For those not proficient in "Fed Speak", the above comment included in the December minutes of the Federal Open Market Committee (FOMC) that were released in January could be easily dismissed as economic gibberish. Nonetheless, an understanding of the Fed’s outlook may help to explain what has occurred in the capital markets thus far in 2005. Put simply, the Fed was concerned that low interest rates were making it too easy for investors to bid up investment prices to what they deemed to be unjustified levels. Presumably, the Fed tipped its hand in publicly disclosing this concern to remind the markets that, under normal market conditions, riskier assets should carry a commensurate risk premium over less risky (or risk-free) assets. Given the capital market’s sensitivity to both the official position of the Fed and the opinions of its governors, most notably Chairman Greenspan, such comments were likely intended in part to influence market valuations.
If that was the intent, their goal has been accomplished.
Stocks continued to tumble through the end of April, with smaller cap stocks leading the downward trend. The S & P 500 Index loss of 1.9% allowed it to maintain its domestic market leadership over small cap stocks. The Russell MidCap Index slipped by 3.2%, while the Russell 2000 dropped 5.7% for the month, sufficient to bring its year-to-date loss to 10.8%. The international equity markets also faltered. The EAFE Index lost 2.4% for the month, but its 2.5% cumulative loss for the year still stacks up well relative to the U.S. market.
The fixed income markets rebounded in April offsetting, in part, the losses in stocks. The Lehman Aggregate Bond Index return of 1.35% pushed its year-to-date mark back to into positive territory by a fraction. International bond markets kept pace with a comparable increase. The rally was broad and inclusive of both defensive and longer-term issues as well as taxables and municipals.
Of late, we are hearing more about the potential that we are amid a "soft patch" in the economy. GDP growth for the first quarter came in at a lower-than-expected 3.1% annualized rate, a more moderate rate than that in 2004 and its slowest pace in two years. Nonetheless, the Fed appears to be more concerned about inflationary pressure increasing than the economic expansion slowing in the shortterm. For some time, the Fed’s official position has been that a "measured removal of policy accommodation" was appropriate. In layman’s terms, a gradual increase in short term interest rates would likely suffice to contain inflationary pressure while nurturing an environment of growth. As evidenced by their more recent comments, that tone appears to be changing.
In the minutes to the March 22 meeting, there were hints that their references to "measured pace" may need to be toned down to accompany a change toward a more aggressive policy in the near term. Specifically, it was noted that "…some (FOMC members) expressed the view that such language could constrain future policy inappropriately…" since some members believed that "…the odds that the Committee might need to step up the pace of policy firming were thought to have increased."
Ultimately, the Committee concluded to retain their "measured" stance, but this disclosure hinted of their concern about increasing inflationary pressures and their potential need to take more aggressive steps to stem that tide. Since that meeting, however, more recent data has suggested that the economy may be down-shifting even further than expected from its rapid expansionary rate in 2004. This slowdown may have relieved some of the immediate pressure on the Fed. In its brief comments issued yesterday accompanying its most recent quarter point increase in the fed funds rate, the FOMC conspicuously maintained its reference to its "measured" approach to lifting short-term rates. Perhaps the "soft patch" in economic growth will trump concerns of escalating inflation, which still appears to be gathering steam. If economic growth stabilizes or regains strength in the face of bubbling inflationary pressures, however, the Fed may be persuaded to act more forcefully to cool things off.
We are not in a position to predict which direction the Fed might head at this point. Even their publicly disclosed comments clearly demonstrate that they see conflicting concerns and perhaps even suggest some dissention about whether or not they should stay the course or accelerate rate hikes. One thing appears certain: short-term interest rates will continue to rise, which will likely keep bond returns low. Whether or not the market begins pricing in higher rates on intermediate to long-term bonds remains to be seen. If the yield curve does push higher, fixed income performance would take a hit. Moreover, an announcement or action by the Fed suggesting that they intend to more aggressively raise rates to stave off inflation could be a short-term negative for both bonds and stocks.
What’s the good news? The economy is still growing, and at a pace that is more sustainable than was the case last year. Business spending appears to be increasing, suggesting that corporate America may be ramping up to address diminished production capacity in expectation of a continuation of the economic expansion. The economy continues to add jobs and increasing real disposable income coupled with low savings rates suggest that consumers are still spending. In aggregate, the evidence appears to suggest that this slowdown is not the beginning of a dip into a recessionary environment. With inflation squarely in the crosshairs of the Fed, and its policy primarily "aimed at preserving price stability", the economic underpinnings for at least moderate growth appear to remain in place. Shortterm volatility in the stock and bond markets may persist, but a growing economy coupled with increased pricing power should support improving corporate earnings and, ultimately, be a positive for equities.
