A Word From The Advisor

The Federal Reserve (Fed) followed a tight script on the last day of the second quarter, raising the Federal Funds rate a quarter of a point to 1.25% in a widely expected move. The Fed’s goal is to gradually taper the economy and financial markets off their dependency on “cheap” money without extinguishing the recovery or allowing inflation to rampantly reignite. It’s not as if the Fed is saying the economy is overheated and we have to slow it down; it’s simply saying that the economy no longer needs the stimulus of inordinately low rates. It is worth remembering that, with inflation in the 2.0 to 2.5% range, the Federal Funds should trade in a similar range for Fed policy to be considered neutral, a case in which policy neither helps nor hinders economic growth. If policymakers hike rates by a quarter of a point at every meeting, the funds rate would reach a neutral point in early 2005.

Other things being equal, a climb in interest rates would be cause for concern for the stock market, because the higher rates add to businesses’ borrowing costs and can slow the pace of economic growth. The Fed’s policy makers do not raise interest rates in a vacuum, and intend to use this action as necessary to contain inflation. In this set of circumstances, moderation of interest rates has only a small net effect on the average company.

History shows that the average company’s earnings have grown faster when inflation is relatively high. In other words, the stock market is a good long-term hedge against inflation. The following chart shows the change in the index over longer periods of rising rates.

We believe a sound investment approach is to own carefully chosen companies that have the ability to raise prices in the face of their own increasing costs, thereby protecting against inflation and retaining the potential to create real value over time. Oakwood’s equity research process unearths sound businesses with high returns on equity and high returns on capital, which generate real returns, that is, adjusted for inflation.  These high quality types of companies have the pricing power to offset inflationary pressures, thereby securing the ability to maintain profit margins. We seek to achieve superior long-term performance by acquiring equity securities of financially strong, well-managed companies, at market prices significantly below our assessment of their business, or intrinsic value. Because we seek to identify undervalued companies, the investment process is not solely based on such macro-economic factors as the performance of the economy or the direction of interest rates. As a result, our equity portfolios are constructed of high quality companies that should provide respectable returns independent of the macroeconomic environment.

On the bond side, the impact of a rise in rates is fairly straightforward. As interest rates rise, the principal value of an existing bond trends lower.  However, at Oakwood we employ a defensive fixed income approach, by implementing market protection strategies. This allows us the flexibility to take advantage of an upward move in rates. We use daily volatility in the market to advantageously position the duration of client portfolios in order to benefit from these moves, rather than react to them.

We at Oakwood constantly challenge ourselves to find better ways to serve the needs of our clients. We are well-equipped, informed, and able to focus our attention on the issues that affect client portfolios, and remain carefully attuned to developments that will provide opportunities in the market.