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Market Thoughts 9.14.2012

Eric Freedman
CAPTRUST Chief Investment Officer

Global capital markets remain volatile following two significant announcements from the U.S. Federal Reserve and the European Central Bank (ECB) in the past seven days. Both announcements underscore each institutions’ intent to offset some of the world economy’s challenges. Consistent with past communiqués, CAPTRUST sees the current investment environment continually dominated by policymakers as the world economy remains in adjustment mode after the 2008-09 Financial Crisis. While central bank policies can provide short-term relief and lift asset prices, their longer-term implications remain unknown. We continue to advise Clients to rely on a variety of asset class exposure to navigate the potential for both upside to riskier asset classes along with downside should weakening growth supplant policymaker efforts.

To explain the economic dynamic between the public and private sectors, we have often used a relay race as an analogy. In a relay race, runners carry the baton for their leg of the race before swiftly handing it off to a teammate who has (hopefully) accelerated to a similar speed when the exchange occurs to ensure a smooth transition. Historically, the public and private sectors have passed the proverbial growth baton between one another in an attempt to maintain as “smooth” an economic transition as possible. The public sector, represented by central banks, have historically tried to “pace” the private sector in times of economic expansion by increasing interest rates and selling securities in the open market to slow inflation resulting from the private sector running faster than it should. 
Similarly, when the private market runner is fatigued and demand saps, central banks will attempt to pick up the growth baton through a variety of measures such as lowering interest rates and asset purchases. Central bankers hope that such actions will spur lending and kickstart economic growth. Yesterday’s Federal Reserve press release and news conference indicate that, despite over five years of accommodative policies, the private sector remains unable to take the proverbial growth baton. Chairman Ben Bernanke’s comment yesterday that the employment situation “remains a grave concern” provides insight that the Fed is worried that a sticky unemployment rate and ongoing housing market malaise could further delay the economy’s rehabilitation.
But for how long?
Based on yesterday’s Federal Reserve’s statements, their commitment is open-ended. The most impactful news event was the commitment to buy $40 billion of mortgage-backed bonds in the open market every month until the labor market improves; the lack of a defined timetable marks a significant departure from prior accommodation rounds. The Fed also committed to continue its Operation Twist program where the central bank sells short-term bonds to finance purchases of longer-term bonds in an effort to encourage lending; this program is set to expire in December.  Further, while the Fed had stated after past press releases that they were willing to keep short- term interest rates low through 2014, the most recent update indicates that they see low rates until at least mid-2015. Bernanke indicated that his goal is to help push the economy in the right direction, and while he did not use our relay race analogy, he is clearly trying to get the private market runner in a position to carry the baton on her own. However, as Bernanke will readily admit, central bank action alone will not produce sustainable growth.  
Europe faces like issues, although they have the added complexity of one currency connecting disparate, decentralized sovereign nations. Further, their central bank does not have the “maximize employment” mandate; its focus is singularly on price stability. With price levels above the ECB’s comfort zone, the central bank has been loath to provide easy money policies despite anemic growth in northern Europe and recessionary conditions throughout southern European countries. However, last week ECB president Mario Draghi outlined the Outright Monetary Transaction program in response to the potential for “renewed intensification of financial market tensions.” This program would require countries facing financial difficulty and pressure in capital markets to submit to stringent fiscal reform in exchange for support from the ECB through purchasing said countries’ bonds in the open market on a reportedly unlimited basis. Financial markets cheered the ECB’s open-ended commitment similar to the U.S. market’s reaction to the Fed’s stance.
While we understand financial markets’ early reactions, we encourage investors to temper their enthusiasm and remain balanced with their expectations. We see the Fed and ECB’s actions as critical steps in providing some underlying help and clarity, yet the long-term implications of such actions, including potential inflation, currency debasement, and other unintended consequences, drive us to promote high quality and a global portfolio orientation across asset classes. We will continue to communicate our views in what will likely remain a fluid capital market environment. If I or any of my teammates can help answer your questions, please do not hesitate to let us know. 
The information provided in this article is for educational purposes and should not be construed as individualized investment advice. This is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. CAPTRUST Financial Advisors does not render legal, accounting, or tax advice. Clients should consult their tax professional or legal counsel for such advice. 

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