“The Struggle for Growth in a Sea of Liquidity”-Byron Wein
The chorus of economists calling for the Federal Reserve to raise interest rates is growing louder. Following its first rate increase last December the Fed has held its interest rate steady in a range of 0.25%-0.5% yet it is becoming increasingly likely that the Fed will raise rates again by December. In this quarterly update, we’ll explain the impact of rising rates on the economy the implications for the investment environment.
Since the financial crisis of 2008 the markets have been driven higher not only by an improving economy but also by aggressive monetary policies. Numerous quantitative easing programs have expanded the balance sheets of the world’s central banks from $3.5 trillion to $13.5 trillion. While the monetary policies were first introduced to inject liquidity into a stalled financial system, they have been in place long enough to skew stocks higher and quality bond yields lower. A growing consensus of Fed Governors are now concerned about bringing the Fed Funds rate back to a neutral range as employment levels have improved so that the tool will be available to enact monetary policy when the next recession arrives.
We believe that the economic impact of a higher Fed Funds rate will be modest. When rates were lowered in 2008, the financial markets had been frozen by the collapse of Bear Sterns, the bankruptcy of Lehman Brothers, and the Federal bailout of many other financial institutions. Borrowing money at any rate was a challenge. Since then the financial markets have returned to normal operating conditions even though GDP growth remains muted. While debtors have been able to refinance at lower rates, savers have been penalized as the yields on bonds and cash are near historic lows. People saving for retirement are now forced to save three times that amount of money needed ten years ago in order to generate the same income. Equities have become yield substitutes. In 2000 only 3% of companies in the S&P 500 had dividend yields that exceeded the 10 year treasury. Now, 53% of businesses in the S&P 500 have dividend yields greater than the 10 year treasury. What is an income hungry investor to do? He/she is forced to take more risk in stocks.
Looking forward we expect the key driver of future stock market performance to be corporate earnings growth, and not multiple expansion. The stock market is currently trading one standard deviation about its historic level. Earnings of companies in the S&P 500 have remained flat since 2014 and forecasted earnings continue to be revised downward. Taken together these facts suggest that expected returns in the stock market will be modest until earnings growth accelerates.
During the quarter we sold client positions in Hershey after it rallied on an unsolicited takeover proposal. We didn’t believe the company would agree to the transaction and, in fact, the proposal was later withdrawn. We purchased a position in Fiserv, an information management company serving financial institutions. We think the company will benefit from the expansion in cashless transactions. We also purchased a position in American Eagle Outfitters, a mall based retailer. The company is positioned to do well as a couple of its competitors face liquidation and bankruptcy. We will continue to search for investment opportunities positioned to generate attractive long term returns.
As always, thank you for entrusting Ayrshire Capital with the management of your money. We look forward to speaking with you in the coming quarter.
JM Sam Nevin, Jr.
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