University Retirement Specialists, LLC

Should We Break Up the Big Banks

One Federal Reserve official says we should rethink our financial system. 

The newest Federal Reserve policymaker just put forth a radical proposal. Neel Kashkari thinks America’s big banks should be broken up, the sooner the better. 

This opinion comes from the man who once directed TARP, the Troubled Asset Relief Program that bailed out giant banks in the Great Recession. Kashkari was assistant secretary of the Treasury at that time. This year, he became president of the Federal Reserve Bank of Minneapolis, two years after running for governor of California.¹

On February 16, Kashkari spoke at the Brookings Institution and delivered, as one Bloomberg article put it, “a speech that [read] like a cover letter on a resume sent to the White House c/o Bernie Sanders.” Specifically, he called for “serious consideration” of three ideas.¹

The first: “Breaking up large banks into smaller, less connected, less important entities.” The second: “Turning large banks into public utilities by forcing them to hold so much capital that they virtually can’t fail (with regulation akin to that of a nuclear power plant).” The third: “Taxing leverage throughout the financial system to reduce systemic risks wherever they lie.”¹

While the Dodd-Frank Act of 2010 increased regulation of behemoth banks, Kashkari is hardly satisfied with it. As he told the Washington Post recently, “Policymakers have been telling Congress, or maybe Congress has been telling the American people, that Dodd-Frank has solved too big to fail. And I’m saying I don’t believe it.”²

The above reforms would require the approval of Congress. So Kashkari wants to deliver a proposal to Capitol Hill, with input from “leaders from policy and regulatory institutions [and] the financial industry.” All of these parties would convene to “offer their views and to test one another’s assumptions” pursuant to a bill.¹ 

Is this kind of reform necessary? Many voices on Wall Street contend that Dodd-Frank was actually unnecessary, that the credit crisis of the late 2000s never would have occurred if markets, regulators, and Congress had simply abided by existing rules.^1,2,3,4

Others have called for big bank downsizing before this, including some Fed officials. In 2012, the Dallas Fed put out an annual report entitled Choosing the Road to Prosperity: Why We Must End Too Big to Fail – Now. Its president, Richard Fisher, has talked of restructuring large banks into “multiple business entities.” St. Louis Fed president James Bullard once introduced the idea of limiting the size of individual U.S. banks to a percentage of annualized GDP.^3,4 

Of course, not too long ago the federal government helped make the biggest banks even bigger. As it decided certain financial institutions were “too big to fail” during the credit crisis, it also brokered some deals: Bank of America bought up Merrill Lynch and JPMorgan acquired Washington Mutual and Bear Stearns. JPMorgan and Bank of America both received significant help from TARP as a consequence. Taxpayers made a profit on TARP, and Kashkari says TARP was the right move at the right time. However, he prefers that history not repeat.^1,5 

The “too big to fail” idea contends that the nation’s largest banks need a federal backstop if threatened with collapse, because their failure would wreck the economy. Its adherents argue that a giant bank is a better bank, providing more services here and in emerging markets, benefiting from economies of scale that make their services cheaper than services of smaller banks. These banks, the thinking goes, deserve a safety net in a catastrophe.^1,2,3,4

To other observers, the top U.S. banks have grown frighteningly large. An analysis conducted by SNL Financial last year found that just five banks held almost 45% of the U.S. banking industry’s total assets in 2014, about $7 trillion. To put this in perspective, World Bank data shows the entire 2014 U.S. GDP at $17.4 trillion.^6,7 

In time, market forces may actually accomplish what Kashkari would prefer to see. With TARP long gone, the largest banks have had to bolster their capital ratios, a potential disadvantage as they compete with smaller banks and online lenders. So new competitors (and new lending and financial services platforms) could soon emerge to take away some of their business.¹

Kashkari does not want to wait. With the economy in comparatively good health, “the time has come to move past parochial interests and solve this problem,” Kashkari said in his February 16 speech. “The risks of not doing so are just too great.”⁵   

    

Citations.

1 - bloomberg.com/gadfly/articles/2016-02-17/let-s-make-sure-neel-kashkari-s-right-before-splitting-up-banks [2/17/16]

2 - washingtonpost.com/news/wonk/wp/2016/02/17/neel-kashkari-oversaw-the-bailout-of-the-big-banks-now-he-wants-to-break-them-up/ [2/17/16]

3 - business.time.com/2012/03/22/break-up-the-banks-dallas-fed-president-calls-for-the-end-of-too-big-to-fail/ [3/22/12]

4 - bloomberg.com/news/articles/2016-02-16/fed-s-kashkari-floats-breaking-up-big-banks-to-avert-melt-down [2/16/16]

5 - money.cnn.com/2016/02/17/news/economy/neel-kashkari-breaking-up-too-big-to-fail-banks/ [2/17/16]

6 - cnbc.com/2015/04/15/5-biggest-banks-now-own-almost-half-the-industry.html [4/15/15]

7 - data.worldbank.org/indicator/NY.GDP.MKTP.CD [2/18/16]

China’s Stock Market Turmoil

Can U.S. shares hold up in the wake of January’s shocks?  

