What we think now….Investing, Brexit and the Federal Reserve Highway

flat roadThink of interest rates like a highway and an exit ramp….except this exit ramp is unlike any other you have ever seen.

Since 2008, short-term interest rates have been near zero and there has been no exit ramp in sight. The short-term interest freeway has been as flat as can be, like driving through the cornfields of Iowa or Nebraska.

In December, the Federal Reserve finally added an exit ramp, but it was a very slight upward slope, with a .25% increase in short-term interest rates. Their projections were for a very gradual upwards slant in the exit ramp, over the next two years, or two miles in my highway exit analogy.

Over the last six months, the slope and length of this exit ramp has continued to change. The Federal Reserve provides occasional interest rate projections. Their projected slope is now expected to ascend even more gradually and has lengthened. To use my road analogy, the highway ramp has been extended from two to three miles. It is a long road with a very mild incline. From December to last week, their average forecast for the end of 2017 has gone from a range of 2.00 – 2.50% to 1.625%. By the end of 2018, they project short term rates of 2.375%, versus a median forecast of 3.3% in December, 2015.

As a result of the Brexit vote last night, it is very unlikely that the US Federal Reserve will increase interest rates in the next few months. The Brexit action likely will keep interest rates lower for longer than their predictions published just last week, cited in the paragraph above.

So if the economic data continues to show improvements, short-term interest rates will rise, but very gradually and over a period of many years.

What are the implications of these interest rate changes to you?Exit ramp

The Federal Reserve has been reluctant to raise interest rates during 2016 due to various factors, including slower growth in employment and corporate profits, as well as overseas concerns. We agree with Fed Chair Yellen, that we do not expect a recession in the US this year. We think slow growth will continue to be the economic story, maybe for a while.

We view holding fixed income investments, like high grade bonds, CDs and municipal bonds, as the safe foundation to your investment portfolio. For this foundation, we do not recommend securities that may cause unnecessary risk of your principal. We do not think it makes sense to “reach for higher yields” by buying low quality “junk bonds” or high yielding preferred stocks. These investments have much greater risk for loss of principal to get a few extra percentage points of interest or dividend income. It is not worth it to reach for higher yield, if the risk is far greater.

What are our initial thoughts about the Brexit vote, and its implications?

The Remain outcome was widely predicted by pollsters and financial forecasters, rather than the UK leaving the European Union. This again reflects the great difficulty of predicting the future and relying on this type of “guidance” for financial strategy. Pollsters have been consistently wrong thuCluH8NSWEAAV-jHs far in 2016.

In the long-term, corporate profits and earnings, as well as valuation measures, drives stock prices. The Brexit action will have localized impact in the UK, but we think after the initial surprise has been digested, the long-term impact to companies and their earnings will be less than the reaction seems this morning.

In terms of fixed income investments, this is again a reminder of the importance of good credit quality. Financial markets in Spain and Italy are particularly weak today, as they are considered weaker EU economies. We will continue to emphasize investing in strong, high quality fixed income debt.

What do we recommend going forward?

For fixed income investments, we continue to recommend holding a ladder of solid, high quality fixed income securities, with maturities of 3-8 years, depending on your specific situation. We would not place bets on specific maturities, as we believe in diversifying by investments, as well as by holding various years of maturities. If you were to use a bond fund, be sure that it is holding high quality bonds and the maturities are not long-term.

Consider the downside risk of someone investing in a preferred stock that yields 5.5% versus a good quality bond which pays 3.5%. Five years from now, let’s assume the bond is sold at maturity. You received a little less interest each year, but your original principal was paid back in full. Your objectives were met. During the same time period, if that preferred stock has declined by 10%, which is a very realistic possibility, reaching for higher yield would have resulted in a loss of money. That is not a risk we recommend for our clients.

If you want to take additional risk, we would review your allocation to stocks or increase your allocation to certain asset classes with higher expected returns (and additional volatility/risk).

If your mortgage rate is greater than 4%, you should consider refinancing, as mortgage rates are very low. As a result of the Brexit vote, US interest rates may go even lower, so refinance considerations should be more immediate. If you have a mortgage of longer than 10 years, we would generally not recommend pre-paying the mortgage.

For the stock market, we do not have a crystal ball. However, we continue to be optimistic that investors will be rewarded for their patience and owning a globally diversified portfolio. Although International markets have underperformed US markets in recent years, International and Emerging markets are statistically much cheaper than US stock markets and got even cheaper due to the Brexit vote, based on a number of valuation measures. Thus, we remain confident in our long-term investment philosophy, particularly the importance of broad global diversification, versus just owning US large company stocks.

 

Conclusion:

Investing can be compared to driving.

You need to take an appropriate amount of risk to get to your intended destination and to meet your financial objectives.

While driving, you should take the necessary precautions, such as wearing a seat belt.

In investing, you should do the appropriate planning to determine an investment allocation of stocks and fixed income investments that you are comfortable with, which allow you to sleep well at night and be able to reach your goals.

We can assist you along this financial highway.

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