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wealth management MONITOR Volume 3 Edition 4 | April 29, 2011 economic theme: Monetary Policy: “Who do you believe, me or your eyes?” The quote, “Who do you believe, me or your eyes?” is attributed to the comedian Groucho Marx. We are not familiar with what context Groucho used the phrase. So, you might ask, what is the connection between the quote and monetary policy? Well, it may qualify as a Bikram (the Yoga teacher) stretch, but Federal Reserve officials seem to have turned a blind eye to reality when it comes to inflation. That’s because the Fed focuses on core inflation which excludes food and energy. As anyone who owns a car can attest, inflation is a reality at the pump. The Fed’s narrow focus has important monetary policy implications because, James nesci alan D. Segars if the spike in oil and other commodity prices is not “transitory” as Fed Senior Vice President Vice President Chairman Bernanke suggested in his recent press conference, then the Chief Wealth Management Officer Investment Management Officer Fed will likely fall behind the curve in combating possible secondary We believe the decline in corporate spreads (corporate yields less inflation effects. With this risk as a backdrop, let’s examine the likely Treasury yields), which is bullish for risky asset prices, will be halted. Bond course of monetary policy based on the Fed’s core definition of inflation. yields could be biased upwards as major support for escalating Treasury The Federal Reserve has two mandates affecting policy decisions: supply is removed; inflationary expectations rise; and foreign central 1) inflation; and 2) full employment. Conveniently, we can forecast the banks, such as China, continue dollar diversification efforts. path of monetary policy based on our expectations of core CPI and the On the subject of inflationary expectations, the increase in oil and unemployment rate. When we went through this exercise in mid-2010, gasoline prices has exceeded our targets and may be more persistent as our model suggested that the Fed funds rate should be a negative 2% well. At a recent $3.88 average price per gallon, petrol prices have based on an unemployment rate of 9.6% and a year-over-year core CPI outstripped the jump in oil. This may be primarily due to two factors: gain of 1%. This analysis suggested to us (rightly so) that the Fed would 1) increased purchases of higher-priced foreign oil by US refineries; and not tighten policy until late 2011 or early 2012, especially as the funds 2) rising refinery margins reflecting increased market uncertainty. Given rate forecast would have to climb out of negative territory first. Our Middle East/North Africa conflicts and geopolitical tensions, these updated forecast is based on expectations of an 8% unemployment rate factors could be in play for a while. Adding fuel to the fire, Russia, the and a core CPI gain of 1.5%. Clearly, labor market conditions have world’s largest oil producer, increased petrol export prices effective improved, and the inflation rate is accelerating. By the end of this year, May 1 to combat internal oil shortages. the funds rate should be at about 0.25% versus the Fed’s current target of 0.0%-0.25%. Consequently, Fed tightening could be a reality by the Bottom line, the spike in energy and other commodity prices could be first quarter of 2012. Fed funds options and futures data indicate that the more than transitory and could produce secondary inflation effects most likely funds rate will be 0.0% through March 2012. Thus, the timing across a broader spectrum of consumer goods and services, ultimately of tightening could be somewhat of a surprise to the market. The influencing wage rates. Assuming economic growth is slowed but not accompanying chart shows the fit between forecast results and actual aborted by this event, the Fed would be forced to acknowledge a Fed funds in our model. greater inflation threat and act accordingly with eyes wide open. Given that the Fed has employed unconventional strategies, such as asset purchases, during this easing phase, the tightening phase or exit strategy will also have unconventional components. Bernanke suggested in the press conference that the initial move could be not reinvesting securities repayments. Other possibilities include selling securities from the Fed’s portfolio; increasing the rate of interest paid to banks on reserves; and traditional hiking of the Fed funds rate. Bernanke also confirmed an end to QE2 on June 30. This so-called Quantitative Easing program absorbed about 70% of Treasury bond issuance since late last year. The program has been successful in elevating risky asset (stocks, commodities, etc.) prices and keeping bond yields stable. While its demise appears certain, the impact on the capital markets is less so. ASSET ALLOCATION RECOMMENDATION On April 13 we adapted a neutral weighting for domestic and international equities, which were previously 3% overweight versus the Provident Target Asset Allocation Benchmark. As indicated above, the liquidity-induced positive environment for risky assets will likely be muted by monetary constraints compounded by fiscal measures. Corporate bond spreads, typically bullish for risky assets, have probably bottomed in our opinion. Upside earnings surprises have recently taken broader market indexes to multi-year highs. Our valuation price targets have been met, and we have no reason to raise them. The 6% in cash raised from the equity reduction was used to increase exposure to short-term credit (CSJ), domestic real return bonds (IPE) and a new asset class, REITs (VNQ). We remain underweight domestic bonds and overweight alternative investments. MARKET CLOSES S&P 500 Index: 1,363.61 Dow Jones Industrial Average: 12,810.5 10-Year Treasury Yield: 3.29% (973) 822-0019 • www.ProvidentNJ.com This commentary has been prepared by the Wealth Management Group of The Provident Bank for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or a solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security or pursuing a particular investment strategy. Any opinions expressed herein reflect our best judgment as of the date of this publication and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and may involve general market risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. The opinions, views, and information expressed in this commentary regarding portfolio holdings are subject to change without notice. The information provided regarding portfolio holdings is not a recommendation to buy or sell any security. Portfolio holdings are fluid and are subject to change based on market conditions and other factors. Investors should consider their individual circumstances, investment goals, and risk tolerance prior to making an investment decision. THE PROVIDENT BANK WEALTH MANAGEMENT GROUP PRODUCTS AND SERVICES: NOT FDIC INSURED • MAY GO DOWN IN VALUE • NOT FINANCIAL INSTITUTION GUARANTEED • NOT A DEPOSIT • NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY
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