  On January 7, China halted stock trading for the second time in four days. The benchmark Shanghai Composite sank 7.0% on January 4 and dropped 7.3% three days later, both times activating a new circuit-breaker rule that stopped the trading session.¹

Markets worldwide fell in reaction to these dramatic plunges. On January 7 alone, Japan’s Nikkei 225 and Germany’s DAX both suffered selloffs of 2.3%. On the same day, the Dow Jones Industrial Average dropped below the 17,000 level and the S&P 500 closed below 2,000.^1,2,3

  While the Dow and S&P respectively lost 2.3% and 2.4% Thursday, the Nasdaq Composite lost 3% and actually corrected from its July record settlement of 5,218.86.³

 Why is China’s stock market slipping? You can cite several reasons. You have the well-noted slowdown of the country’s manufacturing sector, its rocky credit markets, and the instability in its exchange rate. You have Chinese concerns about the slide in oil prices, heightened at the beginning of January by the erosion of diplomatic ties between Iran and Saudi Arabia. You have China’s neighbor, North Korea, proclaiming that its arsenal now includes the hydrogen bomb. Finally, you have a wave of small investors caught up in margin trading and playing the market “like visitors to the dog track,” as reporter Evan Osnos wrote in the New Yorker. More than 38 million new retail brokerage accounts opened in China in a three-month period in 2015, shortly after the Communist Party spurred households to invest in stocks. Less than 10 million new brokerage accounts had opened in China in all of 2014.^1,4      

 

In trying to calm its markets, China may have done more harm than good. Chinese officials spent more than $1 trillion in 2015 to try and reassure investors, and right now they have little to show for it. Interest rates have been lowered; the yuan has been devalued again and again. The government has also made two abrupt (and to some observers, questionable) moves.²

 

Last July, they barred all shareholders owning 5% or more of a company from selling their stock for six months. That ban was set to expire on January 8, and that deadline stirred up bearish sentiment in the market this week. The prohibition was just renewed, with modifications, for three more months.⁴

  

On January 4, the China Securities Regulatory Commission instituted a circuit-breaker rule that would pause trading for 15 minutes upon a 5% market dive and end the trading day when stocks slumped 7% or more. On January 7, the CSRC scrapped the rule amid criticism that it was being triggered too easily; Thursday ended up being the shortest trading day in the history of China’s stock market. In the view of Hao Hong, chief China strategist at Bocom International Holdings, the circuit-breaker rule clearly backfired: it produced a “magnet effect,” with selloffs accelerating and liquidity evaporating as prices approached the breaker.^1,2

    

As Peking University HSBC Business School economics professor Christopher Balding commented to Quartz, the CSRC seems to lack sufficient understanding of “what markets are, how they work or how they are going to react.” Quite possibly, China will make further dramatic moves to try and reduce stock market volatility this month. Will U.S. stocks rally upon such measures? Possibly, possibly not.²

 

Wall Street is contending with other headwinds. The oversupply of oil continues: according to Yardeni Research, world crude oil output rose 2.4% in the 12 months ending in November to a new record of 95.2 million barrels a day.¹

 

Additionally, the pace of American manufacturing is a worldwide concern. In December, the Institute for Supply Management’s manufacturing PMI showed sector contraction (a reading under 50) for a second straight month. Factory orders were down for a thirteenth consecutive month in November (the first time a streak of declines that long has occurred outside of a recession) and the November durable goods orders report also disappointed investors.^1,5 

Citigroup maintains an Economic Surprise Index – a measure of the distance between analyst forecasts and actual numbers for various economic indicators. It just touched lows unseen since early last year, which is not a good sign as equities tend to react the most to surprises.¹

If the Labor Department’s December employment report and the upcoming earnings season live up to expectations, stocks might recover from this descent even if China does little to stem the volatility in its market. The greater probability is that more market turmoil lies ahead. That short-term probability should not dissuade an investor from the long-run potential of stocks. 

Citations.

1 - cbsnews.com/news/7-reasons-the-dow-lost-17000/ [1/7/16]

2 - qz.com/588386/chinas-new-stock-market-circuit-breaker-is-broken-and-it-is-panicking-investors/ [1/7/16]

3 - usatoday.com/story/money/markets/2016/01/06/china-stocks/78390650/ [1/7/16]

4 - latimes.com/business/hiltzik/la-fi-mh-a-reminder-china-s-stock-market-is-a-clown-show-20160107-column.html# [1/7/16]

5 - briefing.com/investor/calendars/economic/2016/01/04-08 [1/7/16]

How Could a Fed Rate Hike Affect Retirees?

As the central bank starts tightening, some positives & negatives may emerge.  

 

Economists widely expect the Federal Reserve to raise interest rates this month. Additional incremental rate hikes may follow in 2016. If you are retired (or soon will be), you will want to consider what gradually higher interest rates could mean for you financially.

