TLA continuously researches and monitors economic and market trends on behalf of the families we serve.
Be Careful What You Wish For
Much of the TV airtime, financial columns, and social media buzz this summer was about Federal Reserve Chair Jerome Powell and the Fed’s Open Market Committee (FOMC) and whether they would or should reduce interest rates. First, a point of clarification: The FOMC does not directly control interest rates. The FOMC does set the target for the so-called Fed Funds rate, which is the interest rate that banks charge each other to borrow money overnight. Infact, it’s referred to as a “target” because the Fed establishes not a single rate, but a range (albeit narrow) of rates that banks may charge each other. That range is currently 4-4.25%.
One more point of clarification: The Fed has two mandates – full employment and price stability. Those who advocated for no rate change or even an increase were most concerned with inflation(price stability). Those who instead advocated for a rate decrease of a quarter percent (25 basis points) or even half a percent(50 basis points) were mostly concerned about full employment, as well as the effect on the 10-year Treasury note. Why the 10-year Treasury note? Because its rate has a direct effect on business and mortgage rates. They assumed that if the Fed reduced the Fed Funds rate target, the 10-year Treasury note yield would fall as well. While that may seem logical, it doesn’t always work that way. The chart below shows that just last year, the Fed reduced the Fed Funds target rate three times – first by 50 basis points, then by 25, and then again by another 25. Counterintuitively, the 10-year Treasury yield actually went up pretty significantly during this period, raising mortgage rates and business rates with it. It’s only been a couple of weeks, but so far, since the FOMC reduced the Fed Funds target rate on September 17, the yield on the 10-year Treasury note has again increased, not decreased.
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Sources: T. Rowe Price, Bloomberg Finance L.P., and S&P.
Barbell Investors
A pictorial chart of U.S investors today might look like a barbell with heavy weights on both sides. On one side of the barbell would be those who are still scared by previous major market downturns experienced earlier this century. They currently hold an astounding $7.7 trillion in stable money markets and T-bills.
Holding money market and other short-term interest-bearing investments has paid off in the last couple of years. In fact, there have even been times when the yield of these short-term stable investments has exceeded that of longer-term investments of similar quality. While this approach has worked well over the last few years, these investors should be aware that the Fed’s action will likely reduce the yield on these short-term investments, possibly significantly.
On the other side of the barbell are the speculators who throw caution to the wind. These people remind me of those drivers on Houston highways who zig and zag between lanes while speeding 25 miles per hour over the speed limit. Not only are they investing in high-risk ventures, but they are leveraging those risks with borrowed money. Some of these ventures are leveraged ten-to-one. What does that mean? If the investment price goes up just10%, the investor doubles their money, but if the price goes down by 10%, the investor loses 100%. Odds are about the same as a roulette wheel; odds not as good as a Pass/Don’t Pass line on thecraps table. It’s no coincidence that I’m using Vegas as a comparison here. The exuberance for this type of gambling shows no sign of slowing down, and Wall Street seems to invent ever more speculative products to sell to satisfy that seemingly insatiable appetite. Based on history, this raw speculation will not stop until the bottom falls out.
Economic Headwinds
Referencing the Fed’s dual mandate, Chairman Powell recently said, “We have two-sided risk, and that means there’s no risk-free path.”
Whether due to select worker shortages, new tariffs, or general uncertainty about policy, the U. S. economy continues to grow, but at a sub-optimal rate, and at the same time, persistent inflation remains sticky.
Smaller and privately held companies may not have the access, scale, and negotiating power of their larger competitors when dealing with changes in the economy. According to the U. Chamber of Commerce, small businesses will cumulatively have to pay an extra $202 billion a year in tariffs, which works out to over $800,000 per company on average.
We continue to keep a close eye on the U. S. housing market, which is showing potential fissures, as evidenced by the record low confidence exhibited in a recent National Association of Home Builders survey. Housing challenges include increased single-family and multi-family home inventory (particularly in the previously hot markets of the South and desert West), worker shortages due to stricter immigration enforcement, local government regulations, and the uncertainty about the effects of tariffs on construction costs. Interestingly, current interest rates may not be as great a problem as the formerly record-low mortgage rates during the pandemic. We’re seeing that homeowners with historically low mortgage rates don’t want to give them up, so they are not putting their homes up for sale.
We learned during the great financial crisis just how important housing was to the U. S. economy. Housing’s impact reaches far and wide, directly affecting the construction, surveying, finance, title, legal, appliance, furniture, landscape, and design industries.
Economic Tailwinds
While overall economic growth is not ideal, corporate profits have proved to be quite resilient for those companies that have been able to successfully navigate the ever-changing environment.
By utilizing advanced technology — particularly AI — large, sophisticated companies have become nimbler and leaner, enabling them to leverage their substantial market power. Due to their size, some have been able to develop strategies even before the 2024 election to defend against potential tariffs. And of course, they are more likely to have the lobbying power to massage policy as it’s being formulated.
Looking forward, several provisions in the recently passed tax bill were designed to “juice up” the economy over the next few quarters. They include tax refunds for individuals who qualify, as well as several provisions to reduce overall corporate taxes and encourage capital investments.
Still Defensive
While the most excessive risk-taking is not in traditional stocks and bonds, there’s been plenty of speculation there as well.
When an investor borrows money from their broker to buy stock, that loan is called “margin.” Investment firms love margin because, in normal times, the interest they charge for the loan is close to100% profit. Margin creates leverage, which can magnify gains or exacerbate losses for investors. Market observers view the aggregate volume of margin used at any one time to measure investor sentiment and risk appetite. The excessive speculation now is quite worrisome. Margin debt reached an all-time high in August, the 4th straight monthly increase. As a historical comparison, the last several peaks in margin levels occurred in March 2000, July 200,7, and October 2021. As you can see from the graph below, none of these were good times to take on excessive risk.
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Source: Advisor Perspectives
Historically, far too many investors tend to bounce back and forth from “bungee jumping” to “hiding under the mattress.” At Tanglewood Legacy Advisors, you won’t hear anyone talk about“timing the market.” In over 4 decades of experience, I’ve not found anyone who can successfully do it consistently.
While we are encouraged by the $7.7 trillion potential firepower waiting to be deployed if short-term rates fall lower and while corporate profits continue to meet or exceed expectations, by all measures, U.S. equity prices remain rich, and investors are too confident. We therefore maintain our defensive posture for downside protection.
We prefer a broadly diversified allocation in reasonably valued equities, bonds (including tax-free municipals for those in the highest tax brackets), and alternatives, all to create an asymmetrical portfolio that allows growth while “buffering” downside risk where possible.
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Source: Columbia Threadneedle Investment Advisers, LLC.
Example:
To recover from a 20% loss on a $100 investment (which becomes $80), youneed a $20 gain, which is a 25% return ($20/$80 = 25%).
– Andrew T. Gardener, CFP®