2014 Q3 letter: Rates and Revolutions make the world go ’round

The summer of 2014 has been one of revolutions with unrest spreading across much of Central Asia and the Middle East. Towards the end of September, we also saw a protest movement begin to take hold in Hong Kong. The common thread running through so many of these events is the democratic aspirations of a younger generation—a generation that, through the use of social media, now has instant access to much of the world’s current events and can compare the conditions of their own country with the rest of the world. When this comparison highlights unresponsive, ossified political and economic institutions, this generation demands change. This is happening in ways both big and small, and the United States is not immune as we can see from the manner in which the protests in Ferguson, MO snowballed. In a very real sense, these events are a testament to the radical advances in personal communication technology made over the past few decades. It is also a testament to the soft power of the world’s market-oriented democracies, which are viewed as a role-model by much of the world.

Change though, is by definition disruptive, and these revolutions, both big and small, are no exception. The most violent ones in the Middle East and Ukraine have disrupted life and trade in many ways. The destruction of human and physical capital will, in many countries, take years to mend. US markets have seemed immune to these political events, but that can change quickly.

For investors, the bigger question is in the timing of Federal Reserve’s next steps. Over the course of 2014, the Fed has unwound its highly unusual program of bond purchases. These purchases have helped buoy the bond markets and kept long-term rates low for an extended period. These historically low rates have allowed many creditors to refinance medium and long-term debt at attractive terms. Meanwhile, an unprecedented program to keep short-term benchmark rates at near 0% has helped banks shore up balance sheets and spurred some investment. As bond investors well know, low yields on the safest investments have pushed many into investments riskier than they would otherwise tolerate.

Since late 2007, the Federal Reserve has used every tool in its arsenal to shore up business conditions in the US. They have also developed new ones (including bond purchases that expand the Fed balance sheet) and radically expanded the scope of traditional methods. The most unorthodox of these policies have been almost completely unwound (the Fed is expected to officially end its bond purchasing program on Oct 29th). What is left is an unusually low short-term interest rate and large bond holdings which will roll off over time. In previous public comments, Federal Reserve governors have said they will carefully consider labor market conditions before amending the current interest rate policy. The market has widely read this as waiting for a headline unemployment number under 6%. Headline unemployment as reported on October 3rd was 5.9%. Though most observers agree the labor market is still not robust—which is apparent when we see the extraordinary numbers of discouraged and involuntary part-time workers—we have had zero rates for nearly six years now and many on the board of governors are uneasy with that length.

The US election cycle may play a role in the timing of an interest rate rise, but we do not expect the Fed to move before the upcoming midterm election in November. Similarly, we do not expect them to move rates dramatically in a presidential election year. This means 2015 might be the best opportunity for the Fed to gradually bring rates up from 0% to some nominally “normal” level (say 2.0%) and then pause to take stock and wait out the election. In our view, this is the likeliest scenario, absent another major market upheaval.

Since 2009, the winding down of Fed stimulus programs have led to selloffs in equity markets. We expect Oct/Nov of 2014 to be no different and recommend clients remain defensive with their allocations. If the Fed is serious about ending further stimulus, the stock market will need to stand on its own two feet. Given recent record highs, we are skeptical that equity prices will continue their meteoric rise in the absence of Federal stimulus and with the threat of impending rising interest rates on the horizon. 2014 has already seen the beginnings of a correction in more speculative stocks (the Russell 2000 small cap index is down approx 5% year-to-date through 9/30 and down nearly 10% since its peak in early July). If we see a correction, we expect there will be buying opportunities where quality companies can be had at discount prices.

In other news, after 5+ years of residing in the Flatiron area, we have recently relocated our office to Midtown. Our new contact info is as follows:
261 Madison Ave, 10th Flr
New York, NY 10016

Tel: +1.646.450.9772
Fax: +1.929.244.0256

Regards,

Subir Grewal                                               Louis Berger