 

Some of the effects are already being felt. Glancing at Freddie Mac’s weekly surveys, average interest rates for fixed-rate home loans climbed about 0.2% between October 8 and December 10 on assumptions of the federal funds rate rising. (Bond market behavior influences these rates as much as the yield on the 10-year Treasury.) Interest rates on other types of home loans increased less in that interval, but any upward move by the Fed could quickly send them north.¹  

  

As the price of money rises, it will cost more to use a credit card. When the federal funds rate rises, credit card issuers quickly adjust their interest rates upward. Retirees who routinely pay down the whole balance on their cards every month will be less impacted than those who let outstanding balances linger.²

 

Yields on fixed-rate investments are poised to improve. Risk-averse retirees may finally start to see appreciable rewards on such vehicles with a higher federal funds rate, especially if the Fed makes two or three more upward moves in 2016.

Retirees may see a great chance to exploit a laddered approach with fixed-income investments. By spreading their money over a few such investments with overlapping maturity dates, they can take advantage of the resulting liquidity and flexibility and reinvest money at the end of a maturity term into a subsequent fixed-income vehicle with a higher interest rate.   

Long-term bond values are poised to fall. This is a basic outcome of a rising interest rate environment, and warnings about major oncoming losses in the bond market have been sounded for years. Retirees with an eye on the Barclays U.S. Aggregate Bond Index can take heart in the knowledge that historically, deteriorations in bond prices have been more than offset by the Index’s increases in yield.³

Bond yields, on the other hand, are poised to rise. Total returns on the Barclays U.S. Aggregate Bond Index have indeed diminished this year, although they are not yet in the red. In 2014, the index’s total return was 5.97%; as of December 9, it was 0.95% YTD. That could improve in the near term, for the index will be adding newer bonds over time with presumably higher yields to replace maturing bonds, thereby improving the average yield of the overall index.^3,4

   

How will Wall Street react? One school of thought believes that higher rates will amount to a powerful headwind; another says the market has largely priced a December rate hike in, and will handle successive adjustments calmly. Opinions of equity strategists and fund managers meeting for USA TODAY’s December roundtable varied greatly – some saw the S&P 500 making no progress at all in 2016, others felt that a double-digit advance could happen.⁵

Bearish analysts note two factors that may slow the bulls to a trot. Rising borrowing costs for public companies could cut into their profits and thereby hurt their share prices, and if Treasury yields grow more attractive, appetite for risk might lessen. Bullish analysts are countering with the opinion that rising rates go hand in hand with an improving economy, one characterized by better cash flows, higher revenues, and higher corporate profits. As long as the Fed refrains from tightening too abruptly, they argue, 2016 could be a good year on Wall Street.^2,5,6

A federal funds increase may affect retirees in other ways. Those retirees who are paying off private student loans (either those of their children, or their own) will contend with higher interest rates on those loans, as those rates ride on movements in the prime rate. The same goes for auto loans and other forms of short-term consumer borrowing.²

They may also affect your community, the goods and services going into and out of it, and your travel plans. Retirees that invest conservatively with a large cash position may have more money to spend, translating to an economic bump in retiree-heavy towns and regions. Imports to the U.S. will become cheaper. Also, retirees may find overseas travel less costly in the near future. Once Treasuries yield more, more foreign investment dollars will start to pour into the U.S.; that makes for a stronger dollar, to the benefit of Americans vacationing abroad.^2,6

So, there are upsides & downsides to higher interest rates for retirees. One thing is for certain: interest rates cannot stay at historic lows forever. When the Fed adjusts them upward, investors and economists across the world will react – and then move on.

Citations.

1 - freddiemac.com/pmms/archive.html [12/10/15]

2 - thefiscaltimes.com/2015/11/09/10-Ways-Fed-s-Looming-Rate-Hike-Touches-You [11/9/15]

3 - marketwatch.com/story/how-your-bond-portfolio-can-survive-higher-rates-2015-04-23 [4/23/15]

4 - news.morningstar.com/index/indexReturn.html [12/10/15]

5 - usatoday.com/story/money/markets/2015/12/05/all-nothing-2016-top-stock-pros-say/76802904/ [12/5/15]

6 - theconversation.com/fed-interest-rate-hike-may-have-less-of-an-impact-than-you-think-51970 [12/9/15]

Why Does the Wage Gap Between Men & Women Persist?

While it has narrowed, a notable inequality remains.

                                                                                                                                

Last year, the median weekly earnings for an American woman came to $719. Bureau of Labor Statistics data shows that the median weekly earnings for an American man were $152 higher, or 21.1% more.¹

 

Calculated over the course of 52 weeks, that means the median yearly pay for a man in America was $45,292 in 2014. Median yearly pay for a woman: $37,388.¹

 

The good news, relatively speaking: in the past 35 years, this gap has narrowed. In 1980, women working full-time earned only about 65% of the wages of their male counterparts.²

 

After all these years, why is there still such wage inequality? Two quick explanations are often put forth. One, there is still appreciable wage discrimination against women in the workforce, with mothers being perhaps most affected. Two, some women accept lower-paying jobs or leave work altogether while staying at home with their kids or taking care of ailing relatives.

