All of the buzz in the financial markets since May has been about the Federal Reserve and the rise in interest rates in the wake of the expected “tapering” of their bond purchase program. But in fact the real “rising” story has been stocks. Hurdling a wall of worry that included higher interest rates, possible use of force in Syria and an impasse over the federal budget and debt ceiling, stocks have shot up this year. For the year to date, US stocks have gained nearly 20%.

Not to be outdone by the US, developed international markets also rallied strongly, gaining more than 16%. However, emerging markets continued their lagging behavior as concerns about less Fed stimulus led investors to withdraw investments from emerging markets bonds and stocks. Those economies with high inflation and slowing growth (think Brazil, India and Turkey) were particularly hard hit.

A hallmark of Federal Reserve policy under Ben Bernanke has been open communication, making sure the markets know well in advance what the Fed is planning to do. This policy stood in stark contrast to the Alan Greenspan era when the former chair would go to great pains to ensure that whatever he said was indecipherable. The Bernanke approach was closely followed until the September meeting when the Fed surprised the markets by announcing a deferral of the tapering plans that the Chairman had carefully laid out in the preceding months. While not stated, we believe that the delay was less about economic data than a hedge against the impact of the impasse over the continuing resolution (CR) to fund government spending and the debt ceiling.

Negotiations over the CR and debt limit are noticeably more difficult this time around as the poisonous atmosphere in Washington has only grown worse with mid-term elections looming. Adding drama, if not substance, to the debate is the launch of the open enrollment period that kicks off Obamacare. At this writing, the government is in shutdown mode which we expect to continue until a longer term debt ceiling and full year CR are ironed out. We view all of this as political theater, with the resolution unlikely to have a lasting effect on the path of the economy.

The biggest impact, we believe, is that the Fed will sit tight until the show is over and then begin scaling back its bond purchase program. We believe the US economy is likely to continue growing at a below long term average rate (2-3%), but sustainably growing nonetheless.

With no structural changes happening, Europe remains in neutral, not going backward or forward. China is now well through its power transition and policymakers are clearly focused on the key issues of excess credit creation and conversion to a domestic oriented economy. Recent data from China has been more encouraging but we expect growth to be choppy.

US interest rates are settling into a new trading range reflecting low inflation, modest economic growth and little or no Fed buying. One thing clear from the Fed’s September announcements is that short-term interest rates are likely to stay low for at least two more years, particularly since inflation is well below the Fed’s stated 2% target.

Absent an external inflation shock, we expect inflation to stay low because of the slack in the labor market. The unemployment rate will keep falling from a combination of lower participation and steady employment growth. There has been much debate about whether the drop in the labor force participation rate is due to discouraged workers dropping out or baby boomers retiring. No one really knows how much each factor contributes but it is clear that new college grads are still having a hard time finding jobs. And the baby boomers are the first generation with two wage earners retiring, sometimes simultaneously. The debate about the cause is less important than the fact that the lower participation rate will keep the economy on a slow growth, low inflation path.

This kind of path should be good for stocks and that has certainly been the case this year. We think US stocks are on the expensive side right now and need a breather to allow earnings growth to catch up. International stocks had been cheaper but they too have rallied strongly of late. While we remain overweight stocks and underweight bonds, we are trying to keep a modest cash reserve that we can deploy if we see a significant pullback.

Within our general underweight in bonds, we believe there will be opportunities for reasonable total returns if we remain nimble. However, the general trend for rates will be up, toward a more normal long term structure, so minimizing interest rate risk remains a paramount consideration.