You may recall that in our January letter we suggested that the reduction in the Federal Reserve’s asset purchases (tapering) would not be the main topic as the year progressed. With the first quarter of the year behind us, where do we stand? “Worries” often do not come to fruition and actual events usually surprise investors.
Newly-confirmed Federal Reserve Chair Janet Yellen’s first encounter with the press surprised the market and fostered uncertainty. The media focused on two or three words that, in retrospect, were misconstrued. Ms. Yellen mentioned that the first rise in the federal funds rate could occur “about six months” after the end of its asset purchase program—but that any decision would be driven by the economic data. The press and others took it to mean that the Fed’s time frame would be set in stone and that an interest rate hike would occur sooner than previously expected by the market.
However, we still think the US employment rate will remain significantly above the Federal Reserve’s target, while key measures of inflation will remain well below the Fed’s target. As a result, the Fed along with its central bank peers around the world, will be slow to raise short-term interest rates. During the last week of March, Yellen gave a speech in Chicago in which she looked beyond the headline-grabbing statistics and focused on the plight of real people. She chose three workers struggling in the current labor market environment to convey the point that millions of Americans remain unemployed or underemployed. We think this speech may be remembered as one of the most “dovish” presentations from a Fed Chair in recent history. In Yellen’s mind, the Fed remains duty-bound to pursue policies that help Main Street. Yellen’s stance suggests to us that the central bank will keep short-term interest rates low throughout 2014 and beyond.
Global politics provided the other surprise during the quarter. Specifically, it was Russia’s actions in Crimea and the Ukraine that caught the world off-guard. We think there will be other geopolitical surprises that will crop up and that we will continue to live with volatility in global markets.
Over the long term, we should not forget that over 50% of the world’s economic output comes not from developed nations, but rather from countries where middle class demand for goods and services are growing rapidly. The fear of increasing interest rates globally should be tempered with the thought that this rise will probably be gradual and that income producing assets continue to be attractive, as the “carry” or income component will more than offset any negative reduction in principal due to higher interest rates. We remain optimistic and continue to believe that diversification and liquidity in portfolios will provide flexibility and opportunity.
My best wishes for the coming months.