    

These factors are certainly present in wage inequality, yet so are others that get less media notice.

 

More women work for low pay than men. Citing BLS data, the National Women’s Law Center notes that more than two-thirds of minimum-wage jobs in this country are held by women. In fact, the NWLC found in 2014 that women made up 76% of employees in the ten most common occupations with hourly wages of $10.10 or lower. Even in these low-salaried jobs, full-time working women still made an average of 10% less than their male co-workers.^3,4

 

As the Great Recession ebbed, these entry-level jobs were an immediate source of work for many women: 35% of the net employment gain for women from 2009-13 occurred in these fields, compared to 18% of the net employment gain for men. As the number of women in these low-wage occupations markedly exceeds the number of men, this is one of the underpublicized reasons for the continuing wage gap by gender.⁴

   

Careers in which women predominate pay less than careers in which men predominate. As an example, more than 75% of classroom teachers in America are women (and the median pay for classroom teachers, adjusted for inflation, is essentially where it was in 1970). Only recently have initiatives emerged to encourage women to enter “STEM” career fields (careers rooted in science, technology, math and engineering), which are male-dominated and comparatively high-salaried.⁵

 

It may be argued that a teacher contributes much more to society than a software engineer, but that argument is not bolstered by the pay gap between those careers. Looking at Payscale.com, the average salary for an elementary school teacher is $40,311 while the average software engineer earns $63,080.⁶

    

Women do a lot of unpaid work. A mother earns no salary for raising children; a wife earns no salary for taking care of a disabled or seriously ill spouse or partner. Historically, women have left the office to perform this work to greater degree than men have. This tendency also contributes to the wage gap, as the woman involved may end up choosing lower-paying work or not work at all. 

   

Wage discrimination still exists, and is partly accountable for the differential in median wages between the sexes. There is more to the story, however; the career and life choices women are encouraged or impelled to make also influence the numbers.

   

     

Citations.

1 - bls.gov/cps/cpsaat37.htm [2/12/15]

2 - sandiegouniontribune.com/news/2015/may/09/fair-pay/ [5/9/15]

3 - nwlc.org/resource/fair-pay-women-requires-fair-minimum-wage [5/13/15]

4 - nwlc.org/resource/women-are-76-percent-workers-10-largest-low-wage-jobs-and-suffer-10-percent-wage-gap [4/2/14]

5 - nytimes.com/2014/09/07/sunday-review/why-dont-more-men-go-into-teaching.html [9/7/14]

6 - payscale.com/salaries-by-occupation [7/30/15]

At Last, A Greek Debt Deal

A look at the winners, losers & terms.

 

It looks like Greece will stay in the euro. After eurozone finance ministers pulled an all-nighter, negotiating for 17 hours into early Monday morning, the government of the beleaguered nation accepted the latest bailout terms offered by its creditors. The deal was unanimously approved by the eurozone’s 19 member countries.¹

 

This third bailout agreement contains the harshest austerity measures yet. There was no debt haircut for Greece, and this latest round of relief comes at a remarkable price. In exchange for another $95 billion worth of aid over the next three years, Greece agreed to more than just sales tax hikes and cuts in pension payments – it also agreed to sell off state assets.¹

    

To explain this a bit further, Greece will transfer about $50 billion worth of “valuable” assets into a “guarantee fund”. (This was Germany’s idea.) These assets – likely bank shares that the Greek government will buy up with bailout money in order to recapitalize its banks – will be used as collateral on the latest bailout package. The mission is to sell them in reasonable time, with half the cash going toward repayment of the bailout funds, a quarter toward investment, and another quarter applied to Greece’s national debt.^2,3

 

This yet-to-be-named privatization fund will be based in Greece and run by Greek authorities, but Greece’s creditors will supervise its actions. Greece might have until the mid-2020s (or longer) to sell these assets, as the new bailout loans may have long maturities.³

   

In the words of French President Francois Hollande, Europe had “a good night, and a good day” – and no Grexit. Who won and lost most in this new deal? ¹

 

The winner: Angela Merkel. Germany is the premier economy in the eurozone and Greece’s biggest creditor, and its chancellor decided enough was enough. Merkel took a very hard line in the negotiations; in fact, Germany, along with Finland, ardently supported throwing Greece out of the eurozone and letting the country take care of its financial problems without any further loans.^1,4

 

Merkel looks very good even after Germany’s apparent conciliation to the pleas of France, Italy and other European Union members that argued for the necessity of a third Greek bailout. As she commented, “The advantages [of the deal] far outweigh the disadvantages.”²

 

The loser: Alexis Tsipras. Tsipras and his left-wing Syriza party have all but written themselves out of Greece’s future. After disparaging the austerity measures Greeks live with and praising the Greek people for the “very brave choice” they made in voting against another bailout, Tsipras signed off on austerity cuts that were even deeper. 

