Rate Hikes, Inflation and What You Earn
Thursday, March 16, 2017

Yesterday’s interest rate hike by the Federal Open Market Committee was the third in a 15-month period. More notably, it was just the third rate hike since the financial crisis. The rate hike represents an another step in the (so far) very gradual removal of stimulus. At current levels, rates remain low on a historical basis and allow the FOMC plenty of room to continue raising rates if economic growth continues. In saying this, I should add that I remain on the “I believe them when I see them” bandwagon. In other words, to paraphrase Fed chair Janet Yellen, my view is dependent on future Fed statements.

By raising rates, the Federal Reserve is trying to get ahead of potential future inflation. There is a lagged effect to rate hikes. Furthermore, unlike drug trials, we can’t run a control group study. We’ll never know how the economy would have actually evolved if the Fed were more aggressive or dovish with rate hikes. Despite all of the research and economic theories, interest rate policy has been and will continue to be trial and error. There are simply too many external factors to say with absolute certainty what the best decision is at any given point in time.

For us as investors, the rate hike is a double-edged sword. It creates the opportunities for higher interest rates on our cash savings. This will be welcome, as BankRate.com listed the national average as a still-paltry 0.11% as of Tuesday morning. (AAII members can earn 1.01% through our affinity program with Discover Bank.) Bond yields are also rising, with the 10-year Treasury note recently hitting a two-year high. This is good for those buying bonds. To the extent that interest rates are being driven upward by a strengthening economy, stocks could be helped. The downsides are lower prices on currently held bonds (yields and prices are inversely related) and a tapping on the economic growth brakes. Utility and telecom stocks could also see selling pressure as the interest rates on bonds begin to look more attractive. Corporate borrowing (and personal borrowing) will become more expensive.

As far as inflation is concerned, we’ll have to see if this week’s rate hike keeps it within acceptable ranges or not. Some inflation is good, as long as it doesn’t get too high. There are gray areas between keeping inflation under control, not being aggressive enough in controlling it and being overly aggressive. We may not know where the borders actually are, but we sure notice when they’ve been crossed.

Inflation not only impacts what we pay, but the impact that returns on our investments have on our ability to buy goods and services in the future (or, simply, purchasing power.)

We commonly think of returns in absolute measures because it’s easy to so. Take the S&P 500 index for instance. The large-cap index had a nominal 12-month return of 18.3% at the end of Wednesday. A person can look at a chart and see this change. The number does not tell you how much more purchasing power you have now, however.

To do that, you need to know what the rate of inflation was: Over the last 12 months, the consumer price index (CPI) rose 2.7%. Since you are dealing with returns that grow or compound, you need to use the formula [(1 + Asset Return) / (1 + Inflation Rate)] - 1 = Real Return. With this, you get a real return for the S&P 500 of 15.2% [1.183 / 1.027) - 1].

The argument for holding stocks over the long term is that they are the best asset for expanding your purchasing power over the long term. Real estate investment trusts (REITs) and even longer-dated bonds do this as well. Gold seems to depend on the period measured; I’ve seen arguments for and against the precious metal’s ability to thwart inflation’s erosive properties. Keep in mind the phrase “long term”: Over shorter periods, all the aforementioned assets can realize negative real returns (and even negative nominal returns).

Not all of the asset side of personal finance is about achieving positive real returns, however. Maintaining adequate savings in cash equivalents (savings accounts, CDs, money market funds, etc.) covers short-term expenses and allows you to let your stocks and equity funds time to continue appreciating in value. Bonds provide a ballast against volatile market conditions and throw off interest income. Dividends also throw off income, giving you cash to reinvest or fund withdrawals, if you’re retired. Attractively valued stocks with good fundamentals offer long-term price appreciation far in excess of the rate of inflation over the long term.

I realize that the drumbeat of long-term investing and diversification can sound repetitive at times. Yet, when pundits and strategists are being asked “what to do now following the Fed’s latest meeting statement and Yellen’s press conference,” focusing back on the long-term drumbeat is often the best move.

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Highlights from this month's AAII Journal

AAII Model Portfolio Update

No changes were made to either the Model Shadow Stock or the Model Fund portfolios.

