July 2, 2013
Interest rates spiked suddenly in the second quarter
as the Federal Reserve Chairman outlined a path to normalcy in a post QE world.
Market participants got the much anticipated correction in stock and bond
prices. Holders of long maturity bonds and precious metals suffered double
digit declines and are now questioning the safety of those assets.
Gold suffered its biggest quarterly loss ever declining 23% since March 28, 2013. Commodities such as copper dropped 16%. China suffered a bout of financial indigestion with a liquidity crunch.
These events coincided with sharply higher US interest rates and caused Emerging market stocks and bonds to suffer losses of 14.5% and 11%.
In spite of this caustic climate U.S. equities advanced 13% year to date but only 2.9% in this past quarter. June was the first down month all year.
As the Federal Reserve Chairman explained, continued QE will now be "data dependent" not a given fact of life. On June 19th Mr. Bernanke’s words threw fixed income markets into a selling frenzy. The 10-year Treasury note reached a 2.65% yield, a full percentage point higher than mid May’s 1.63%. Some corporate and municipal bond ETF's dropped 9% from their highs while the Standard and Poor’s 500 dropped 5.8% in short order.
Investors are learning that bonds are now as risky and volatile as stocks in an era of Government repressed interest rates. We learned governments cannot hold back huge sellers when they want out. Bond funds experienced record redemptions exceeding 60 billion in June, after inflows of more than 1 trillion over the past 5 years. The Fed was clearly surprised by the severe reaction and has since sent out spokesmen to dial back on Mr. Bernanke's remarks.
It appears that low duration bonds and floating rate notes are a good place to whether the interest rate storm. The latter asset class dropped less than half of one percent during the selloff. US stock markets performed extremely well considering the carnage that went on in other world equity markets.
Japan +14.2% year to date had strong equity gains due to their QE announcements early in the year. Major markets in Europe showed little gain, while China, Russia, Brazil, and South Africa each lost about 20%. Australia, Canada, India, and Mexico were down between 8% and 11%. Diversification hurt rather than helped returns.
Consensus expectations for S&P 500 earnings is $108 in 2013 and $114 for next year. Selling at a P/E multiple of 15 times earnings, stocks are priced below historical norms. If interest rates rise rapidly to 3% on the 10-year Treasury, markets may swoon again. However the Fed has often stated they will remain a buyer of bonds until the unemployment rate reaches 6.5%. That level of unemployment can occur only if the economy improves which brings higher earnings for most companies.
If continued bond redemptions result in money moving into stocks, all will be well for long term investors who go with the flow. If however, rates climb for reasons other than solid economic growth, it will be hard for corporations to continue to grow earnings as margins are at record highs. It becomes unlikely that P/E's will revalue higher in a rising interest rate environment.
Neither economists nor Central Bankers worldwide have a crystal ball but the fact remains that governments will try to keep rates low while economies recover. Governments in Europe, Japan and the US can ill afford higher rates given the level of sovereign debts and deficits.
US companies with transparency, large cash balances, increasing dividends and share repurchases should do well relative to the competition. While P/E ratios abroad are lower than those at home, money moving from cash or bonds will seek safety and liquidity over higher return but riskier possibilities.
I expect numerous economic clouds will remain on the horizon in Europe and China. Higher US interest rates will not drastically slow domestic economic growth. The United States is increasingly energy self - sufficient, thanks to fracking technology and vast natural resources. Low energy prices are giving domestic companies another competitive advantage.
Corporate revenues are expected to be up 1.8% while earnings should climb 3.0% according to new estimates in Barron’s. In a 2% GDP growth economy with 1% inflation, it is unlikely we see another interest spike soon. Bond rates will eventually climb as the Federal Reserve scales back on QE and consumers gain more confidence. US shares are likely continue to do well in this environment.
Douglas Coppola
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