  

In the end, he simply had to; for all his posturing, two financial shocks would have occurred if he had refused. Without a deal in place, Greece’s banking system could have collapsed this week. Greece also could have found itself out of the eurozone – a danger signal for institutional and retail investors.

 

Global markets started the week with a relief rally. Monday’s trading day found the Dow, Nasdaq and S&P 500 all rising 1.1% or higher; the STOXX Europe 600, FTSE 100 and Nikkei 225 were also up from 1.0-2.0%. The deal is not set in stone yet – eurozone parliaments must approve it – but the accord just reached relieves much uncertainty.⁵

 

 

Citations.

1 - usatoday.com/story/money/2015/07/13/greek-bailout-talks/30068857/ [7/13/15]

2 - time.com/3955221/greece-bailout-marathon/ [7/13/15]

3 - blogs.wsj.com/briefly/2015/07/13/how-will-the-greek-privatization-work-the-short-answer/ [7/13/15]

4 - reuters.com/article/2015/07/06/us-eurozone-greece-idUSKBN0P40EO20150706 [7/6/15]

5 - markets.wsj.com/us [7/13/15]

If Interest Rates Rise, What Will Happen to Bonds?

Investors in longer-term Treasuries could really be punished.

 

Will bond investors soon suffer major losses? In the last few years, Bill Gross, Jim Rogers and other pundits have warned of a bond bubble. While it has yet to occur – the broad bond market yielded an annualized 4.42% from 2010-2014 – the threat remains.^1,2

 

Quality bonds have a place in a portfolio, but many investors are directing their money elsewhere. Seemingly everyone believes the Federal Reserve will raise interest rates later this year, with bonds set to lose market value. Assuming the economy stays healthy and appetite for risk stays strong, what will happen to bonds and bond funds when rates begin to climb?

   

The impact of rising rates will vary. Bonds and bond funds are different animals; some might even call them different asset classes.

 

In a rising interest rate environment, bond fund investors will see principal values decline until rates level off or dip again. A diversified bond fund will reinvest interest payments into new bonds with higher coupons, however – meaning investors will see larger returns with time.^3,4

 

Long-term bonds tend to be hit harder by higher rates. They may lose market value, but eventually the higher rates will result in extra income for the patient investor.

 

How about short-term and intermediate-term bonds? Some analysts warn against purchasing short-duration Treasuries and municipal and corporate bonds, contending that these debt securities might be hurt the most should the pace of rate hikes quicken. Others disagree.

 

Higher rates have not always imperiled the bond market. Since 1975, our economy has witnessed six rising interest rate environments. They lasted from two to five years with T-bill rates increasing between 2.3-11.9%. In those six instances, the total annual return for Barclays U.S. Aggregate Bond Index (the S&P 500 of the bond market) ranged from 2.6-11.9%, with most of the total annual returns at between 4-6%. In short, no disaster for a bond investor. (Last year, the total return for the index was 5.97%.)²

 

Still, if the federal funds rate rises 3% over a period of a few years, a longer-term Treasury might lose as much as a third of its market value as a consequence – and if bulls run on Wall Street with only brief retreats between now and 2025, how attractive will a short-term or intermediate-term Treasury be?

 

What if you want or need to stay in bonds? Some bond market analysts believe now might be a time to exploit short-term bonds with laddered maturity dates. The trade-off: accepting lower interest rates in exchange for a potentially smaller drop in the market value of these securities if rates rise. If you are after higher rates of return from short-duration bonds, you may have to look to bonds that are investment-grade but without AAA or AA ratings.

   

If you see interest rates rising sooner rather than later, exploiting short maturities could position you to get your principal back in the short term. That could give you cash which you could reinvest as interest rates go up. If you think bond owners are in for some pain in the coming years, you could limit yourself to small positions in government bonds, investment-grade corporate bonds and bond funds with durations of 10 years or less.

   

Bonds still belong in the big picture. In a bull market, putting money into an investment returning 1.5% for 10 years may seem nonsensical. It may make more sense in light of the goal of portfolio diversification and the need for consistent returns. If interest rates rise significantly in the next few years, current owners of long-term bonds might find themselves losing out in terms of their portfolio’s potential. On the other hand, bonds have never lost half their value; stocks have.

   

    

Citations.

1 - bloomberg.com/news/2013-02-07/u-s-30-year-bond-losses-pass-5-as-fed-price-gauge-rises.html [2/7/13]

2 - marketwatch.com/story/how-your-bond-portfolio-can-survive-higher-rates-2015-04-23 [4/23/15]

3 - mainstreet.com/article/how-to-invest-in-bonds-when-interest-rates-rise-in-the-future [4/20/15]

4 - money.cnn.com/2015/04/29/retirement/bonds-investing/ [4/29/15]

 

Strong Dollar, Good or Bad?

What is dollar strength & who invests in it?

