24 Feb

Hold on: Change is Likely and (We Believe) it is Good, Revisited

Last May, we penned a blog commenting on the impending changes to the U.S. Federal Reserve (Fed) policy on the fiscal stimulus and monetary policy (http://www.epiqpartnersllc.com/blog/item/50-hold-on-change-is-likely-and-we-believe-it-is-good). Now that the central bank is two months into its policy of removing the unprecedented stimulus, we thought it a good time to update our expectations.

As we have expressed in the past, we believe that predicting the movement of interest rates is a futile endeavor and does not, in itself, add much value. The history of "investors" making money betting on the fluctuation of interest rates (or currencies) is thin relative to those who speculate in this area.


At EPIQ, we prefer to invest in the equity or credit of businesses that are well-run, well-financed, and possess structural advantages. With that said, when investing in bonds, we still express a view by selecting a term for investments (maturity). Cash interest payments are only part of the return equation. We also need to consider changes in price when calculating total return. In today's environment, the cash payment from bonds is very small by historical standards. If too much duration (longer dated, fixed-rate bonds) is assumed, returns will suffer if interest rates rise.

Pundits are constantly expressing views on future movements of rates. During the past several years, there has been a chorus of them fearing inflation and higher rates due to the massive amount of intervention by the Fed. Gold bugs were the loudest, proclaiming that hard assets like the yellow metal were the best place to protect against this risk.

Well, this has not materialized to the extent predicted. Although, the U.S. bond market has declined since the Fed indicated it would reduce open-market bond purchases. During the past year, the return on the U.S. 10-Year Treasury was -3.0 percent. This is not terrible considering that rates have nearly doubled during this time period. Gold, on the other hand, has declined more than 18 percent during the same time.

At EPIQ, we continue to stress short-term debt and assume prudent credit risk to enhance return potential. We come to our conclusion because we embrace these concepts:

  • The world will continue to use the U.S. Dollar as the preferred reserve currency
  • Productivity gains will keep ahead of job creation/wage inflation
  • Economic activity as measured by GDP will continue to improve, but at a sub-optimal rate
  • A low Federal Funds Rate supports earnings at financial firms and equity valuations.

There are many factors that contribute to asset pricing. Attempting to reduce them to just a few is what humans do when there is too much information, whether appropriate or not. With that said, the last point above is critical. Banks and other financial firms are the backbone of our global economy. During the past five years, the Fed's policies have allowed financial firms to repair their damaged balance sheets. For the most part, the repairs are complete. Moving forward, the Fed cannot afford to surprise the market or move faster in removing its support than previously communicated.

Our best-case scenario is that the Fed will end Quantitative Easing at the end of 2014 and will begin the process of raising short-term rates from 0 percent in the middle of 2015. The risk is not that the Fed moves faster but rather proceeds slower, allowing global markets to absorb these changes in an orderly fashion.



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