bonds …a threat to stocks?

I read an odd article in the Wall Street Journal yesterday, an opinion piece that in the US bonds are a current threat to stocks.  Although not explicitly stated, the idea seems to be that the US is in the grip of cult-like devotion to stocks.  One day, however, after a series of Fed monetary policy tightening steps, the blinders we’re wearing will drop off.  We’ll suddenly see that higher yields have made bonds an attractive alternative to equities   …and there’ll be a severe correction in the stock market as we all reallocate our portfolios.

What I find odd about this picture:

–the dividend yield on the S&P 500 is just about 2%, which compares with the yield of 2.3% on a 10-year Treasury bond.  So Treasuries aren’t significantly more attractive than stocks today, especially since we know that rates are headed up–meaning bond prices are headed down.  Actually, bonds have been seriously overvalued against stocks for years, although they are less so today than in years past

–from 2009 onward, individual investors have steadily reallocated away from stocks to the perceived safety of bonds, thereby missing out on the bull market in stocks.  If anything there’s cult-like devotion to bonds, not stocks

–past periods of Fed interest rate hikes have been marked by falling bond prices and stock prices moving sideways.  So stocks have been the better bet while rates are moving upward.  Maybe this time will be different, but those last five words are among the scariest an investor can utter.

 

Still, there’s the kernel of an important idea in the article.

At some point, through some combination of stock market rises and bond market falls, bonds will no longer be heavily overvalued vs. stocks and become serious competition for investor savings.

Where is that point?  What is the yield level where holders of stocks will seriously consider reallocating to bonds?

I’m not sure.

Two thoughts, though:

–I think the typical total return on holding stocks will continue be around 8% annually.  For me, the return on bonds has got to be at least 4% before they have any appeal.  So the Fed has a lot of interest-rate boosting work to do before I’d feel any urge to reallocate

–movement in yield for the 10-year Treasury from 2.3% to 4.0% means that the price of today’s bonds will go down.  So, while there is a clear argument for holding cash during a period of interest rate hikes, I don’t see any for holding bonds–and particularly none for holding bonds on the idea that stocks might fall in price as rates rise

Of course, I’m an inveterate holder of stocks.  And this is an interesting question to ask yourself.  What yield on bonds would make them attractive to you?

 

 

the Fed’s next move

The highest economic policy objective of the US is achieving maximum sustainable growth in the economy consistent with annual inflation around 2%.

If growth deviates from this desired path, either through overheating or recession, the government has two tools it can use to nudge the economy back toward trend:

monetary policy, controlled by the Federal Reserve, which can relatively quickly alter the rate of growth of the money supply and thereby either energize or cool down activity

fiscal policy–government taxing and spending–controlled by the administration and Congress, and which may be thought of as more strategic than tactical, since there are typically long lags between need and any legislative action.

As a matter of fact, the Fed has been calling for fiscal stimulus from Congress and the administration for several years–worrying that continuing monetary stimulus is increasingly less effective and even potentially harmful to the economy.  Its pleas have fallen on deaf ears.

The Fed has been using two methods to keep rates low:

–it has kept the Federal Funds rate, the interest rate it sets for overnight bank deposits, at/near zero, and

–it has taken the unconventional step of putting downward pressure on rates of long-maturity instruments by buying a total of $4 trillion+ of government securities in the open market.  This is called quantitative easing.

Donald Trump was the only candidate to address the problem of fiscal policy inaction, by promising giant fiscal stimulus through lower corporate tax rates plus a massive spending program to repair/improve infrastructure.

After Mr. Trump’s surprise win last November, the Fed seems to have breathed a sigh of relief and aanounced a series of interest rate hikes that would begin to return monetary policy closer to a normal amount of stimulus–based on the idea that Washington would also provide serious fiscal policy stimlus in 2017.

We’re now in month nine since the election, without the slightest sign of any action on the fiscal front, despite the fact that the Republicans hold the Oval Office and both houses of Congress.  Senator Pat Toomey (R-Pa) remarked last week that this is because no one expected Mr. Trump to win, so Congress made no plans to implement his platform.   It hasn’t helped that, despite his campaign rhetoric, Mr. Trump has shown little grasp of, or interest in, the issue.

This leaves the Fed in an awkward position.

I think its solution will be to shift from raising the Fed funds rate to slowing down or stopping its purchases of securities farther along the yield curve.  Although in a sense the Fed is already no longer buying new government bonds, it is taking the money it receives in interest payments and principal return from its current holdings and reinvesting that in new securities.