 You may have heard that the dollar is “strong” right now. You may have also heard that a strong dollar amounts to a headwind against commodities and stocks.

 

While there is some truth to that, there is more to the story. A strong dollar does not necessarily rein in the bulls, and dollar strength can work for the economy and the markets.

   

The U.S. Dollar Index has soared lately. Across July 2014-February 2015, the USDX (which measures the value of the greenback against key foreign currencies) rose an eyebrow-raising 19.44%.¹

 

On March 9, the European Central Bank initiated its quantitative easing program. The dollar hit a 12-year high against the euro a day later, with the USDX jumping north more than 3% in five trading days ending March 10. Remarkable, yes, but the USDX has the potential to climb even higher.^2,3

  

Before this dollar bull market, we had a weak dollar for some time. A dollar bear market occurred from 2001-11, partly resulting from the monetary policy that the Federal Reserve adopted in the Alan Greenspan and Ben Bernanke years. As U.S. interest rates descended to historic lows in the late 2000s, the dollar became more attractive as a funding currency and demand for dollar-denominated debt increased.⁴

 

In Q1 2015, private sector dollar-denominated debt hit $9 trillion globally. Asian corporations have relied notably on foreign currency borrowing, though their domestic currency borrowing is also significant; Morgan Stanley recently researched 625 of these firms and found that dollar-denominated debt amounted to 28% of their total debt.^4,5

 

So why has the dollar strengthened? The quick, easy explanation is twofold. One, the Fed is poised to tighten while other central banks have eased, promoting expectations of a mightier U.S. currency. Two, our economy is healthy versus those of many other nations. The greenback gained on every other major currency in 2014 – a development unseen since the 1980s.⁴

 

This explanation for dollar strength aside, attention must also be paid to two other critical factors emerging which could stoke the dollar bull market to even greater degree.

 

At some point, liabilities will increase for the issuers of all that dollar-denominated debt. That will ramp up demand for dollars, because they will want to hedge.

 

Will the dollar supply meet the demand? The account deficit has been slimming for the U.S., and the slimmer it gets, the fewer new dollars become available. It could take a few years to unwind $9 trillion of dollar-denominated debt, and when you factor in a probable rate hike from our central bank, things get really interesting. The dollar bull may be just getting started.

 

If the dollar keeps rallying, what happens to stocks & commodities? Earnings could be hurt, meaning bad news for Wall Street. A strong dollar can curb profits for multinational corporations and lower demand for U.S. exports, as it makes them more expensive. U.S. firms with the bulk of their business centered in America tend to cope better with a strong dollar than firms that are major exporters. Fixed-income investments invested in dollar-denominated assets (as is usually the case) may fare better in such an environment than those invested in other currencies. As dollar strength reduces the lure of gold, oil and other commodities mainly traded in dollars, they face a real headwind. So do the economies of countries that are big commodities producers, such as Brazil and South Africa.⁶

 

The economic upside is that U.S. households gain more purchasing power when the dollar strengthens, with prices of imported goods falling. Improved consumer spending could also give the Fed grounds to extend its accommodative monetary policy.⁶

 

How are people investing in the dollar? U.S. investors have dollar exposure now as an effect of being invested in the U.S. equities market. Those who want more exposure to the rally can turn to investment vehicles specifically oriented toward dollar investing. European investors are responding to the stronger greenback (and the strong probability of the Fed raising interest rates in the near future) by snapping up Treasuries and corporate bonds with longer maturities.

   

Stocks can still rally when the dollar is strong. As research from Charles Schwab indicates, the average annualized return for U.S. stocks when the dollar rises has been 12.8% since 1970. For bonds, it has been 8.5% in the years since 1976. A dollar rally amounts to a thumbs-up global vote for the U.S. economy, and that can certainly encourage and sustain a bull market.⁷ 

       

  

 

Citations.

1 - wsj.com/mdc/public/npage/2_3050.html?mod=mdc_curr_dtabnk&symb=DXY [3/9/15]

2 - reuters.com/article/2015/03/10/us-markets-stocks-idUSKBN0M612A20150310 [3/10/15]

3 - forbes.com/sites/maggiemcgrath/2015/03/10/u-s-equities-hammered-on-dollar-strength-and-oil-weakness/ [3/10/15]

4 - valuewalk.com/2015/02/us-dollar-bull-market/ [2/4/15]

5 - tinyurl.com/ptpolga [2/25/15]

6 - blogs.wsj.com/briefly/2014/12/24/how-a-strong-dollar-affects-investors-at-a-glance/ [12/24/14]

7 - time.com/money/3541584/dollar-rally-global-currencies/ [2/13/15]

 

 

Ebola Fears Weigh on Wall Street

How will the market contend with a major unknown?

 

What is the Ebola virus doing to stocks? That depends on who you ask. While the threat of another European recession, rapidly falling oil prices and the oncoming end of QE3 all had a hand in the selloff that intensified this week, the Ebola virus – a great unknown – sent a definite shudder through Wall Street.

