Update on Current Bull Market:
The Economic Expansion Cycle is now 117 months old. The record is 120 months. The average since 1950 is 40, There have been 13 Fed hiking (raising interest rates) cycles since 1950. Ten of them resulted in a US recession.
What’s Happened in 2019? Why is the Federal Reserve so Important?
The markets soared during the first 2 months of 2019 with the S&P 500 up 11.48%, and the Vanguard Total International Stock Index up 12.4%. You may be asking yourself, what’s changed dramatically since the nearly 20% drop before Christmas Eve? Not much…actually. The following remain outstanding and unresolved issues: Trade wars, slowing corporate earnings, weak retail sales, an inverted yield curve, Brexit uncertainties, near-recession conditions in Europe and the threat of more government shutdowns. Add to this a Federal Reserve that was increasing interest rates in December and you have an environment where investors frantically sell stocks and hide out in cash, waiting for a clearer picture. But not my clients. We stayed true to our investment strategy, and ignored the headline noise. And you’ve been rewarded with a sharp rally to start out 2019. So what actually caused the market to rally over 10% in the ensuing months? The answer, a major policy shift announced at the FOMC January meeting by the Federal Reserve. Clearly this announcement proved significant enough to overshadow many of the issues highlighted above, and allowed the market to recover, and rally to near all-time highs.
In the interest of keeping you engaged, I’ll avoid the financial jargon often associated with coverage of the Federal Reserve and its activities. Instead, allow me to provide a simple explanation of what the Federal Reserve System does, the significance of what happened at the FOMC meeting in January, and why this change in policy has resulted in improved market performance. Ultimately, you’ll begin to understand why lower interest rates are often good for you, the investor.
The Federal Reserve System is the Central Bank of the United States, making it the single most important actor in the US Economy, and naturally the world given the US’ importance in the Global Economy. It was founded in 1913 with President Woodrow Wilson’s signing of the Federal Reserve Act into law. The Federal Reserve sets the target for the Federal Funds Rate, the rate at which banks pay to borrow from each other to meet the reserve requirement at the end of every day. A high Fed Funds Rate means that banks will lend out less money, and alternatively a low Fed Funds Rate means that they will lend out more money, because they are able to charge a lower rate to borrowers making it more attractive to borrow. When banks costs to borrow go up, so do yours!
High interest rates also lower consumer income, as consumers with debt are paying more in interest on their loans. This is turn has a negative impact on their spending habits, and with consumption accounting for ⅔ of US GDP, this means less disposable income to spend on products and services, impacting the very companies that rely on consumer spending to boost sales and thus earnings to shareholders. Higher interest rates also make it more expensive for companies to borrow, discouraging them from continuing to invest in equipment, hiring, and other efforts taken to expand.
Interest rates impact every single loan product available to both consumers and corporations. From car loans and home mortgages, to credit cards and bank loans, lower interest rates, known as expansionary monetary policy often lead to accelerated economic growth and activity.
On December 19, the Federal Reserve raised interest rates for the 4th time in 2018 to 2.25-2.5%, the 9th such adjustment since 2015. Markets reacted, dropping nearly 20% from their highs. Panic ensued, with intraday market price swings of +/-3%. The dreaded R word (Recession) suddenly appeared in every major financial news publication with predictions of the next one happening sometime in 2020 or 2021. Industry pundits voiced that this indeed was the end of the great 9-year expansion as we know it.
But the Fed acted swiftly and surprised market participants in its January 2019 meeting where it reversed its current rate hiking course, revealing it is likely to hold interest rates steady for an extended period of time, and that the committee will exercise considerable flexibility in its monetary policy. Remember, more accommodative monetary policy (lower interest rates) means easier financial conditions, and historically stocks tend to perform better in such a backdrop, which benefits you the investor. With this quick U-turn in policy, we can reasonably expect that the Fed won’t allow any further steep corrections beyond what we saw in December, if it can. But this reversal in policy also signals that global economic activity appears to be slowing down as we enter the mature phase of the expansion.
Now, to end on a positive note. There is an old adage on Wall Street: “As goes January so goes the year.” The S&P 500 rallied 8% on a total return basis in the month of January – erasing most of the losses in December. With January posting strong returns, it is an early seasonal signal that the markets should have a positive return on the year – with history showing a positive year 92% of the time. This does not always work as last year was a good example; nonetheless it is a positive box we can check.
Aaron Hattenbach, AIF®