Bernanke’s First Test – April 2006

April 27, 2006

Dow Jones Average: 11,383
S & P 500 Index: 1,310


Bernanke’s First Test

Central banks throughout the world have the dual mission of controlling inflation while encouraging economic growth. By setting short term interest rates at certain levels the central bankers hope to balance other factors that influence inflation and economic growth. A sustainable economic growth rate accompanied by minimal inflation is the ultimate goal of economic policymakers.

The central bank of the United States is under new leadership with Ben Bernanke taking over the Chairmanship of the Federal Reserve Bank system, following an eighteen year reign by Alan Greenspan. Investors are wondering how Ben Bernanke perceives the current balance between inflation and economic growth. His decisions over the next few months will indicate whether he is inclined to contain inflation or stimulate economic growth. Bond, stock, currency, and commodity markets around the world could be roiled as investors digest Bernanke’s first important decisions. Adverse market reactions can test the resolve of the most confident, experienced central banker. Bernanke’s first test is likely to come at the next meeting of the Federal Reserve Board in May.

The economy does not respond quickly to changes in interest rates. A shift in Fed policy can take a year or more to show up in economic activity. The lag time between policy change and economic impact makes it difficult to calibrate the proper setting for economic policy. It took a sharp rise in interest rates from the three to seven percent level to slow the economy and break the stock market bubble of 1999-2000. Once the bubble burst and the economy started to slow it was hard to revive economic growth again. The Fed was forced to cut rates dramatically, and hold them at a record low level for an extended period of time in an effort to spur economic activity. Low interest rates and the big tax cuts of 2003 finally propelled the economy, producing some inflationary trends that have created new worries for policy makers. Over the past eighteen months the Fed has expressed its concerns by raising interest rates fifteen straight times by a quarter point each time. For most of the past eighteen months monetary policy has been stimulative even as interest rates have risen, because they started from such a low base of one percent in 2004. With rates now approaching five percent, one could say that the Fed is finally applying some pressure to the economic brake. It will take some time to determine whether more pressure in the form of even higher rates is necessary to reverse inflationary trends.

Participants in the financial markets are reacting to every shred of information on inflation, because the Fed’s interest rate policy will be determined by inflation trends. There is a vigorous debate about the true level of inflation, but most observers think inflation is a growing problem. We agree with those analysts who think that the government understates the inflation rate by excluding home price appreciation and using a rental index to measure housing costs. In addition the government employs a subjective methodology called “hedonic value” which discounts price increases to the extent that consumers get more pleasure or utility from using an improved product. Regardless of how one measures inflation there is no question that it is rising, particularly in areas such as energy, housing, medical, food and education costs. All the basics seem to be shooting up in price. A twenty-five percent rise in oil prices over the past few weeks has put the spotlight on inflation, and on Bernanke’s response at the upcoming Fed meeting in May.

The Federal Reserve Board has typically favored a policy of controlling inflation, even when that strategy inhibits economic growth. Policy makers do not want to let the inflation “genie” out of the bottle, because when accelerating inflation becomes widely expected by consumers and businesses it becomes self-fulfilling. If Bernanke shows a lack of concern about inflation, the bond, stock, and currency markets could be thrown into turmoil. On the other hand if he indicates that interest rates have to go significantly higher to control inflation the markets will pull back as investors move to cash. Investors want to hear that he is concerned about inflation trends, but believes that interest rates near the current level are sufficient to control the threat of increased inflation. While Bernanke may tell the market what it wants to hear, it is likely that he will raise interest rates a bit more than generally expected over the next few months to establish his credentials as an inflation fighter.

Current Strategy

Stock markets around the world have been in a solid upward trend since the bottom was reached in 2002-2003. The leading gainers have been commodity oriented companies such as those engaged in oil and gas production and mining. The suppliers to the commodity companies have benefitted as well. Industries that have been dormant for decades, such as steel and oil service, roared to life in 2004-2005. Small stocks have outperformed large company shares, heavy industry has trumped consumer goods and services. The stock market leadership since 2002 has been the opposite of the 1990’s, when growth companies in the technology, medical, and financial sectors led the way. Many investors have been frustrated by the 2003-2005 run-up in stocks, because their portfolios are still largely in shares of the widely owned companies that are not moving, such as Pfizer, Johnson & Johnson, Walmart, Coke, IBM, Microsoft, and a hundred other similar, big, well known companies.

The question for investors is whether the trend toward economically sensitive, commodity oriented companies is peaking. Every time the Fed increases interest rates it increases the odds that the economy will slow. Investors are ready to take profits and exit the economically sensitive stocks at the first sign of an economic slowdown. On two occasions during the past year investors sold industrial stocks in a panicky fashion, dropping prices by forty percent in a matter of weeks. The stocks rallied back after investors concluded that their fears were premature. We believe that risks are growing for investors in the cyclical, commodity companies. While one may be able to successfully execute a short term trade after a sharp downswing, the probability of making a steady, longer term gain in the industrial/commodity sector is diminishing.

Our equity strategy is eclectic at this time. We favor smaller companies that should be able to grow even if the economy weakens. We are buying some of the big capitalization companies that are out of favor in this market such as AIG, Gannett, Sanofi Aventis, Abbott Labs, Oracle, and 3M. Because we bought these stocks when they were well down from their highs, our clients have already experienced sizable gains in several of the positions. We are also looking at some of the less obvious suppliers to the world wide industrial boom, hoping to catch part of that wave in a prudent fashion.

The bond market has entered a period of high drama. Interest rates on ten year and longer bonds are surging above five percent for the first time in four years. We have been keeping client funds in shorter term instruments such as treasury bills and money market funds, waiting for yields to make this move from one to five percent. We believe that it is time to start putting some of our clients’ funds into 2-5 year bonds, now that rates have reached the five percent area. This may not be the top in rates, because market conditions may not allow Fed Chairman Bernanke to stop at five percent. Under certain scenarios rates may climb over the course of this year to the 5.75- 6 percent range. We do not think that the economy can handle rates above six percent given current debt levels. The best fixed income strategy in our opinion is a phased bond buy starting at the 4.75 percent level and concluding at about 5.75 percent. Even though rates are substantially higher than in recent years, we favor maturities in the relatively short 2-5 year range, because inflation could undermine the value of longer dated bonds.

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