30 May

Hold On, Change is Likely and (We Believe) it is Good

This past week the Federal Open Market Committee (FOMC), signaled to investors potential policy changes that may lead to higher interest rates.

Four years ago, the Federal Reserve took unprecedented action to stave off what was widely viewed as an impeding global financial collapse by dropping the Federal Funds rate - the rate commercial banks loan to one another - to essentially 0%. Who says there is no such thing as free money?

The purpose of this action was to motivate investors to accept risk rather than bank it while earning nothing. As an analogy, think of a gathering where there is music, lights, food, beverages and lots of people, but no party. To get things grooving, the Fed hosted an open bar instead of charging regular or even happy hour prices. It has taken four years to get the party started and now that the economy (party) looks to be slowly taking off, the Fed announced last week that it may soon start charging, at the very least, happy hour pricing --as early as next year.

So party-goers (investors), let’s get ready so we don’t have the same issues we experienced when a similar event back in 1994 took place, where the punch bowl was taken away from the party before everyone had dipped in for a drink. Nearly 20 years ago the Fed raised rates from 3% to 6%, and even though then-Chairman Alan Greenspan sent plenty of signals that rates were headed up, the move still shook the credit markets when it happened.

So back to this latest FOMC announcement, what does this mean to financial markets in the short and medium term? We will likely experience an uptick in volatility, which means that stock prices won’t be going up four out of five days a week and bond prices may be challenged. We’re already seeing pressure on bonds of all stripes.

There are many who predict that bond prices have peaked and will fall hard while interest rates rise. For the past six years, many financial gurus have felt this would be the case but have been wrong, or perhaps just early in their predictions. This is why we stress short maturities for our fixed income investments. This strategy has worked, but not to the degree as buying long term bonds.

Now, the largest player in the bond market—the Federal Reserve—has stated that the time is coming when its hosted bar is going to be closed. We believe this is a really good thing for the long term. It is not sustainable to run a business when all you do is give away your products and services instead of charging for them. The Fed believes it can start running the dance hall like a real business and party goers will continue to come even if they have to pay for drinks and appetizers.

For equities, valuations are fairer than any time in the recent past and as earnings grow so should share prices. This goldilocks economy - where things aren’t too hot or too cold - continues to warm up slowly, which has historically proven to be an ideal time in the market cycle for strong risk-adjusted returns.

Under the scenario we have painted, business leaders, who drive the real economy as opposed to the price of stocks on a given day, can have more confidence than in the recent past to invest and expand their enterprises. This should help stem “un” and “under” employment, which in turn should lead to more confidence and better economic conditions. But be aware, as we see an improvement in the economy, we may face different challenges as the Fed might feel the need to slow down the economy so inflation does not become the next issue. See the pattern?

Where does EPIQ stand?

We continue to invest in great businesses and business leaders. This time of year brings many annual shareholder meetings. We have attended several, including a pilgrimage to Omaha for the Berkshire Hathaway/Buffett-fest weekend. With a bit of cash and an eye for opportunity and non-correlated, alternative asset classes, we feel well positioned for the on-going party of investing on behalf of successful families.

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