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May 15, 2013

The Federal Reserve is in the midst of unprecedented actions.  It all started in the Fall of 2008 as the famed investment bank Lehman Brothers failed, and credit markets began to freeze up.  In an effort to provide liquidity to the capital markets, while striving to spur economic growth, the Federal Reserve established a quantitative easing (QE) program.  Originally implemented in December 2008, QE1 was designed to purchase $600 billion in agency, mortgage, and treasury securities.  Prior to the fall of Lehman Brothers, the Fed’s balance sheet stood at approximately $800 billion.  Now, some five years later, and in the fourth round of quantitative easing, the Fed’s balance sheet exceeds $3.3 trillion.  The Fed must unwind these assets at some point, and if done responsibly, may be accomplished without shocking markets.

With QE4 in full force, the Fed must first stop buying.  At its current pace, the Fed is purchasing $40 billion per month of mortgage-backed securities, and $45 billion per month of treasury securities.  They stress their flexibility and willingness to adjust the timing, size, and type of asset purchases, but have maintained the goal of achieving an unemployment rate below 6.5%, so long as inflation stays below 2.5%.  We are not nearing either of those figures, and speculation is rampant surrounding how long the asset purchases will continue, though a consensus seems to land a little short of two more years.  As a result of the Fed’s actions, interest rate sensitive sectors of the economy such as housing and automobiles have fared rather well, which has helped stimulate some job growth.  However, many investors are moving funds into riskier asset classes which may align poorly with their long term objectives.  As the Fed unwinds such programs, these investors could be in for a surprise, as the risk in their portfolios may exceed their tolerance levels.

Unwinding the Fed’s balance sheet should be done slowly.  Given assets of $3.3 trillion, and a weighted average duration of slightly over 10, it may be prudent for the Fed to allow their securities to mature, and cease reinvesting the proceeds.  If the Fed sold significant holdings prior to maturity, they risk shocking markets in a similar, but inverse way, that their current asset purchasing program has.   Regardless of the speed and timing of the changes, investors may rest assured that the Fed has pledged to effectively manage market expectations.  Despite allegations from certain politicians and pundits, the Fed has done an excellent job of releasing its updated balance sheet weekly, and has very effectively provided markets with guidance in regards to the thoughts surrounding their current and future actions.

Changes in the Federal Reserve’s policies are very likely to have an impact on your portfolio.  A multitude of factors have helped fuel the five year bull market pushing the S&P 500 index to record levels in May, and Fed stimulus has played a key role.  Markets have a high sensitivity to changes in the Fed policy, and irresponsibly unwinding their balance sheet could run the risk of shocking equity markets.  Likewise, continued stimulus could further fuel equity markets.  As an investor, it is critical to assess your portfolio, and have it allocated among assets including equity, fixed income, and real estate, in order to achieve growth objectives, attain income objectives, and manage downside risk.   Alamo Capital specializes in building such balanced portfolios, and we encourage you to review your portfolio with your Alamo Capital Financial Advisor today to ensure it aligns with your objectives.

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