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The Exit Plan

Eric Freedman
CAPTRUST Chief Investment Officer

Our third child, Conner, was born in August 2007. After experiencing the delivery process with Conner’s older sisters, my wife, Jamie, and I considered ourselves old pros; not only did we have experience with two other children, but we also had bicoastal credentials, with Hailey born in San Francisco and Elle in Boston.

Don’t get me wrong, we (or perhaps more appropriately, I) made lots of mistakes along the way to earning said credentials, from bringing back a pungent curry dish for my lunch an hour after Hailey was born (Jamie claims she could smell it before I exited the elevator on her floor) to mistakenly overfeeding Hailey’s pet goldfish just before Elle was born (requiring a trip to the pet store in a New England blizzard). My first unaccompanied trip to pick up basic baby supplies was also eventful; I managed to spend $185 on items including organic baby wipes, a self-cleansing pacifier travel case, and other sundries that seemed like a good idea at the time. Jamie was thankful that I kept the receipt.

After Conner arrived and his sisters and grandmother held him for the first time, I calmly told Jamie that I would run out and get her a salad from a nearby shopping mall; that is what credentialed husbands with newborns do, after all. I found a parking spot near the food court, spotted a salad maker, selected her favorite veggies, paid for the salad, and walked briskly to the exit. As I reached for the door out of the food court, a police officer stopped me, indicating that the mall was on lockdown due to a shoplifting incident; my fellow shoppers and I would have to wait. This particular situation was not covered in my mental version of the to-be-written credentialed-husband handbook, but I quickly gathered my faculties and appealed to the officer. I needed an exit plan, and fast. “Sir, I am not creative enough to make up the story I am about to tell you, but I came to the mall to get the woman who just gave birth to my first son a salad, and if I don’t deliver it to her before the dressing wilts the lettuce, I will be sleeping on the couch indefinitely.” I showed him the receipt (again, receipts have power) and with an ambiguous smile he opened the mall door. I high-tailed it back to the hospital, relieved.

The U.S. Federal Reserve, the governmental entity responsible for conducting monetary policy (influencing borrowing conditions and interest rates), may not have to react as quickly, but its governors are similarly formulating an exit plan — and that plan is the single most important driver of capital markets for the foreseeable future. Its plan centers on how to unwind a massive, multiyear intervention in the capital markets intended to revive an economy crippled by the 2008-09 credit crisis. During this intervention, the Federal Reserve engaged in several unconventional programs, sometimes in coordination with other central banks in Europe, Japan, and the UK, and other times, on its own.

Coincidently, the Fed started its unconventional policies on the day Conner was born: August 17, 2007 (he was born in the evening, so Jamie had to suffer through both labor pains and in-room financial network viewing for most of that day). The Fed took its first action that morning, issuing a statement about deteriorating financial conditions and cutting the rate it charges banks for short-term loans in an attempt to make it easier for businesses to borrow, noting that changes made “will remain in place until the Federal Reserve determines that market liquidity has improved materially.”1 Almost seven years later, the Fed has driven interest rates to their lowest levels in history, introduced a new chairperson, instituted a more frequent public communication program (including a press conference), and grown its balance sheet from around $870 million on Conner’s birth date to $4.4 trillion in early July.2 No one, not even the Fed, expected that the economy would encounter so much turmoil or take so long to repair.

But is the economy truly repaired? Can the Fed safely make its way toward the exit? Or is it too early to do so, especially after the U.S. economy contracted by almost 3 percent in the first quarter? These are the questions currently being debated by buyers and sellers in the stock and bond markets, and we do not see an end to that debate, with market participants hanging on every Fed line. The exit plan really depends on three factors: first, when the Fed will stop its bond purchase program (more technically referred to as quantitative easing or QE); second, when it will stop reinvesting the proceeds it receives from past bond purchases; and finally, when it will decide to raise its target interest rate, called the federal funds rate — or just fed funds. In addition to investors pondering the plan’s timing, the Fed itself is at odds over when these steps will materialize.

Fed governors appear to be in agreement on the decision to stop the bond purchase program after their October 2014 meeting, and they largely expect to stop reinvesting interest and principal payments around the same time they decide to raise their fed funds target, a phenomenon referred to six times in their June 2014 policy meeting minutes as “liftoff.”3 However, the crux of the debate is when liftoff will occur and how quickly the Fed will raise interest rates after liftoff. Not only does considerable conjecture exist within the Fed about when and how quickly (evidenced by projections from its last meeting minutes) but also across the investment community. Research firm Cornerstone Macro shows this in Figure One. The black line represents what the investment community expects for the timing and magnitude of fed funds, and the dashed line reflects what the Federal Reserve expected at the end of its March and June policy meetings, as measured by an average of what voting members expect.

As you can see, the difference between the Fed and the market is widening, not shrinking. Something has to give here; either Fed governors have to ratchet down their expected future path of interest rates, or the market needs to raise its expectations. We see the push-pull of an economy not fully self-sustaining yet starting to experience some inflationary pressures, combined with the Fed executing an exit plan that investors are not convinced we are ready for, producing something we haven’t seen in a while: market volatility.

So what should investors do in this environment? We continue to see the glass as half full, and we remind clients that one must not confuse the economy with capital markets. They are linked, but not perfectly; you can have a bad economy and still manage to grow your portfolio. The reverse is also true. We see a single-digit return environment over the next three to five years, but we note that markets do not move in straight lines. Diversification across asset classes (stocks, bonds, nontraditional assets) as well as within asset classes — for example, having multiple bond subsectors, maturities, and issuers represented — may once again be an investor’s friend after years of a narrow set of asset classes leading portfolio returns. While Fed activity is just one of many variables my investment committee and I assess when thinking about your capital, it is the most important right now. The Fed is nearing a critical juncture in its plans while we think about yours.

As we approach Conner’s seventh birthday and seven years since the Fed began the plan it is currently seeking to exit, the single best piece of advice that we can give all investors is pretty simple: Keep your receipts. 

Sources:

1 Board of Governors of the Federal Reserve System, August 17, 2007, press release, http://www.federalreserve.gov/newsevents/press/monetary/20070817a.htm
2 Board of Governors of the Federal Reserve System, “Recent Balance Sheet Trends,” accessed June 24, 2014, http://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm
3 Board of Governors of the Federal Reserve System, “Minutes of the Federal Open Market Committee,” June 17-18, 2014, http://www.federalreserve.gov/monetarypolicy/fomcminutes20140618.htm