 

As respected economist and market analyst Ed Yardeni commented last week in a note, “The stock market is now driven by emotion rather than fundamentals. The former rapidly switches from greed to fear on Ebola news.” According to CNBC’s Jim Cramer, stopping Ebola is top-of-mind on Wall Street, with recent headlines suggesting that “we do not know what we are doing as a nation. The fear is so palpable that we have to expect a SARS-like cutback in travel.”^1,2

 

There is no precise way to measure the impact of Ebola fears on the S&P 500, but industry groups have certainly felt it. Shares of some of the major airlines and cruise lines have fallen as much as 20% within the past month. Major hotel stocks have taken a pronounced turn south as well. Shares of biotech companies linked to potential Ebola cures and firms that make Hazmat suits have recently doubled and tripled in value. The CBOE VIX, the so-called “fear index”, is up about 90% in the past month.¹

   

A global health problem implies a global economic problem. The S&P is down about 8% at this writing from its last record close, and the market’s potential to rally suffers when you have an X factor that seems unquantifiable breeding bearish sentiment.¹

 

Last month, global investors largely perceived Ebola as a West African health crisis, but that perception has changed. Stopping the pandemic before it gains ground in America is vital not only to our health, but also to our economy. If dozens or hundreds of Ebola cases were suddenly diagnosed in the U.S., you would see significant changes in consumer behaviors – and that could really dent corporate earnings. 

 

As Cumberland Advisors CIO David Kotok put it in an October 10 note to investors: “Economic consequences [result] when fear and concern change behavior. If consumers and businesses retrench by reducing flights on airplanes, changing vacation plans, or altering business connections in a globally interdependent world, GDP growth rates will fall farther. We do not know how much, at what speed, or for how long.”³

   

The World Bank recently ventured a couple of guesses. In its worst-case scenario, the world sees 200,000 cases of Ebola by the end of 2015 and $32.6 billion drains out of the global economy. In the best-case scenario, the pandemic is almost wholly contained within Guinea, Liberia, and Sierra Leone with a short-term cost of $359 million to the global economy.⁴

   

Can stocks bounce back soon? Pessimists see a correction in progress, caused by Ebola fears, worries about Europe and the Middle East and a collective admission that the market is way ahead of the economy. Optimists see a buying opportunity – a turbulent moment that will pass with the federal government ultimately containing the virus, the eurozone and Japanese economies buoyed by stimulus efforts and earnings surprising to the upside.⁵

 

The health of the bull market may not depend entirely on keeping the Ebola pandemic in check, but it is undeniably important to its sustenance.      

         Citations.

1 - money.cnn.com/2014/10/15/investing/ebola-spooks-wall-street-investors-stocks/ [10/15/14]

2 - thestreet.com/story/12913204/1/10-things-that-can-stem-the-global-panic-from-ebola-to-isis.html [10/14/14]

3 - blogs.wsj.com/moneybeat/2014/10/14/what-ebola-means-for-wall-street-an-unquantifiable-outcome/ [10/14/14]

4 - dealbook.nytimes.com/2014/10/13/calculating-the-grim-costs-of-ebola/ [10/13/14]

5 - businessweek.com/articles/2014-10-15/understanding-the-bears-case-for-stocks-and-the-bulls [10/15/14]

The Market's Wild Swings

A hugely volatile week concludes. What’s next as earnings season gets underway?

 

      

During this past trading week, volatility ruled Wall Street. In fact, stocks either fell or rose 1.5% or more on three consecutive trading days. That had happened only 54 times since 1928.¹ 

   

What prompted these ups & downs? Several factors.  The International Monetary Fund just cut its global and Asia growth forecasts for 2015 and stated that the eurozone could soon slide into another recession. European Central Bank president Mario Draghi wants easing to stimulate the eurozone economy, yet German finance minister Wolfgang Schäuble doesn’t. The DAX and CAC 40 (the benchmark indices of Germany and France) have both corrected since spring.²

 

So has the Russell 2000, which wrapped up last week down 13% from its peak in early March. Oil entered a bear market Thursday. Finally, the end of the month will presumably see the end of the Federal Reserve’s quantitative easing effort – which has played a big role in the market’s bull run. The S&P 500 ended Friday down more than 5% from its September 18 record close, and Friday actually saw a rare 100-point drop for the Nasdaq Composite (102.10, to be precise).^2,3

       

Where might things go from here? Stocks could fall further – keep in mind that the S&P has gone more than two years without a correction, definitely an abnormality. On the other hand, fall earnings seasons have tended to give stocks a lift throughout history, so let’s hope history repeats. Bespoke Investments cites some encouraging data: in instances where the market sees 1.5% or greater swings on three straight trading days, the S&P has averaged a gain of 0.55% on the next trading day and 1.13% during the following trading week.¹

    

How big a drag will Europe continue to exert on the market? Agreement between EU finance ministers would give domestic and foreign stocks a lift. If that isn’t there, perhaps earnings – the “mother’s milk” of stocks – will help guide the market back to equilibrium and gains.²

   

Perhaps the wisest words came from Cornerstone Wealth Management CIO Alan Skrainka, who told USA TODAY Friday: “The market was overdue for a correction. Not every correction develops into a bear market. Every economic slowdown is not a recession. Look for opportunities and maintain a long-term perspective.”³

             

     

Citations.

