March 25, 2014

U.S. and EU Team Up on Russia

After a series of moves that proved far more effective, but were almost as complicated as the Acme Corporation strategies Wile E. Coyote employed in pursuit of the roadrunner, Russia dropped an anvil on Ukraine and annexed Crimea. In response, Ukraine's acting Prime Minister Arseniy Yatsenyuk signed a political association agreement with the European Union (EU), and the United States slapped sanctions on some of Russia's President Vladimir Putin's wealthy allies and Bank Rossiya.

The EU also took action although the BBC reported Russia's foreign ministry called the European Council's decision to impose sanctions "regrettable" and "detached from reality." European and Russian economies are interdependent. Twenty-five percent of the EU's gas comes from Russia, and more than one-half of Russia's budget is derived from oil and gas sold to the EU. In addition, experts cited by the BBC indicated sanctions on Bank Rossiya could tie up monetary transactions in EU banks and potentially affect individual European countries' business dealings with Russia if economic sanctions are implemented.

Economists cited by The New York Times said, "The uncertainty that now hangs over nearly every profitable enterprise in Russia is what poses the gravest threat to the country's long-term prosperity, rather than any immediate consequence of the specific sanctions." While many of Putin's allies seemed relatively unaffected by the sanctions, at least one has experienced consequences. Reuters reported Russian billionaire Gennady Timchenko was forced to sell his ownership stake of almost 50 percent in a global commodities trading firm after sanctions against him disrupted the company's operations.

Russian markets have been unsettled by recent events. Consumers and businesses already have been stung by interest rates which are very high by western standards and may move even higher. Rating agencies, like Fitch and Standard & Poor's, have warned they will downgrade Russia's credit rating. Russian consumers have been thwarted as both Visa and Mastercard have stopped doing business with Russian people or companies that have been targeted by sanctions.

U.S. stock markets remained relatively blasé about events overseas but were alarmed by Federal Reserve Chairman Janet Yellen's comments during her first quarterly press conference. She suggested the Fed might begin tightening interest rates in 2015, just a few months after tapering ends.

What's Next for the U.S. Stock Market

Some worry the U.S. stock market, like a first time marathoner a few miles from the finish, may be getting a little wobbly. There is no denying the Standard & Poor's 500 Index has had a good run. It has gained about 172 percent since its low following the financial crisis, and its earnings have grown by 121 percent since 2008, according to Barron's. Of course, that growth has been supported by extraordinary measures including very low interest rates and multiple rounds of quantitative easing.

Low interest rates have meant businesses could borrow money relatively cheaply. Barron's pointed out lower borrowing costs were reflected in bond spreads - the difference between the current yield on one type of bonds (for example, high-yield bonds, investment-grade bonds, or government bonds) and that of other types of bonds with similar maturities. The differences in yield between higher risk and lower risk bonds are a lot smaller than they once were. According to Barron's, from late 2008 through early 2014, the yield on high-yield bonds and comparable Treasury bonds has narrowed from about 22 percent to about 4 percent.

As private borrowing costs have dropped, companies have been able to borrow billions of dollars and pay relatively little in interest. Some have returned the money to shareholders as dividends; some have used the cash to make acquisitions; and others have repurchased shares on the market or directly from investors. Typically, when companies repurchase stock, their earnings per share rises and so does the value of any outstanding stock. Regardless, low interest rates and cheap borrowing costs have helped fuel share price appreciation and the bull market in stocks.

Three rounds of quantitative easing (the Fed's bond buying programs) also helped push stocks higher. An expert cited in Barron's noted "there has been a more than 90 percent correlation between the growth of the central bank's assets and the S&P 500 since the bull market began five years ago."

Now, the Fed is tapering quantitative easing and has indicated tighter monetary policy may begin as soon as early next year. Should investors worry the bull market will go away as these exceptional support measures are taken away?

If an investor has long-term financial goals, the answer is no. The portfolio allocation may have been chosen to help pursue those goals through all kinds of market conditions. If the stock market is slowing down, an investor may experience slower growth but that doesn't mean the goals have changed or the holdings are unsound.We may want to stay focused on the finish line.

Weekly Focus - Think About It

"Humility is not thinking less of yourself, it's thinking of yourself less."

—C. S. Lewis, novelist, scholar, broadcaster

Best regards,
Sean M. Dowling, CFP, EA
President, The Dowling Group Wealth Management