Market update — Cautionary signals from some domestic sectors mixed with optimism from abroad

William F. (Ted) Truscott, Chief Investment Officer
June 10, 2009

Don't fight the tape. Don't fight the Fed. These are two old investment sayings that certainly seem to be holding true over the last two months. A highly stimulative and creative monetary policy engineered to counter the effects of the credit crunch has taken hold some nine months after the first programs were introduced in the wake of Lehman Brothers' failure. The Federal Reserve has introduced this plethora of programs with a single purpose — to restart the most fundamental engine in a modern economy — the extension of credit to businesses and consumers.

Nowhere is this more visible than the Fed's own balance sheet, which according to Grant's Interest Rate Observer has ballooned from over $700 billion at the end of 2007 to just over $2 trillion dollars in May 2009. In expanding its balance sheet, the Fed has purchased assets from banks and other market participants that it never would have dreamed of buying just a few years ago. How does the Fed buy these assets? It prints money. Often, however, this printed money is mopped up or “sterilized” through the issuance of Treasuries, which the Fed buys. This takes money out of circulation, which in turn increases the country's debt.

The Fed has done something else that is equally powerful. It has lowered short-term interest rates to near zero just as participants fled the market for the comparative safety of cash. In doing so, the Fed has made it extremely painful to hold this cash. This is a calculated move designed to push businesses and consumers to spend or invest that cash. This tactic finally seems to be working and the following chart provided by The Bank Credit Analyst tells you why.

The chart shows that until recently there was a mountain of cash in excess of the total market capitalization of the Wilshire 5000 (the broadest index of the U.S. stock market) earning almost nothing. At the end of May, Wilshire reports that the index had a total value of $9.9 trillion. Thus, the chart suggests that there are still trillions of dollars sitting on the sidelines earning nothing or next to nothing. Stock and bond markets have rallied strongly because that cash is finally being put back to work and we are now moving from a period of extreme risk aversion to increased risk taking.

Encouraging investors to take risk again is part of the plan and we are encouraged the plan is finally working. That said, we are skeptical that a stock market rally can be sustained without much better economic news. Even the bond market, which has been our favorite place to be since last October, has rallied strongly. While we still find value in the non-Treasury portions of the market such as corporate debt, municipal bonds and high yield, the opportunity is diminished from just a few months ago and we believe that caution is in order based on the following issues.

Treasury bonds

We have stated for some time that longer-dated Treasury notes and bonds did not offer much value. We are now watching a rise in Treasury bond yields with a mixture of concern and some relief. Investors should note that 30-year Treasury bonds now yield in excess of 4.6%, a huge move from yields that were only about 2.5% at the end of the year. The fall in Treasury bond prices and the corresponding rise in yields are significant in the following four ways:

• The yield curve (a graph depicting Treasury bond yields from one month to 30 years) has a strong positive slope. This is normally the sign of an expanding economy or one that is likely to expand in the future. Economic expansions are often associated with increased inflation, so long-term bond holders demand a higher yield as compensation for taking on the risk of future inflation.
• The yield curve may be signaling far greater concerns about inflation than would normally be associated with an expanding economy. The weapons of choice to combat both the downturn and the threat of deflation (the phenomenon of falling prices) have been unprecedented fiscal and monetary stimulus. Concerns of much higher inflation in the next two years, therefore, are well founded.
• Mortgage rates are tied to longer-dated Treasury yields. A rise in those yields means higher mortgage rates, which is unwelcome as lower mortgage rates and subsequent refinancing was one way the Fed was seeking to arrest the fall in housing prices.
• To keep Treasury yields low and stimulate low mortgage rates, the Fed committed to buying hundreds of billions of dollars of Treasuries. The market is now testing the Fed's resolve to continue buying Treasuries and further expand its $2 trillion balance sheet.