1 - tinyurl.com/k9nfbxc [10/10/14]

2 - bloomberg.com/news/2014-10-09/index-futures-slip-as-stocks-slump-while-oil-extends-drop.html [10/10/14]

3 - usatoday.com/story/money/markets/2014/10/10/stocks-friday/17022819/ [10/10/14]

 

Rising Interest Rates

How might they affect investments, housing & retirees?

 

    

How will Wall Street fare if interest rates climb back to historic norms? Rising interest rates could certainly impact investments, the real estate market and the overall economy – but their influence might not be as negative as some perceive.  

 

Why are rates rising? You can cite three factors. The Federal Reserve is gradually reducing its monthly asset purchases. As that has happened, inflation expectations have grown, and perception can often become reality on Main Street and Wall Street. In addition, the economy has gained momentum, and interest rates tend to rise in better times.

 

The federal funds rate has been in the 0.0%-0.25% range since December 2008. Historically, it has averaged about 4%. It was at 4.25% when the recession hit in late 2007. Short-term fluctuations have also been the norm for the key interest rate. It was at 1.00% in June 2003 compared to 6.5% in May 2000. In December 1991, it was at 4.00% – but just 17 months earlier, it had been at 8.00%. Rates will rise, fall and rise again; what may happen as they rise?^1,2

 

The effect on investments. Last September, an investment strategist named Rob Brown wrote an article for Financial Advisor Magazine noting how well stocks have performed as rates rise. Brown studied the 30 economic expansions that have occurred in the United States since 1865 (excepting our current one). He pinpointed a 10-month window within each expansion that saw the greatest gains in interest rates (referencing then-current yields on the 10-year Treasury). The median return on the S&P 500 for all of these 10-month windows was 7.93% and the index returned positive in 80% of these 10-month periods. Looking at such 10-month windows since 1919, the S&P’s median return was even better at 11.50% – and the index gained in 81% of said intervals.³

 

Lastly, Brown looked at the S&P 500’s return in the 12-month periods ending on October 31, 1994 and May 31, 2004. In the first 12-month stretch, the interest rate on the 10-year note rose 2.38% to 7.81% while the S&P gained only 3.87%. Across the 12 months ending on May 31, 2004, however, the index rose 18.33% even as the 10-year Treasury yield rose 1.29% to 4.66%.³   

 

The effect on the housing market. Do costlier mortgages discourage home sales? Recent data backs up that presumption. Existing home sales were up 1.3% for April, but that was the first monthly gain recorded by the National Association of Realtors for 2014. Year-over-year, the decline was 6.8%. On the other hand, when the economy improves the labor market typically improves as well, and more hiring means less unemployment. Unemployment is an impediment to home sales; lessen it, and more homes might move even as mortgages grow more expensive.⁴

 

When the economy is well, home prices have every reason to appreciate even if interest rates go up. NAR says the median sale price of an existing home rose 5.2% in the past year – not the double-digit appreciation seen in 2013, but not bad. Cash buyers don’t care about interest rates, and according to RealtyTrac, 43% of buyers in Q1 bought without mortgages.^4,5

 

Rates might not climb as fast as some think. Federal Reserve Bank of New York President William Dudley – whose voting in Fed policy meetings tends to correspond with that of Janet Yellen – thinks that the federal funds rate will stay below its historic average for some time. Why? In a May 20 speech, he noted three reasons. One, baby boomers are retiring, which implies less potential for economic growth across the next decade. Two, banks are asked to keep higher capital ratios these days, and that implies lower bank profits and less lending as more money is being held in reserves. Three, he believes households and businesses are still traumatized by the memory of the Great Recession. Many are reluctant to invest and spend, especially with college loan debt so endemic and the housing sector possibly cooling off.⁶

    

Emerging markets in particular may have been soothed by recent comments from Dudley and other Fed officials. They have seen less volatility this spring than in previous months, and the MSCI Emerging Markets index has outperformed the S&P 500 so far this year.²

   

    

Citations.

1 - newyorkfed.org/markets/statistics/dlyrates/fedrate.html [5/22/14]

2 - reuters.com/article/2014/05/21/saft-on-wealth-idUSL1N0NZ1GM20140521 [5/21/14]

3 - fa-mag.com/news/what-happens-to-stocks-when-interest-rates-rise-15468.html [9/17/13]

4 - marketwatch.com/story/existing-home-sales-fastest-in-four-months-2014-05-22 [5/22/14]

5 - marketwatch.com/story/43-of-2014-home-buyers-paid-all-cash-2014-05-08 [5/8/14]  

6 - money.cnn.com/2014/05/20/investing/fed-low-interest-rates-dudley/index.html [5/20/14]