The mood of the market continues to shift from a feeling of anxiety and nervousness toward relaxation. While conditions are not normal, investors have adjusted to activist central banks, uncertain U.S. fiscal policy, and Europe's economic stagnation. At the moment, investors are out of crisis mode. This shift requires us to rethink portfolio positioning. We have done so, raising gradually the amount of risk in our model asset allocation strategies since last fall.
Evidence of relaxation can be seen in a myriad of data. Indices of small- and mid-capitalization stocks— the Russell 2000 and Russell Midcap—have reached all-time highs. The strength of these indices is significant, because small and mid caps generally are considered riskier than their mega-cap cousins. Investors are accepting, perhaps embracing, greater risk. The CBOE Volatility Index, or VIX, a "fear indicator" that measures expected stock market volatility, is below 13, a low level. Yields on speculativegrade bonds are low, suggesting that few investors are concerned about defaults and many are confident in the strength of the economy. More reports of merger and acquisition activity, including airline mergers, the acquisition of H.J. Heinz by Berkshire Hathaway, and Dell going private, are indications of a willingness to invest capital for the long term.
In our view, these are steps toward normality. There is less focus on a "risk-on, risk-off" approach to the markets and more attention being paid to the individual characteristics of companies. The chatter on CNBC is less centered on the Federal Reserve and the European Central Bank, though they still get a lot of airtime. More time is being devoted to the idiosyncrasies of individual companies, such as the cash hoard at Apple. This shift means there is value to be gained from intra-market bets, such as growth versus value. While there continues to be news related to the federal spending sequester—an $85 billion budget cut scheduled to begin on March 1—it does not appear to be driving the market.
Higher interest rates? Maybe in the second half of 2014
In my conversations with clients, there are fewer questions about Europe. Lately the number one question, in various forms, has been about the future path of interest rates. When will they rise and by how much? The discussion generally includes the same question about inflation. Our response is that we do not expect significantly higher interest rates and inflation this year. Interest rates and inflation probably will not rise meaningfully until the second half of 2014. Inflation and interest rates generally are correlated, as investors seek returns sufficient to compensate them for their loss of purchasing power. We live in unusual times, with the Fed engaging in "financial repression"—engineering interest rates below inflation rates. The Fed has said it will be less active when the unemployment rate reaches 6.5%. A back-of-theenvelope analysis shows that if 85,000 people join the U.S. workforce each month and employment increases by 160,000, which seem like reasonable estimates to us, then we reach 6.5% unemployment in the first half of 2015. By that time, the Fed will have purchased another $2.1 trillion of bonds at its current $85 billion / month rate. This isn't meant to be a precise forecast but to support the point that we believe that a number of months are likely to pass before rates and inflation climb meaningfully.
Possible supply shocks aside, inflation should remain contained in the near term
A higher rate of inflation can be the result of increasing demand outpacing supply or supply shocks, such as disruptions in the oil supply. Given the slow pace of employment and wage growth, combined with the slack in capacity that exists around the world, we do not expect inflation from that source. Around the globe, countries are trying to depress their currencies. They are trying to make their goods cheaper. This is deflationary for countries that are not devaluing their currencies or that tend to run trade deficits, like the U.S. One can argue that no one wins a currency war. Our point is that countries engage in this behavior when they want to increase exports, which they are inclined to do when they have extra capacity. Put another way, people around the globe are not demanding higher prices. Thus, demand could increase before inflation rises. We do believe a higher rate of inflation is likely eventually. First the excesses and deflationary forces need to be worked out of the system.
Supply shocks can occur without warning. When we say they are not on our horizon, we mean we cannot predict their timing in the near term. Disruption in the Middle East is the poster child of supply shock. A sudden increase in oil prices would be inflationary in the short run. It probably would not last. The supply would be reinstated; alternatives would be found; or, the higher prices would curtail demand, thereby easing prices.
Eventually, interest rates likely to rise in two-steps-up, one-step-down fashion
We are the first to admit that economic forecasting is highly imprecise. Rising inflation and/or interest rates might surface earlier than we expect. Currently, we do not expect a dramatic rise in rates, because rising rates will be self-correcting. Rising interest rates will slow the sale of items bought on credit (e.g., automobiles, houses, factories, and equipment). We expect rates to rise, the economy to weaken, and rates to fall (but not back to the initial level). Thus, the increase will appear saw-toothed. Investors' expectations get priced into the markets. Since the Fed has indicated when it will take its foot off the accelerator—not to be confused with hitting the brake—markets presumably will act before unemployment reaches 6.5%. Thus, we expect rates to rise in the second half of 2014, before the Fed adjusts its course, in 2015.
Stocks could prosper amid higher rates, if growth expectations also climb
We also expect that interest rates will, over the long run, exceed the inflation rate. Currently yields on government bonds maturing in up to a decade or more are below the inflation rate. We might see inflation rates rise before interest rates rise. And the Fed may tolerate some inflation to make sure the economy is hot enough for growth to be self-sustaining. But once interest rates start rising, we expect their rise to be larger than that of inflation. Bond prices obviously suffer in the face of rising rates. The question is: What will happen to stocks? This can't be answered definitively. Higher interest rates will be a headwind as the future dividends will be discounted at a higher rate, just as the cash flows from bonds are discounted at a higher rate. However, investors will likely expect an increase in the amount of dividends that companies pay, due to the growth of the economy and inflation. This is positive for stocks. Whether the downward force of higher discount rates outweighs the upward force of increased growth expectations remains to be seen. We think the upward force will tend to win out, leading to slightly higher multiples. Higher interest rates will be seen as certain, while future growth will not. Stock market volatility is apt to rise in the face of higher uncertainty about interest rates and growth rates.
One of the difficult lessons of market history is that markets can remain rich or cheap far longer than one
might expect, as the buildup of various bubbles has indicated. Bonds may remain rich—and hence interest
rates low—longer than we expect, especially given the power and willingness of central banks to achieve
such a goal.
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