First Republic Private Wealth Management

Week in Review: September 26, 2016

Investors’ near obsession with statements by central banks adds to short-term volatility.  Portfolios need greater diversification while investors wax and wane over global monetary policy. 

Both stock and bond prices jumped after the Federal Reserve and the Bank of Japan (BOJ) maintained pro-growth policies. The Fed left interest rates unchanged and the Bank of Japan moved away from targeting an explicit amount of bonds to buy, giving it more operating flexibility. Investors sighed in relief, sending (1) the S&P 500 initially back within 1% of its all-time high, (2) the 10-year Treasury bond yield down to 1.62% and (3) the U.S. dollar down against the euro, the British pound and many emerging-market currencies. 

The broad rally in financial markets reversed about half of the decline from two weeks ago when other central bankers spoke. The S&P 500 had dropped more than 2% after the European Central Bank disappointed investors and one regional Fed president changed his mind on the timing of an interest rate increase. Central banks also moved markets in July following the Brexit vote. After plummeting June 23 – 24, the S&P 500 reached a new record high by July 11 due to reassuring rhetoric from central banks. The pattern is clear. With economic growth tepid, financial markets are dependent on central bank stimulus and therefore often overreact to statements from central bank policymakers.

In the market’s short-term myopia, investors may have missed the most important messages from both the Fed and the BOJ. In its forecasts, the Fed lowered its estimate of long-run economic growth to 1.8% and tweaked its “neutral” or target short-term interest rate to below 3.0%. Plus, the Fed projected a slower and shallower path to reach the reduced target.  It’s true that the specific numerical forecasts are basically statistical guesses and based on assumptions. However, we think the Fed’s message was clear – it will take a very deliberate and very slow path towards its target short-term interest rate. Therefore, whether the Fed takes a 25 basis point increase in December or not isn’t important from a fundamental view; short-term interest rates are likely to be below normal for the next couple of years (depending on the pace of inflation and other economic conditions). 

Similarly, the BOJ’s announcement was more than maintaining the status quo. The central bank set a new goal to keep the 10-year Japanese bond yield near zero and, more generally, to manage the slope of the Japanese yield curve. This means the amount of bonds the BOJ buys will change as needed to guide the 10-year bond yield. Furthermore, the BOJ said it would overshoot its inflation target. To us, this is another way of saying that the BOJ will stay biased towards easing. 

During this period of slow growth and short-term volatility, portfolio diversification is even more important. We prefer equity exposure in large cap U.S. equities, but we’re watchful for other opportunities. For example, we plan to refresh our analysis of emerging market equities. These markets have rallied in the past six months or so due to heavy fund flows.  However, fundamentals may be set to improve. The slower trajectory for Fed policy should translate to a lower U.S. dollar and help emerging markets. 

Key economic releases in the week ahead include, for the U.S., durable goods orders (Wednesday), international trade (Thursday) and personal income (Friday); for Europe, economic sentiment (Thursday), inflation and unemployment (Friday); for the U.K., GPD (Friday); for Japan, inflation and industrial production (Thursday); for China, manufacturing reports (weekend).  

Market Returns 9.26.16

First Republic Private Wealth Management encompasses First Republic Investment Management, Inc., an SEC-registered Investment Advisor, First Republic Securities Company, LLC, Member FINRA/SIPC, First Republic Trust Company (“FRTC”) and First Republic Trust Company of Delaware LLC (“FRTC-DE”). 

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