Worth Watching

There are interesting forces at play that aren’t making headline news, but could significantly impact the economy and your finances.  A lot has been made of the healthcare debate on Capitol Hill, and admittedly it is a whale of an issue.  However, at this point, it doesn’t seem to be impacting the overall market, although healthcare stocks keep chugging higher, gaining about 18% thus far this year.  Rather than focus on healthcare reform, which won’t likely be resolved anytime soon, I’ll share some interesting dynamics at play that may have noteworthy influence on the economy.

Fed Unwinding the Balance Sheet

Remember back in the fall of 2008 when the Federal Reserve began buying lots of mortgages, bank debt and Treasuries, enacting something called 'Quantitative Easing'?  Over a six month period, the Feds bought about $1 Trillion worth of bonds.  The program appeared to work as the stock and bond markets began to stabilize.  The Feds pressed on and continued buying more bonds in an effort to keep the ship afloat.  In the investment world, we referred to each step of bond purchases as ‘QE 1’, ‘QE 2’, ‘QE 3’, and then we all stopped counting and started referred to it as ‘QE infinity’ (true story). 

All those bond purchases over the years added up to around $4.5 Trillion in assets that the Federal Reserve now holds on its balance sheet.  By purchasing the bonds, the Fed essentially created $4.5 Trillion worth of demand that didn’t exist before it began buying the bonds.  This has helped keep interest rates low over the past nine years.  Now that the economy is on more stable footing, the Fed has decided to begin unwinding its holdings and slowly sell these bonds back in the open market in an orderly fashion. 

The unwinding of the Fed balance sheet is set to begin later this year.  If all goes well, it will likely become an irrelevant side note to the saga that was the Great Recession.  Still, many investors are watching closely to see how bond prices may be impacted.  In essence, the Fed is about to add a whole lot of new supply to the bond market.  According to basic economic theory, adding excess supply can lead to falling prices.  Demand for the additional bonds may be adequate to make up for the additional supply and, if so, prices may remain flat.  We shall see.  From an investment standpoint we don’t recommend making major allocation changes based on this possibility, but our stance may change as the unwinding begins.

Weak Dollar

Back in February I wrote that the US dollar was at a 14-year high relative to other currencies.  That has changed as the US Dollar has weakened dramatically since then.  Year to date, the dollar is now 8% lower against a trade weighted basket of currencies (Bloomberg).  This is a bad thing for international travelers (because their dollars buy less as the dollar weakens), but it could be a nice tailwind for multinational US companies that sell their goods overseas.  As the dollar weakens, it makes US products less expensive, and thus more appealing to international consumers.  In theory, this should help American companies sell more shampoo, toothpaste, jets, hamburgers, etc., to consumers overseas.  Morgan Stanley analysts project that the weak dollar could add as much as 6.5% to net earnings estimates for next year, which would be a nice unexpected surprise.

We continue to be cautiously optimistic on the US markets, but haven’t lost sight of the fact that US stocks continue to trade at a notable premium, which generally isn’t a good thing for long-term returns.