The Turn in Interest Rates and the Economic Outlook – July 25, 2013 Client White Paper

By John H. Halleran;
President Halleran Financial Group

Rates Finally Turn

The end of the much discussed multi-decade secular decline in interest rates was likely seen in the second quarter of this year. The testimony of Federal Reserve Chairman Ben Bernanke in the June 18-19 Federal Open Market Committee meeting marked a turn in Fed semantics relative to Fed stimulus and, in particular, a shift in policy relative to quantitative easing. Barring any unforeseen crisis, the Fed is expected to begin to exit its purchasing of Treasury bonds (quantitative easing) in the fourth quarter of this year. Chairman Bernanke’s statements to this effect sent shock waves through the bond market causing one of the worst quarters for bonds in the last 20 years.

Several of the most widely owned bond investments saw year-to-date returns turn negative through the end of June. The degree of weakness in the bond market was punctuated by severe weakness in TIPS (Treasury Inflation Protection Securities) which in turn accelerated the overall sell off. In the days that followed the Chairman’s testimony, the Fed was quick to temper its message in the interest of calming debt markets. Such calm has indeed taken place but it would seem that we could look back and see the bottom in rates behind us.

It is time to take stock of how one’s fixed income strategy performed through the turn and make any necessary changes to be properly positioned for a long secular rise in US interest rates going forward. I was pleased with the overall performance of our discretionary fixed income model and will be making some strategic changes going forward. Many retirement plans and college savings plans are ill equipped with effective tools for managing the negative effect of rising interest rates. If you have concerns about such accounts, please contact the office to get our insight on how you may deal with this.

Economic Outlook

The central global economic issues that will dominate the markets over the next year and beyond are the outlook for growth in the US and China. US GDP has been stubbornly stuck at “stall speed” below 2% for several quarters. Despite many positive signs from key components of the US economy, the level and speed of commerce has remained low. High unemployment, low cost of capital, declining energy costs and clean corporate balance sheets have the US economy well positioned for expansion and broad earnings growth. Despite this, lack of acceleration in consumer and corporate spending has held back any substantial jump in overall commerce. It would seem that a new conservatism has settled into household and corporate psyches and may be with us for a while.

There are certainly global impediments to growth not the least of which is the level of sovereign debt that plagues government balance sheets around the world and vacillating polices intended to reduce this debt and/or stimulate growth. Unfortunately, the best elixir continues to be time. The majority of economists from both Wall Street and academia are guarded about the next 12 months. Beyond that point, there is a rising voice of optimism. If China stabilizes its declining output and the trend of US output rises above 2 – 2.5% without substantive inflation, the outlook for the second half of 2014 and beyond brightens significantly.

Equity Markets

Much is made on a daily basis about equity indices reaching new highs. Current levels sound less lofty when one realizes that they are only modestly above where they were 6 years ago. Regardless of perspective and grammar, corrections are the standard byproduct of equity advancement over time. It will not surprise us to see a pull back or two over the next few years. If such occurs absent GDP retreats in China and the US, we would regard them as such normal events. Many investors still suffer from PTSD acquired during the financial crisis and fear that a 10% correction is the beginning of something much worse. The truth is that a crisis is always possible regardless of era and economics. The number of fear-based websites and “experts” has exploded in the last 4 years. If you come across such, I advise a close look at the quality of the source and a call to the office. An overwhelming majority of the economists that we follow expect slow to positive growth rather than a severe setback over the next few years.

LPL Financial Annual Academic Conference

The third installment of this conference (Wharton – 2012 and Booth – 2011) took place at the Sloan School of Business at MIT on July 9th, 10th and 11th. This highly attended and anticipated conference was in keeping with the productive value of the two previous years. I was happy to attend despite the loss of my luggage and it’s not so subtle arrival at 4:00AM. The presentations of keynote speakers Dr. Roberto Rigobon, Dr. Joseph Coughlin and Dr. Peter Weill from MIT Sloan were particularly valuable as was that of Dr. Robert Merton (Nobel Prize 1997) from the Harvard Business School. This conference offers the unique opportunity to view the economy from a distinctly different perch than those that are commonly available on a daily basis. The event provides new perspective on and affirmation of our work. We will be happy to share the value we have taken from this event and its contribution to our research model when we talk to you next.

Asset Allocation and Risk Management

There is a rising voice in planning regarding “goal-based” performance assessment vs. indexed-based, i.e.; the notion that, for many, risk management and being on track with ones long-term goals have greater importance than the pursuit of outperformance of a given index at an elevated risk level. Indeed, this was a focal point of the presentation by Dr. Merton at the MIT Sloan conference. The science of asset allocation that I have written about in previous white papers continues to wrestle with the lingering effects of the financial crisis, high correlation across asset classes and the challenges of a rising interest rate environment. We continue to draw from many sources for our models with key influences coming from Goldman Sachs, JP Morgan and others. As always, a review of your asset allocation model and its fit with your goals and risk tolerance is a part of our regular conversations with you. If you have any questions on this subject, please call the office.

Author
John H. Halleran;
President Halleran Financial Group

Securities Offered Through LPL Financial, Member FINRA/SIPC

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.  To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.  Any performance referenced is historical and is no guarantee of future results.  Any indices referenced are unmanaged and may not be invested into directly.  Asset allocation does not ensure a profit or protect against a loss.  Government bonds and treasury bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.  Bonds are subject to market and interest rate risk if sold prior to maturity.

Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

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