On Feb. 3, 2018, Janet Yellen’s term as chairperson of the Federal Reserve Board (Fed) will come to an end. She began her tenure as chair in 2014 after a four-year stint as vice-chair, but has been an active member of the Fed since being appointed president of the San Francisco Federal Reserve Bank in 2004. On Feb. 3, 2018, Jerome Powell, a current member of the Fed board, will succeed Yellen as chair. (Technically Yellen’s term as a Fed governor doesn’t end until 2024 but she’s announced that she’ll retire when Powell is sworn in as her successor). Powell, though not a classically trained economist as Yellen (and most prior Fed chairs), has been a Fed governor since 2012 and has therefore been indoctrinated on the typical uses of Fed policy. Furthermore, he has seen firsthand (and voted on) the most recent set of Fed policies each time supporting the decision reached by Yellen. While Powell may be the new boss, we don’t expect him to differ much, if at all, from the old boss. This is important because over the nine years since the stock market bottomed in March 2009 and the U.S. economy began its most recent expansion, the Fed has done much of the heavy lifting to create the monetary conditions necessary for those two things to occur.
by The Who, “Won’t Get Fooled Again.” Of course the 21st century operating procedure for the Fed is to make sure they don’t fool the market with their activities but rather telegraph each move to allow markets to digest them and react in an orderly fashion over time. All expectations are that the new boss will operate just like the old boss and telegraph to the markets what the upcoming monetary policy plans are at the Fed. In this tightening cycle, where rates are expected to gradually track upwards and the Fed is planning to shrink its enormous balance sheet, it is important that we continue to see the Fed telegraph policy maneuvers to avoid any massive shocks to the monetary system and global capital markets. After all it is all very easy for markets when the Fed is easing money but when it enters a tightening cycle the market is constantly on edge for signs of overreach. Since the Fed first cut interest rates back in the first quarter of 2009 to aid the economic recovery coming out of the financial crisis, the Fed has been by and large acting alone in trying to stimulate economic growth. Monetary policy has carried the day while fiscal policy has been largely absent. Now, however, with the recent passage of the tax bill (like it or not) at least the fiscal side has tried to help spur economic activity and growth. If the cut in corporate tax rates stimulates greater corporate investment (and thus greater corporate growth) today’s already tight labor market could get even tighter. That, potentially, could lead to greater wage pressures and ultimately a jump in inflation. Low, almost non-existent inflation has been a key contributor to market returns since 2009.
The ongoing accommodative monetary conditions coupled with the promise of tax reform (which was passed right before the quarter ended) helped fuel further stock market gains in the fourth quarter. For the quarter, the S&P 500 gained 6.6% putting up a very healthy 21.8% for 2017. After three quarters of pacesetting, developed international stock markets cooled off a bit and relinquished their market-leading gains to the United States but still posted returns for the fourth quarter of 4.2% for developed markets (MSCI EAFE) and 7.4% for emerging markets (MSCI EM). For the year, the non-U.S. markets saw higher returns with EAFE up 25% and EM up 37%. Large cap stocks extended their leadership position over smaller cap ones with the Russell 1000 Index up 6.6% in the quarter and 21.7% for the year while the small cap Russell 2000 Index “managed” to only return 3.3% and 14.7%, respectively. Similarly, growth stocks continued to outpace value ones with the Russell 1000 Growth Index up 7.9% for the quarter and 30.2% for the year while the Russell 1000 Value Index saw returns of just 5.3% and 13.7%, respectively, thanks to ongoing struggles for energy and telecom stocks, which both posted losses for 2017. It is typical for growth stocks to outperform value as a market cycle progresses and reaches its later stages as investors are more willing to pay up for growth while value stocks have often been bid up to their perceived level of value at this point. Overall 2017 did not have a 5% correction in U.S. equity markets and volatility remained very low throughout the year despite a seemingly never-ending cycle of geopolitical headlines and worries.
Bond markets continued to show positive gains in more equity-like areas like high yield (up 7.5% for the year) after posting gains of 0.5% for the fourth quarter, while interest-rate sensitive government bonds struggled under the weight of the third Fed rate hike of the year and promises of three more in 2018 as well as a shrinking of the Fed’s balance sheet. The Bloomberg Barclays U.S. Aggregate Bond Index was up just 39 basis points for the quarter but did return a respectable 3.5% for the calendar year.
We expect Powell (the new boss) to continue the gradual fiscal tightening started by Yellen (the old boss). Powell does enter at a more difficult time as the expansion is nearing a decade in length and inflation is possibly lurking in the shadows of any accelerated economic growth ushered in by recent tax cuts. Therefore, he should make sure that monetary conditions remain loose enough for corporate America to function and grow while not staying too loose for too long and thus ushering in a period of higher than expected inflation. If the new corporate tax plan stimulates an accelerated growth rate for the U.S. economy, new chair Powell is going to have to have a steely hand in incorporating additional tightening to U.S. monetary policy to ward off inflation while not creating a recession. That’s a difficult needle to thread. Past bosses at the Fed have largely failed in that objective, often tightening monetary policy too much and thus choking the economy and fomenting a recession.
It is too tough to predict which way the chips will fall and there isn’t enough evidence about how the old boss would have handled things to surmise how the new boss might. Therefore, in the absence of strong convictions the right approach is to maintain an appropriately diversified portfolio that matches your goals and risk tolerance.
Market Trends is written by Reliance’s Jim Foster. Questions or comments on Market Trends, LifeStyles portfolios or other investment services offered by Reliance, contact email@example.com.The material herein is based on data from sources considered to be reliable, but it is not guaranteed as to accuracy, does not purport to be complete and is subject to change without notice. This communication is for informational purposes only. Use by other than intended recipients is only allowed prior to Reliance Financial Corporation’s consent. Sender accepts no liability for any errors or omissions arising as a result of transmission. Any comments or statements made herein do not necessarily reflect those of Reliance Financial Corporation or its affiliates.