FEDweek

TSP Had Roaring Start in 2018

The equity funds had an aggressive start to 2018. For January, the C Fund was up 7.5%, the S Fund is up 5.3%, and the I Fund is up 6.5%.

Meanwhile, the G Fund was up a fraction of a percent and the F Fund had fallen about 1% on the back of rising interest rates.

Keeping a balanced TSP helps reduce the risks associated with any specific fund. Equity funds give the best long-term growth potential, while bond funds act as shock absorbers for a portfolio to help offset the impact of market declines and volatility.

New Fed Chair Confirmed

The Senate confirmed Jerome Powell last week as the next Fed Chairman, and he will begin his 4-year tenure on February 3rd. Since he is widely viewed as a safe pick that will continue current monetary policy, he received a broad bipartisan Senate vote of 84-13, which is a much more positive vote than his recent predecessors.

The Federal Open Market Committee (FOMC) of the Federal Reserve sets interest rates that ultimately affect the borrowing costs of both consumers and businesses. Rapidly rising rates can hurt bond prices and put a brake on the economy. On the other hand, keeping interest rates too low for too long is feared to lead to higher inflation.

All U.S. recessions in modern history have been preceded by rising Federal Reserve interest rates.

Currently, the FOMC is raising the base rate by 0.25% three times per year and expects to continue that trend into 2018. The market, however, is pricing in slower rate increases than the FOMC has projected:

Source: J.P. Morgan Guide to the Markets Q1 2018

Inflation data may be the deciding factor. If inflation remains low, the FOMC may delay some of their rate increases. If inflation picks up, they are more likely to maintain their current set of rate increases or even accelerate them.

In addition, the Federal Reserve is slowly winding down its massive balance sheet. They are not re-investing their interest and proceeds from their holdings. This is a conservative way to reduce the magnitude of the balance sheet without giving any negative shocks to the stock market, since it is all being done very gradually.

The European Central Bank plans to wind down its purchases in 2018. The net result is that the combination of U.S. Federal Reserve and European Central Bank net purchases is expected to turn negative by mid-2018:

Source: Barron’s

Many analysts view this ending of western central bank buying as a headwind against continued stock price gains. It is a quantitative tightening; a reversal of years of quantitative easing that may have benefitted the stock market.

But the good news is that several recession indicators, like the ISM purchasing managers index, are showing that the U.S. economy is strong and that a recession is seemingly not on the short-term horizon. Therefore, many analysts believe that the economy can withstand this period of tightening. The European Union is also enjoying declining unemployment rates; a positive sign for continued economic growth.

Stock valuations remain a concern in the United States. Based on most metrics, the U.S. stock market is the second-highest it has ever been valued relative to fundamentals like earnings or book value. And interest rates (red) tend to be inversely correlated with high stock valuations (blue):

Source: Professor Robert Shiller’s Online Data

As interest rates rise, it may put pressure on stock prices. But with inflation nowhere in sight yet, and the Federal Reserve currently employing a policy of very gradual rate increases, we may remain in a period of low interest rates for a while.

Lyn Alden is a financial writer and an engineer, and holds a bachelor’s in engineering and a master’s in engineering management, with a focus on financial modeling and resource management. She specializes in analyzing and presenting financial data. Her investment work can be found on LynAlden.com.