Anticipating Changes in the Economic Environment: aka Reading a Crystal Ball | Moneta

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Achieving positive investment portfolio returns would be much easier if there were a crystal ball available. Knowing where the interest rates will be next year or buying into the market at the bottom and exactly before a steady upturn would not be just a fairytale. With this kind of magic on hand, an investment strategy would not be necessary.

In the real world, however, money managers and financial advisors do not have such paraphernalia, so they must rely on historical data and conventional wisdom. Monetary policy, fiscal policy—and investor sentiment—direct the variation on the return curve.

Monetary Policy

The monetary policy of the Federal Reserve is determined by the Board of Governors and the Federal Open Market Committee. Its guidance and forecast of interest rates is a two-edged swordit may instill fear in bondholders and shareholders or spark anticipation. Fixed income vehicles, like long-term bonds and preferred stock, are affected by changes in interest rates. In times of rising rates, history suggests that the best fixed income strategy is short-term investments.

It is a little more difficult, perhaps, to see that equity investments are also affected by changes in rates. A corporation’s net income is directly influenced by the interest rate paid on debt used to fund expansion and investment. Higher interest payments reduce the excess cash on the balance sheet used to pay shareholder dividends. Conventional wisdom holds that the share price of financial stocks, and stocks of utilities and cyclical companies, move inversely to interest rates. In times of rising rates, history suggests that the best strategy for equities is to limit investments in firms whose cost of funds or dividend rate is sensitive to interest rate changes.

Fiscal Policy

The fiscal policy of the Federal government impacts security prices through taxation and expenditures. Taxation reduces the net income of corporations as well as the disposable income of individuals. Lower income translates into lower demand for goods and services. When the Federal government finances expenditures by issuing debt securities, these securities compete with all other securities (stocks and corporate bonds). In times of higher taxes and higher federal deficits, history suggests that stock prices will fall.

Investor Sentiment

Investor sentiment and consumer confidence impacts all sectors of the market. An investor’s confidence in the overall economic environment and his or her personal financial environment regulates personal spending. The expectation of good news has a trickle affect:  first, consumer confidence increasesthen consumer spending increasesand, finally, prices increase. Investor confidence rises after security prices have risen. But even so, historical data discourages establishing an investment strategy on consumer confidence levels.

What’s the best strategy?

An investment strategy based on taking advantage of changes in the economic landscape requires portfolio movements before changes occur. This is where that crystal ball would really come in handy! But since it is unavailable—and history gives us plenty of data against trying to time the market—the best investment strategy is one that avoids any kind of magical thinking: determine an appropriate asset allocation and stick to it. Leave the magic where it belongs. In fairytales.