The Fed fog seems to be lifting. Syrian smoke may be clearing, too. That calls for a strategy change.
- The Syria problem has morphed from a military action into a diplomatic initiative. The risk of military action and the unintended consequences from it seem to be diminishing. President Obama and President Putin each had a problem. They decided to make their lemons into lemonade and found a way to accommodate each other. The more time passes and the more negotiations progress, the less likely it is that there will be a US military attack on Syria. However, Syria's internal civil war will continue to rage. The Middle East will remain an incendiary place. The antagonism between Sunni and Shia is not likely to wane. Other Middle Eastern hot spots could flare up. Geopolitical risk premia are high and will remain high, but it seems to us that they have peaked, at least for a while. Meanwhile, oil production shortfalls in Libya, Syria, and other countries are being made up for by increased production in Saudi Arabia. Some think the Saudis are at peak capacity as they stabilize oil markets and obtain revenue used to support their allies in Egypt and elsewhere.
- Markets are adjusting to the fact that Larry Summers has withdrawn his name from consideration as Fed Chairman appointee. Most market agents would prefer that Janet Yellen succeed Ben Bernanke as Fed Chair. Though there are other names being circulated, and this issue will not be resolved until the President makes the announcement, in any case, the clock will run and the issue will be settled. Therefore, the fundamental questions of what the Fed's policy will be and who will make the policy are on a course toward resolution, and so markets are looking forward. It is uncertainty that causes risk premia to rise, and resolution lets them fall. We expect more clarity after this afternoon’s post-meeting press conference with Ben Bernanke.
Whether it revolves around issues in geopolitics, Fed policy, or political appointments, the uncertainty period is the worst. Markets know how to handle good or bad news. The biggest fear of markets is no news. With respect to the Fed, we are moving from no news to resolution, regardless of outcome. That is an improvement for markets.
Ahead of us in Congress remain the sequester fight, the federal budget battle, a continuing resolution, and the ongoing deficit debate. The contest is likely to get ugly and go to the eleventh hour on each item. There will likely be a repeating pattern of temporary resolution alternating with deferral of serious decision-making. That is the nature of our political system, whether we like it or not. There is a sufficient number of congressional suicide bombers who are willing to blow up the majority of the Republican caucus and House of Representatives in order to contest funding for ObamaCare. This is creating a problem for the leadership of the House and may ultimately result in a change of Speaker if John Boehner cannot control his coalition. Whether that issue will be resolved or not remains to be seen.
Deficit
One thing we know about the federal deficit is that it peaked at $1.4 trillion per year run rate. It has been shrinking ever since. The current estimate has the deficit run rate at about $400 billion by the end of the year. The deficit has shrunk by about $1 trillion while political consternation has continued to simmer.
The shrinking deficit and the structure of net new issuance of Treasury debt mean that the Fed can easily taper for the next year. It can bring its policy to nearly neutral. In so doing it will still assist the shrinking deficit by further reducing financial pressure. The United States can easily finance 3% of its GDP through the sale of US Treasury obligations to offshore entities. The global structural demand for Treasury debt exceeds the newly created supply, and that will allow the Fed to be neutral.
We can visualize the situation a year from now. The US deficit is in the neighborhood of $300 to $400 billion or even smaller. The Fed has gone back to a neutral position. It has a huge balance sheet, approximately $4 trillion in size. It is managing that balance sheet in a gradual roll-off without any additional pressure on interest rates.
Interest Rates
That is a scenario in which, a year from now, the short-term interest rate remains very close to zero while longer-term interest rates will reflect the economic situation at that time. We think the economic outcome will be slow growth (approximately 2%) and low inflation (somewhere between 1% and 2%, depending on which index is used to measure it). Thus, current interest rates in the Treasury market are very much in line with what you would expect them to be in one year.
With respect to tax-free interest rates, the current yields are exceptionally high. We would characterize them as a gift to investors who are willing to look out into the future and calculate the value of a tax-free cash flow generated by a high-grade tax-free bond.
As far as the stock market is concerned, the peak of urgency and risk was reached in August. As readers and clients know, we did some selling and raised some cash. As the Syria crisis has eased, the Fed outcome has become clearer, and the deficit numbers have continued to shrink, we have been redeploying that cash.
At this point we are nearly fully invested. We believe the stock market will end the year higher than its present level. We see the outlook for slow growth and low inflation as being very conducive to profitable stock market investing using exchange-traded funds.
David R. Kotok, Chairman and Chief Investment Officer