Its first step will be to reduce or eliminate such reinvestment–which will presumably nudge longer-term interest rates upward.  Since the process is being so well advertised in advance by the Fed, it’s likely that most of the upward movement in rates will have occurred before the Fed begins to act.  The most likely date for the Fed to more is in September.

 

Employment Situation, March 2017

The Bureau of Labor Statistics released its monthly Employment Situation report earlier this morning.

With an addition of +98,000 jobs, the figures were a little more than half the rate of gain or recent months.  Revisions to data from the prior two months clipped another -38,000 positions from the total.

Although the report isn’t great reading for stock market bulls, we’ve seen over the past eight years of economic recovery that bad months occasionally occur, even in the midst of a sharply upsloping trend.  In addition, although the monthly figures are seasonally adjusted, the weather during 1Q17 has been so unusual in the populated regions of the US–unusually mild in January-February, ugly in March–that the first two months probably look better than they should and March worse.

The only really eyebrow-raising aspect of this report, in my view, is that despite the unemployment rate being at a very low 4.5%, there is still no sign of acceleration in wages.  This implies no urgency for the Fed to raise interest rates aggressively.

reversing quantitative easing

US stocks were up by about 1% yesterday when the minutes of the last Fed meeting came out.  As Fed watchers saw the topic of paring down the Fed’s $4 trillion+ holdings of government bonds was mentioned, stocks (but not bonds) began to give back their gains and ultimately finished the day lower.

What’s this about?

  1.  The Fed typically uses the Federal Funds rate for overnight loan to loosen or tighten money policy.  In doing so, it depends on the banking system to broadcast increases or declines in interest rates into the market for longer-term debt.  The problem since 2008 is that the banks had destroyed their own creditworthiness through years of unsavory and unsuccessful speculative financial markets trading.  So they were ineffective in performing this crucial rate-determining role.  Congress and the administration were–and still remain–lost in their inside-the-Beltway alternative universe, so there was no hope of help for the failing economy from that source.  The Fed’s solution was to begin “unconventional” operations, by buying huge amounts of longer-dated government debt in order to push down long-term interest rates itself.  It now holds something like $4.3 trillion worth of Treasury and government agency debt.
  2. The Fed has long since stopped making new net purchases of longer-dated bonds.  But as its existing bonds mature, it has continued to roll over the money it gets from them into new bond purchases.  The next step for the Fed in normalizing the long-term debt market will be to stop this rollover.  The consensus is that this change will happen later this year or early next.
  3. What’s “new” from yesterday is that the Fed put this thought down in writing, without specifying any details.

My take:  while the Fed announcement may have been the trigger for an intra-day selloff in stocks, the Fed minutes are not a big deal.  There is an investment issue as to how the Fed will proceed, but that will ultimately be influenced by how capable Mr. Trump will be to get Washington working again.

The President’s early performance has had two consequences:  US investors are beginning to think about shifting money to Europe.  Despite Brexit, that region is beginning to experience its own economic growth.  As well, it is having deep second thoughts about electing Trump-like figures in their own countries (we’ll learn more in the first round of the French elections on April 23rd), thereby increasing their attractiveness as an investment destination.

the Fed’s inflation target: 2% or 3%?

There seems to me to be increasing questioning recently among professional economists about whether the Fed’s official inflation target of 2% is a good thing or whether the target should be changed to, say, 3%.

The 2% number has been a canon of academic thought in macroeconomics for a long time.  But the practical issue has become whether 2% inflation and zero are meaningfully different.  Critics of 2% point out that governments around the world haven’t been able to stabilize inflation at that level.  Rather, inflation seems to want to dive either to zero or into the minus column once it gets down that low, with all the macro problems that entails.  It’s also proving exceptionally hard to get the needle moving in the upward direction from t sub-2% starting point.  My sense is that the 3% view is gaining significant momentum because of current central bank struggles.

This is not the totally wonkish topic it sounds like at first.  A 2% inflation target or 3% actually makes a lot of difference for us as stock market investors:

–If the target is 3%, Fed interest rate hikes will happen more slowly than Wall Street is now expecting.

–At the same time, the end point for normalization of rates–having cash instruments provide at least protection from inflation–is 100 basis points higher, which would be another minus for bonds (other than inflation-adjusted ones) during the normalization process.

