Fed Overstep?

To modify a phrase from the sage words of Magoo. "Oh my Fed! You've done it again!" Looking over the broad economic data it seems that the Fed may have over cooked interest rates in December of last year. At the time it didn't appear to be an unwarranted move to normalize rates. Low interest rates became a soothing tonic for US small cap companies which tend to borrow at or near the prime rate. They also have relatively higher equity costs then large cap companies. As prime has inched its way up from 3.25% to 5.25% over the last two years it has not only put the screws to small cap companies in the form of higher interest payments on their floating rate and revolving debt, but it also increased their implied future equity costs. The 2018 tax cut did help small and large cap companies tremendously. This served as an offset while interest rates were starting to cut into their profitability. As interest rates crept higher through 2018 the tax cuts boon to cash flow started to lose ground to the rise in the future cost of capital. A back of the envelop calculations has this at nearly 10%. A 10% rise in equity cost roughly translates in to a 10% discount in stock price. The market in its inevitable way tried to front run this discounting and plunged in late winter. The increased cost of equity capital, driving stock prices lower, is not reflected on income statements, but increased interest cost is. Despite this, the market had over reacted. Uncontrollably interest rates in the rest of the world have remained low and over the last 6 months rates on US Treasuries have been pushed back down to pre-tax cut levels of ~2%. Large cap companies which can afford to float bonds that have coupons with only a modest premium over US Treasuries have in fact seen their cost of capital go back down. Small cap companies, not so much. The prime rate which is offered a 3% over the Feds discount rate of 2.25% has stayed at at 5.25%! Small cap as a group have seen their profitability dinged by higher interest costs, and have under performed large cap companies over the last year. Witness the market cycle in action!

The Federal Reserve, by all appearances, has at last sniffed out this disparity and is expected to cut the discount rate to something more reflective of a slower growing world economy with benign inflation. Despite US small cap companies being somewhat insulated from trade restrictions and tariffs, the cost of capital is fungible everywhere. Capital moves to where it is treated best and lowering interest rates acts like rocket fuel for stock prices. The positive feed back loop of higher stock prices and lower capital costs have been shown to promote economic growth. A move to lower rates should, in theory, act to offset lower profitability and slower growth outlooks. On the other hand, lower rates suggest the dollar will become relatively less attractive in the future, and a less attractive future dollar implies relatively higher future US inflation. Enter the gold bug and this year's 10% rise in the price of gold. The US's Federal Reserve Bank must do what they must to fulfill their primary mandates of full employment and low relative inflation. The reserve banks in the rest of the world have their own concerns. Holding large dollar reserves is not always congruent with that. Russia and China currently being among the largest buyers of gold are case in point. The reasons given are various, but at least some have attributed it to US tariffs and economic sanctions for poor statesmanship. Barring expectations of a worldwide economic collapse many believe higher gold prices equate to inflation expectations. It is more likely that gold prices are reflective of the commodity cycle and the pull of demand by central banks. Broadly speaking inflation in the US should remain low because of its relatively strong economy. Until and unless the rest of the world finds a reason to no longer want dollars the price of gold is most likely a speculative anomaly resulting from the confusion caused by negative real interest rates and the policy driven actions under the preview of other reserve banks.

What I Learned

When I started to learn about stock investments some 40 years ago, I asked my father what his minimum expectations were when he bought a stock for a client's portfolio. He raised his hand with five outstretched fingers as if offering a bid across a trading room floor and said "5% over the yield on 10-year US Treasuries." An economist would say that when offered a risk-free bond yielding x% and a stock priced with an expected return of x+5% he was ambivalent between the two. Given the choice one would then expect when stocks offered less then x+5% he would place marginal portfolio investments (excess cash) in risk free bonds. Risk free bonds are only risk free when held to maturation, and ten years is a long time to be subject to the pushes and pulls of rising and falling interest rates. It is impossible to know for sure what will occur in the future, one can only judge the relative value of one investment over another at a single point in time. My father was subject to annual and quarterly performance reviews, and for that reason alone sometimes he judged it was better to sit on his hands, hold cash and wait for other entry points. I learned later that when one casts aside the short-term performance game, they make better choices. Long term it is neigh impossible to beat the broad markets performance. Those who do are more often just lucky rather than good. The question then becomes not which stock to invest in, but rather how much to put into the markets offering the best relative value.

Investment Ideas

Currently, US small cap and International stocks have under performed and are offered at more attractive long-term prices. US large cap stocks have recently outperformed and are firmly in hold territory. Past performance is no guarantee of future results, and discipline should trump near-term performance. If the Fed does cut rates it should help the ailing investment classes most, but keep in mind that August has statistically offered an opportunity to catch short term down drafts in the stock market. Regardless of what the Fed does this Wednesday there could be an opportunity. If you have money to invest now a good strategy would be to put some in the weaker market segments now and hold some in reserve with a good for 30-day limit order ~5-10% below current prices. Good luck!