The future of the Fed Funds rate is now one of the most important, if not the most important factor in accessing financial asset values as we enter the 6th year of post crisis investing.
The US, and most of the developed world, have been at or near 0% on short term government lending rates for so long many assets around the world have been 'revalued' versus their historical norms. Real estate, high yield bonds, corporate bonds, short term government bonds, and many stocks now offer' investors historically low yields and therefore lower future total returns.
Below is an excerpt of an article authored by Jon Hilsenrath right after the Fed announcement was released yesterday. Mr. Hilsenrath looks at how a piece of what the FED is saying could affect the valuations of all asset classes.
...the Fed is a little less optimistic about the outlook for economic growth. Officials said the economy's growth potential might be as low as 2.1% in the long-run, the latest in a string of downward revisions made in recent years. That gloomier long-run growth outlook could help explain why the central bank is producing a lower long-run interest rate forecast of 3.75%.
What Mr. Hilsenrath (and the Fed) are saying is a long term structural change to the US economy has occurred. Because of a permanent slowdown in credit growth, demographic trends, and slower global growth there should be a semi-permanent' reduction in long term interest rates. Prior to 2008 the average Fed Funds, or neutral rate, was considered to be around 4.25% - 4.75%. Now the future long term average could be in the mid 3% range (or in my opinion somewhat lower).
This has a positive effect on all asset class prices and valuation multiples, with the following to benefit the most:
Longer Term Municipal Bonds: The combination of lower long term interest rates, a steep yield curve, negative correlation to stocks, and the prospect for higher tax rates over time makes these bonds a good long term addition to a portfolio. Some good ETFs in the space include Power Shares Build America Bonds (NYSE:BAB), Power Shares Insured National Muni Bond (NYSE:PZA), and I-shares National AMT-Free Muni Bond (NYSE:MUB). Investors should take note that BAB' contains taxable municipal bonds, so in general should be bought within an IRA or other tax deferred account.
Emerging Markets: After a tough couple years in absolute and especially relative terms, these stocks now offer attractive valuations and dividend yields. If you simply buy an emerging market stock index you can obtain a dividend yield of close to 3% compared to 1.8% on the SP500. In addition, most emerging markets are insulated from the demographic and growth headwinds plaguing developed countries. The lower our long term rates are, the more attractive emerging assets (higher growing/yielding) become. An investor can obtain cheap diversified access to the space with Vanguard Emerging Stock ETF (NYSE:VWO) or SPDR Emerging Market Small Cap (NYSE:EWX).
Large Cap Dividend Paying US Equities: Although these types of stocks are not cheap on a historical basis, relative to other areas they look attractive. As a group they look to return 6%-6.5% per year over the long term and as long as interest rates remain low that can be a fair return. These companies exhibit less volatility than the market overall which makes that return all the more appealing. A great way to access these companies is through the Vanguard High Dividend Yield ETF (NYSE:VYM). Eric Mancini, CFP is the director of Investment Research for Traphagen Financial Group (www.tfgllc.com).
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