The action in the Treasury market points to the larger question of when the Fed should begin to throttle back on the monetary stimulus engine. Withdrawing the stimulus too soon (by raising short-term interest rates) could choke off an economic recovery that is expected to be weak. Waiting too long to withdraw the stimulus introduces the risk of high inflation down the road. Calibrating the withdrawal of monetary stimulus at just the right time is like trying to land a Boeing 747 on an aircraft carrier in a hurricane. It's just not easy.

Housing

While the housing market may be forming a bottom in some parts of the country, we observe housing prices that continue to fall. In an editorial in the June 7 New York Times, Professor Robert Shiller (well known for the home price index that carries his name) noted the following:

“But market changes that big don't occur every day. And when they do, there is a coordination problem: people won't all change their views about homeownership at once. Some will focus on recent price declines, which may seem to belie any improvement in the economy, reinforcing negative attitudes about the housing market.

Even if there is a quick end to the recession, the housing market's poor performance may linger. After the last home price boom, which ended about the time of the 1990-91 recession, home prices did not start moving upward, even incrementally, until 1997.”

Housing continues to be a drag on the U.S. economy, as well as the economies in the United Kingdom, Ireland and Spain. Yet, Professor Shiller's commentary points to a larger issue. Those of us who have been in the financial world for 20 to 30 years are somewhat conditioned to expect rapid bounce backs in prices after a sell off. These V-shaped recoveries have been a common feature of the last quarter century's worth of financial history in stock, bond, real estate and other markets around the world. The notable exception is Japan. Shiller points out that land prices in Japan fell for 15 consecutive years after its bubble burst in the early 1990s. The Japanese stock market correspondingly has gone virtually nowhere over the past 20 years although there have been significant advances and declines during this period.

This is a long way of saying — I do not think it will be that easy this time nor is a V-shaped recovery in the offing in real estate, stocks or bonds. Global economic imbalances, financial mismanagement, flawed policies and greed have created the greatest global financial crisis since the Great Depression. Emerging from the crisis and ending the U.S. economy's dependency on extreme monetary and fiscal stimulus will be extremely difficult and the road ahead has lots of dangerous twists and turns.

The consumer

Consumer spending as a percentage of GDP has averaged about 63% since 1960 according to figures from economist David Rosenberg and The Bank Credit Analyst. This figure surged to an unsustainable and unprecedented level in excess of 70% of GDP from 2002 to 2008. Consumers borrowed their way into this level of consumption as the savings rate plunged to zero. Consumers are now saving again and paying down debt, and many are no longer able to use their house as a borrowing vehicle. The question is, how long will this trend have to continue and what will its long-run effect be on the economy?

The Bank Credit Analyst recently published a study that analyzed the prospects for consumer spending. The estimates, while conservative, assume a growth in consumer spending of only 1.3% per annum from 2008 to 2013. The publication further notes that any level below 1.5% per annum over the next five years would be the slowest period of five-year growth since the 1930s.¹ This period of retrenchment will be necessary to increase savings and lower debt — all with the worry of unemployment in the back of many people's minds.

To be sure, the government stimulus package is designed to counter the negative effects of a retrenching consumer, but the current level of stimulus is unlikely to make up for the return of consumer spending to a level more commensurate with history. This could result in a period of below-average economic growth. Companies have already dramatically adjusted cost structures and will continue to do so, which would increase the unemployment levels. However, there is only so far a business can cut costs before it hurts revenue, meaning corporate earnings could be less robust. Muted earnings growth or a lower absolute level of earnings would put a cap on stock market appreciation.

