For the month of September, the G Fund rose by a fraction of a percent while the F Fund fell by nearly one percent. The C Fund went up a solid 2%. The S Fund rose a tremendous 4%, which is great for a one-month period and helped undo some of the underperformance the fund has had lately compared to the larger capitalization C Fund. The I Fund climbed 2.5%, which is another strong month for that as well.
The biggest news in September for the stock market was that the Trump Administration released an outline for a broad tax cut, and the Federal Reserve released new information about its upcoming monetary policy plans.
I wrote an article earlier this year about how corporate tax cuts are somewhat limited in how much they can increase corporate earnings and the stock market. In short, most companies already pay an effective tax rate well below the official tax rate, and most of the potential profitability gains from lower tax rates were already factored in by the stock market shortly after Trump’s election. It’s not surprising, therefore, that we saw solid gains this month when tax reform plans were released, but nothing as big as what we saw in November 2016 when the stock market surged.
I plan to write future articles on the topic as a clearer picture emerges of what form the tax overhaul might take. Consumer tax cuts can also impact the stock market by increasing consumer disposable income, but at the cost of most likely increasing the federal debt and deficit. By how much remains uncertain, because much could change between this outline and more detailed bills.
So, this week, the more tangible news to focus on is that the Federal Reserve plans to start unwinding its $4.5 trillion balance sheet.
A Fed Bubble?
One of the most novel and unprecedented actions that was taken to combat the 2008 financial crisis was that the Federal Reserve started buying massive amounts of treasuries and mortgage-backed securities, in what was called Quantitative Easing.
This increased the Fed’s balance sheet from under $1 trillion to about $4.5 trillion over a six year period:
The full ramifications of this are unknown and widely debated, and there is no “control group” to see how the economy would have performed without this major intervention. It helped keep interest rates down, which has been arguably the single biggest driving factor for today’s high stock valuations.
The cyclically-adjusted price-to-earnings ratio of the S&P 500 is over 30, which is higher than any time other than 1929 and the Dotcom Bubble. Other valuation metrics like the ratio of stock market capitalization to GDP, and average corporate book value multiples, are also extremely high.
This has led many economics and market commenters to argue that an unwinding of the Fed balance sheet could shake the markets, and that these high valuations are largely based on extremely low interest rates.
That’s why the Fed announced in September that they plan to start unwinding their balance sheet very, very slowly. They won’t sell any assets. All this time, as certain securities expired, they have reinvested that money into replacement securities, which is why the balance sheet has stayed perfectly flat.
Starting now, the Federal Reserve will only reinvest some of the money from expiring securities. They will begin shrinking their balance sheet by $10 billion per month by allowing a fraction of their securities to expire without reinvesting the money, and this figure is expected to rise to $50 billion a month in 2018. At the forecasted rate, the balance sheet would be down to about $3 trillion in 2020 from its current height of $4.5 trillion.
BlackRock, the company that manages most of the TSP investment funds, has predicted that this could result in the 10-year US treasury to hit a 2.5% interest rate by the end of 2017 and up to 3% in 2018, as interest rates trickle up. Currently this figure is about 2.3%. Since the G Fund’s interest rate closely follows that figure, it gives some insight into potentially improving G Fund returns over the coming year.
But as to how this may affect the stock market is unknown. Historically, rising interest rates are terrible for stock market returns, but it’s widely expected by the Federal Reserve, and many investors and companies, that interest rates will remain low for a long time to come, and only inch up slowly.
Janet Yellen, the Fed chairwoman, also admitted this month that she doesn’t know why inflation is so low. The Federal Reserve expected inflation to rise this year with increased unemployment and continued low interest rates, but that never happened. The Fed’s target ideal inflation rate is a little bit above 2%, but it currently is about 1.6%.