June 25, 2013

Bonds down, stocks down. Why?

The last week brought worldwide gyrations as bond and stock markets alike went down.

What has changed? What has not changed?

The biggest economy in the world, the United States, is still moving forward in a steady upward progression. The news out of the emerging countries is mixed as China, the largest developing economy, has shown more signs of weakness, but not recession. And in Europe, already mired in recession, the news has been better, with higher manufacturing indications from Germany and somewhat better confidence numbers in the smaller countries. None of this is earth shaking or fundamentally different than what we have been witnessing.

So the answer must lie in the announcement of the US Federal Reserve. It has just come forward with a tentative plan for ending the current quantitative easing program that has existed during much of this business cycle. But is the end of quantitative easing the same as interest rate hikes? Not in our view.

Fed chairman Ben Bernanke said that any changes would be calibrated to the economic data and especially to the unemployment rate. So, is this change also to be considered a fundamental issue like factory production, job growth, etc.? Yes, the Fed, like other central banks, has been directly responsible for holding down interest rates. This policy may have prevented a double-dip recession and may have helped the United States avert deflation, but it is not clear that it has actually spurred growth or done anything to make more jobs, one of the Fed‘s main mandates.

So if growth is better and the Fed feels better about leaving interest rates to find its own way in the market, why are stocks down?

Bonds markets are down in the wake of this announcement because the market sees higher interest rates ahead, which means lower bond prices. But stockholders should rejoice in an expansion that no longer needs the help and support of artificially lower rates. The reason stocks are down is that investors are worried that the rise in rates could damage the slow progress now being made by the economy.

Our work shows that housing is a potential risk and could be impacted by higher rates. Housing is now starting to generate jobs and economic growth. The worry is that higher rates will end this. The difference, though, is that homes are very affordable now and inventory is low. Thirty-year mortgages rates around 6% — and not the 4% or 5% currently seen in the market — would be a real threshold for holding back the housing sector.

The automobile industry recovery could be impacted by the rise in lease and car loan rates. However, it would have to be an extreme rise to counter the fact that it takes only 26 weeks of wages for the average American to purchase a car, the lowest reading in years.

Therefore, it is unlikely that the economy will sink on higher rates, and it is not even clear when higher rates will occur. More to the point, we look to stocks and ask the following: Does this change in rate expectations mean stock prices should be lower?

First, the entire multiple, or price-to-earnings, on the market is lower than would normally be the case, given a ten-year Treasury rate of around 2% or 2.5 %. Second, higher rates may signal some inflation ahead, even if it is not visible today. The stock market actually moves up in times of inflation, at least moderate inflation. The reaction of both stock and bond markets may be extreme, but fundamental tools suggest slightly higher rates ahead and not a seismic shift. The US business cycle is on firm ground even with moderately higher rates. Within the next month, the stock market, now looking at interest rates, will once again focus instead on corporate earnings.

The current rearrangement of the market is disturbing. However, we find solace in the fact that the gears of the US business cycle are still in place, the news from Europe is better and things will eventually improve in emerging markets, given the dynamics of long term consumerism. The US cycle has the strength and durability to soldier on, and it is actually very good news that the Fed is willing to take off the training wheels and let the economy move on its own at some point. The day is coming when the market, not government officials, will determine interest rates.

No forecasts can be guaranteed.

The views expressed are those of James Swanson and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation or solicitation or as investment advice from the Advisor.


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