One source of optimism — emerging market equities

My colleagues at Threadneedle Investments, including Senior Portfolio Manger Julian Thompson who runs the emerging markets portfolios, make a strong case for emerging markets equities in the current environment. We don't have space here to publish Julian's full dissertation on the case for emerging markets, but here are a few of the key points from his assessment, quoted verbatim:

• The main difference between debt ratios for emerging and developed economies [emerging economies are now much better than developed economies] is that there has been little cost to emerging economies from the financial crisis. Other than in the peripheral Eastern European economies, there has been little requirement for taxpayers' money to be injected into emerging market financial systems as most emerging market banks are funded in the traditional fashion from deposits. So the estimated cost of bank bailouts for emerging economies is expected to be around 2.3% of GDP in aggregate according to the International Monetary Fund (IMF). However, the cost for developed economies will be around 43% of GDP.
• The important point now is that the relative growth level between emerging and developed economies has widened significantly. That is to say the potential growth rate of emerging market economies relative to developed economies is now much higher. The importance of this assessment for emerging markets is that capital will increasingly flow to where the growth opportunities lie and that is now unequivocally in emerging markets.
• The impact of capital inflows on emerging markets will be felt in the form of strong currencies and low interest rates, which will kick start a new consumption and investment cycle in emerging markets. As interest rates in the developed world stay low to stave off the impact of consumer deleveraging, consumers in developing markets will take advantage of cheaper credit to increase their leverage. Banks in emerging markets will be incentivized to expand credit because of natural market forces — the rates they earn on the government securities that still form a significant part of their assets are falling fast. For instance, local interest rates in Brazil are still above 10% but are likely to fall to around 8% by the end of the year. This will encourage Brazilian banks to take on more consumer risk and in turn fuel a consumption boom. The same pattern is likely to be seen across other emerging markets outside Eastern Europe.

Threadneedle reports that investors sold over $42 billion of emerging equities during the downturn and are now looking to rebuild positions for the reasons stated above. We agree with Threadneedle's assessment and would add that the world economy needs some serious adjustments, which augment their view. The U.S. must save more and spend less. We have no choice but for our economy to be less reliant on the consumer. Conversely, emerging economies must be less reliant on exporting to the developed world and more reliant on the consumer power of their young populations.

Emerging market equities are a volatile asset class and in a downturn usually fall more than developed markets. They are accessible through funds that invest directly in this asset class or via international funds that have freedom to invest in emerging markets. Like most asset classes, emerging market stocks are best purchased when times are tough and prices are relatively low. While any investment in emerging markets is subject to suitability, we do not believe that emerging markets equities should comprise more than 5% to 10% of an all-equity portfolio.

Conclusion

The recent rallies in stock and bond markets are a welcome relief to the brutal sell off experienced in late 2008 and again in early 2009. The fact that investors are beginning to take risk again is a good sign. It means that the Fed has been successful in pushing people off the sidelines and back into the markets. If this crucial step had not occurred, we would be in a considerably more difficult situation.

We remain concerned, however, that it will not be easy adjusting to our new economic reality. Consumer retrenchment, continued weakness in housing and higher interest rates with the concern of higher inflation are all serious headwinds. Emerging markets have the potential to do much better than developed nations in the current environment as these economies simply have better growth prospects. Investors with cash on the sidelines may find emerging markets to be a compelling investment opportunity in the near and long term. For those wanting an example of a purely tactical trade, I would recommend selling investments one has made in floating rate funds and buying emerging market funds.

For a less tactical way of looking at the current environment, consider taking the following actions to increase your chances of success in reaching your long-term goals and objectives.

• Invest across product and asset classes — implement tactical allocation strategies across asset classes and product solutions to help ensure that you are positioned to capitalize on the sectors that offer potential opportunities and to help limit losses in sectors that may be in an unfavorable position.
• Don't let emotions change your investment approach — getting caught up emotionally in short-term rallies can be just as dangerous as letting fear rule your decisions during down markets. Resist the urge to act on emotions and continue to embrace solid investing strategies like diversification and dollar-cost averaging. Sticking to your long-term plan is often the best way to combat volatile market conditions.
• Stay connected — your financial advisor can help you with both the emotional and tactical side of your investment strategies. Talk to your advisor to make sure that you are positioning your portfolio to meet both your short- and long-term needs.