mid-June, including a 3.3% fall on June 29th. China’s interest-rate cut on the prior weekend did little to restore investor confidence.
The Chinese government has been pulling a number of levers and has taken unpresented aggressive steps to try and stimulate the economy and prop up the markets. The government has been buying stocks outright, loosening margin requirements, banning large shareholders and corporate executives from selling their shares and have allowed approximately 1500 companies to suspend trading of their shares. This is amazing but not a good sign!
Despite this uncertain growth picture, the Shanghai SE Composite Index which has fallen 24% in the last month is still up 21% year-to-date as of July 14, 2015.
Keep in mind that for the average investor in an emerging market fund or ETF, you are invested in offshore Hong Kong-listed China companies which are NOT invested in the China A-shares. So if your portfolio is diversified across all global markets, this should have some effect much not as drastic as those chines stockholders with A-shares.
Again, stay tuned!
And finally, Puerto Rico!
As reported by Reuters on July 13th, Puerto Rico Governor Alejandro Garcia Padilla dropped a bombshell on holders of its $72 billion debt on June 29th, saying he wants to restructure debt and postpone bond payments.
Its economy has been ailing and has indicated that it simply cannot pay its debt.
It does look like, however, that they may be close to a deal with its creditors to avoid a default.
According to the Wall Street Journal, one proposal under consideration would involve creditors exchanging their current bonds for ones with more favorable terms for Puerto Rico, but a swap on this scale would be unprecedented. Detroit, which declared the largest municipal bankruptcy in US history, owed only a fraction of the debt that Puerto Rico has borrowed.
So, What Should an Investor Do?
The first half of 2015 was not easy for investors, but it was not horrible either! We are always faced with the task of balancing portfolios between risk free rates, risk premiums and market returns.
Safety does come at a price. Rates on longer-term certificates of deposit got a small bump in Bankrate.com’s June 24th survey of interest rates. The average one-year CD yield was 0.27% for the 15th straight week. The typical five-year yield was up 1 basis point to 0.87%. A basis point is one-hundredth of 1%. Jumbo CDs sport slightly higher yields for a $100,000 deposit. The average one-year jumbo CD yield was 0.3% for the seventh consecutive week. The average five-year CD yield was up 1 basis point to 0.92%.
For the 37th week in a row, the average money market account yield was 0.09%. For many investors, these low fixed rates will not help them achieve their desired goals. Most investors attempt to build a plan that includes risk awareness. Many times this can lead to lower but safer returns. Traditionally, bonds have been the defacto standard to hedge against market risk, but with bond values at historical highs, they do include some interest rate risk and could pose a greater threat of loss than stocks if your maturity or duration (a bond’s sensitivity to interest rates) is too long. To give you real numbers, just over the last 13 weeks, the US Long Term Bond Index was down 6.14%; the Intermediate Term US Bond Index was down only 0.96%, but the Short Term US Bond index was up .02%. Right now, investors should focus on quality and duration!
Investing is not always about keeping pace with the market (who likes losing 40% during years like 2008?) or beating the market; it’s all about balancing risk and protection so your portfolio suits your individual needs regardless market conditions.
Have a Strategy. Investors need to be prepared. Market volatility should cause you to be concerned, but panic is never a plan. Market downturns do happen; and so do recoveries. This is the ideal time to ensure that you fully understand your time horizons, goals and risk tolerance. Looking at your whole picture can be a helpful exercise in determining your strategy.
Focus on your own personal objectives. During turbulent times it is always wise to create realistic time horizons and return expectations for your own personal situation and to adjust your investments accordingly. Understanding your personal commitments and categorizing your investments into near-term, short-term and longer-term can be helpful.
Make sure you are comfortable with your investments. Equity markets will continue to move up and down; this will never change. Even if your time horizons are long, you could see some short term downward movements in your portfolios. Rather than focusing in on the volatility, you may want to make sure your investing plan is centered on your personal goals and timelines. Peaks and valleys have always been a part of financial markets, and assuredly that trend will continue.
Discuss Any Concerns with Us
Our advice is not one-size-fits-all. We will always consider your feelings about risk and the markets and review your unique financial situation when making recommendations.
A good financial advisor can help make your journey easier. Our goal is to understand our clients’ needs and then try to create a plan to address those needs. We continually monitor client portfolios. While we cannot control financial markets, interest rates or geo-political events, we will always keep a watchful eye on them. No one can predict the future with complete accuracy, so we keep the lines of communication open with our clients. Our primary objective is to take the emotion out of investing. We can discuss your specific situation at your next meeting, or you can call to schedule an appointment. As always, we appreciate the opportunity to assist you in addressing your financial matters.
If it’s been more than a year since your last financial review, please give Jan Berkholtz a call at our office to schedule an appointment so we can make sure everything is in order. If you feel the need to discuss your situation before our next scheduled review, please call our office at (770) 951-9001 or e-mail me at email@example.com.
Alan McKnight, MBA, CFP® is Partner and Vice President of Kays Financial Advisory Corporation He has over 19 years of experience working with retirees and pre-retirees. He is also an Adjunct Faculty Member and Professor of Finance and is an Ed Slott Master Elite IRA Advisor. He can be reached at (770) 951-9001 or at firstname.lastname@example.org.
This report and Mr. McKnight’s comments are provided as a general market overview and should not be considered investment or tax advice or predictive of any future market performance. Any security mentioned in this report may not be suitable for all investors. No investment mentioned in this newsletter constitutes a recommendation to buy, sell or hold a particular investment. Such recommendations can only be made on an individual basis after an assessment of an individual investor’s risk tolerance and personal circumstances. Past performance of any investment mentioned is not a guarantee of future performance. Statements regarding the investment concerns and merits of any company and fair market value computations are strictly the opinion of Kays Financial Advisory Corporation. Employees of KFAC and KFAC clients may have positions and effect transactions in the securities of the issuers mentioned herein.
Sources: MD Producer, CNN Money, MarketWatch.com, CNBC.com, Fidelity, NBC News World, Bankrate.com, Morningstar.com, Reuters, The Wall Street Journal