Three stocks in the actual Model Shadow Stock Portfolio meet the initial selection criteria: Townsquare Media Inc. (TSQ), Salem Media Group (SALM) and Seneca Foods (SENEA). L S Starrett (SCX) remains on earnings probation. PCM Inc. (PCMI) turned in the the strongest performance among the Shadow Stocks in February, gaining 19.8%, and is now approaching the value limit for the portfolio.

The Model Shadow Stock Portfolio was basically flat for February, ticking downward by 0.05% as small-cap value lagged other strategies for the month. Since its inception in 1993, the Model Shadow Stock Portfolio has a compound annual average return of 15.8% versus the Vanguard 500 Index fund (VFINX), which has gained 9.2% a year, on average, over the same period.

The Model Fund Portfolio gained 2.7% in February, compared to a 3.96% return for the SPDR S&P 500 ETF (SPY). Since its inception in June 2003, the Model Fund Portfolio has a compounded annual average return of 9.0%, while the SPDR S&P 500 ETF has an 8.8% average annual return over the same period.

The Week Ahead

Only nine members of the S&P 500 are scheduled to report. Included in this group is Dow Jones industrial component Nike Inc. (NKE) on Tuesday.

The week’s first economic reports will be February existing home sales, which will be released on Wednesday. Thursday will feature February new home sales. February durable goods orders and the March purchasing managers’ index (PMI) composite flash will be released on Friday.

Seven Federal Reserve officials will make public appearances: Chicago president Charles Evans on Monday and Friday; Kansas City president Esther George and Cleveland president Loretta Mester on Tuesday; chair Janet Yellen and Minneapolis president Neel Kashkari on Thursday; and St. Louis president James Bullard and San Francisco president John Williams on Friday.

The Treasury Department will auction $11 billion of 10-year Treasury inflation protected securities (TIPS) on Thursday.

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AAII Sentiment Survey

Pessimism among individual investors fell from last week’s AAII Sentiment Survey, while bullish and neutral sentiment rose.

Bullish sentiment, expectations that stock prices will rise over the next six months, rose 1.2 percentage points, to 31.2%. Despite the slight increase, bullish sentiment remains below its historical average of 38.5% for the third week in a row.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, rose 6.6 percentage points to 30.1%, bouncing back from a three-month low last week.

Bearish sentiment, expectations that stock prices will fall over the next six months, slid 7.8 percentage points to 38.7%. While a significant decline from last week, pessimism remains above its historical average for the fifth week in a row.

This week was the much-anticipated Federal Reserve announcement on whether interest rates would be held steady or raised. At the end of its two-day meeting, the Federal Reserve raised its target range on overnight rates by one quarter of a percentage point, bringing the range to 0.75% to 1.0%. The bank also projected that it will increase interest rates twice more this year. For investors who were concerned that there would be more aggressive increases throughout 2017, this came as good news.

The central bank’s median projection for real gross domestic product during 2017 is 2.1%, unchanged from its December 2016 projection. Its median 2017 personal consumption expenditures (PCE) inflation expectation is 1.9% while the median inflation expectation is 4.5%; both figures are also unchanged from the December projection.

An article from The Wall Street Journal mentioned that this year’s rally indicates that investors see the economy growing more rapidly than the Fed does, which could push up growth and inflation and push down unemployment more than the central banks believe.

This week’s special question asked AAII members how fourth-quarter corporate earnings results have impacted their outlook for stock prices. Forty-three percent of investors said that it has no to little impact on their outlook for stock prices, or that they were focused on other economic factors rather than corporate earnings. Thirty-one percent of respondents said that recent earnings have given them a more bullish outlook on the stock market, 5.5% had a neutral outlook and 20% had a bearish outlook.

Here is a sampling of the responses:

  • "I don’t follow consensus earnings opinions. If a company is making money I stick with them.”
  • "Although corporate earnings are improving, I think GOP control of the White House and Congress will lead to ruinous fiscal policies and another Great Recession.”
  • "A number of earnings conference calls discussed how the last few weeks of the quarter were showing stronger growth. More positive now than previously.”
  • "Stocks are still expensive but earnings growth is helping justify higher prices.”
  • "Good earnings = higher stock prices.”

This week’s Sentiment Survey results:

Bullish: 31.2%, up 1.2 points
Neutral: 30.1%, up 6.6 points
Bearish: 38.7%, down 7.8 points

Historical averages:

Bullish: 38.5%
Neutral: 31.0%
Bearish: 30.5%
Take the Sentiment Survey.

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