–Over long periods of time, stocks have tended to deliver annual returns of inflation + 6%.  If inflation is 2%, nominal returns are 8% yearly; at 3% inflation, returns are 9%.  In the first case, your money doubles in 9 years, in the second, 8 years.  This doesn’t sound like much, either, although over three decades the higher rate of compounding produces a third more nominal dollars.

Yes, the real returns are the same.

But the point is that the pain of holding fixed income instruments that have negative real yields is greater with even modestly higher inflation than with lower.  So in a 3% inflation world, investors will likely be more prone to favor equities over bonds than in a 2% one.

–Inflation is a rise in prices in general.  In a 3% world, there’s more room for differentiation between winners and losers.  That’s good for you and me as stock pickers.

 

three steps and a stumble?

That’s the conventional wisdom (read: old wives tale) about Fed rate hikes and the stock market.  The idea is that the market absorbs the first two hikes in any rate rise series as if nothing were going on   …but reacts negatively on the third.

The third in this series of rate hikes will almost certainly come tomorrow.

The problem with this particular old saw is that there’s very little evidence from the past to support it.  Yes, there may be an immediate knee-jerk reaction downward.  But in almost all cases the S&P 500 is higher a year after a third hike than it was on the day of the rate rise.  Sometimes, the S&P has been a lot higher, once in a while a percent or two lower, but there’s no third-hike disaster on record.

Generally speaking, the reason is that rate rises occur as a policy offset to the threat of the runaway inflation that can happen during a too-rapid acceleration in economic growth.  As financial instruments, stocks face downward pressure as higher rates make cash a more attractive investment option.  On the other hand, strong earnings growth exerts contervailing upward pressure on stock prices.  In most cases, the two effects more or less offset one another.  (Bonds are a different story.  With the possible exception of junk bonds, all the pressure is downward.)

Of course, nothing having to do with economics is that simple.  There are always other forces at work.  Usually they don’t matter, however.

In this case, for example:

–I think of a neutral position for the Fed Funds rate as one where holding cash gives protection against inflation and little, if anything, more.  If so, the neutral Fed Funds rate in today’s world should be between 2.5% and 3.0%.  Let’s say 2.75%.  Three-month T-bills yield 0.75% at present.  To get back to neutral, then, we need the Fed Funds rate to be 200 basis points higher than it is now.

I was stunned when an economist explained this to me when I was a starting out portfolio manager.  I simply didn’t believe what she told me, until I went through the past data and verified what she said.  Back then, I was the odd man out.  Given the wholesale layoffs of experienced talent on Wall Street over the past ten years, however, I wonder how many more budding PMs are in the position I was in the mid-1980s.

–the bigger issue, I think, is Washington.  I read the post-election rally as being based on the belief that Mr. Trump has, and will carry out, a mandate to reform corporate taxes and markedly increase infrastructure spending.  The Fed decision to move at faster than a glacial pace in raising interest rates is based to a considerable degree, I think, on the premise that Mr. Trump will get a substantial amount of that done.  If that assumption is incorrect, then future earnings growth will be weaker than the market now imagines and the Fed will revert to its original snail’s pace plan.  That’s probably a negative for stocks …and a positive for bonds.

 

 

 

a steadily rising Fed Funds rate into 2019

That’s the thrust of Fed Chair Janet Yellen’s remarks yesterday about rates in the US.

She said that there would be “a few” increases in the Fed Funds rate in each of 2017 and 2018.  Assuming that a few = three and that each increase will be 0.25%, Yellen’s statement implies that the rate will rise steadily until it reaches 2.0% sometime next year.

In one sense, two years of rising interest rates sounds like a lot–I know that’s what I thought the first time I was facing this prospect as a portfolio manager.  But if the neutral target rate for overnight money is the level that achieves inflation protection but no real return, 2% should be the target.  If anything, it’s a bare minimum.

In my view, two surprises to the Yellen forecast are possible:

–if President Trump is able to launch a significant fiscal stimulus program, the rate rise timetable will likely be accelerated, and

–if the inflation rate rises above 2%, which I think is a good possibility, then the Fed Funds rate may need to rise above 2% (2.5%?) to keep inflation in check.

Typically, a time of rising rates is one in which stocks–buoyed by increasing corporate earnings–go sideways, while bonds go down.  In the present case, earnings growth will likely depend on an end to dysfunction in Washington.