Macro

Taking Stock of the Rally

May 23rd, 2013 | By Nick Sargen

Highlights
  • The rally in risk assets has sent the U.S. stock market to record highs and yields on junk bonds to record lows. It has caught most investors by surprise, and some believe it is a liquidity driven event that will end badly.
  • I am more sanguine about the long-term prospects for the stock market, mainly because there is evidence the economy is transitioning to stronger growth. While this may not show up yet in high-frequency data, balance sheets of households and businesses are improving and banks are relaxing lending standards.
  • Meanwhile, the Federal Reserve could begin scaling back on quantitative easing later this year if the economy improves. If so, market volatility would likely increase and it could produce a pullback in equities of 5%-10%. However, we expect this would be temporary assuming the economy continues to improve.
  • In this context we are maintaining an overweight position in favor of equities over bonds in balanced portfolios. Our rationale is that the stock market is reasonably valued and economic fundamentals are improving, whereas bonds are expensive and yields are likely to rise as the economy gains traction.

What's Driving the Rally in Risk Assets?

The rally in U.S. equities and high yield bonds over the past 12 months has been truly remarkable: Since June 1, the S&P 500 index has generated a total return of more than 30% while high yield bonds have returned more than 16%. Even more surprising is the lack of a meaningful pullback along the way.

The rally began last June against a backdrop of worries about Greece being able to stay in the euro-zone and fears about Spain's financial system being vulnerable to a bank run. These fears abated in the summer when Mario Draghi vowed to do everything to keep the euro intact: The ECB subsequently received authority to purchase debt of troubled sovereigns, which enabled it to act as a true lender of last resort.

Confidence in the world's financial system was bolstered further when the Federal Reserve announced it would purchase $85 billion of securities on a monthly basis for an indefinite period. The rally continued during the period surrounding the U.S. elections, and it gained new impetus after worries about a 2013 fiscal cliff faded. So far this year, the S&P 500 index is up by about 16% despite concerns about the effects of sequestration and weakness abroad.

For some observers the rally is entirely a liquidity-driven event in which the Fed's ongoing purchases of treasuries and agencies is inducing investors to rebalance their portfolios into higher risk assets. They see the U.S. economy being stuck in 2% trend growth for the foreseeable future, and believe risk assets are vulnerable to a sell-off once the Fed winds down quantitative easing.


A More Sanguine View

My own view is more sanguine, as there are increasing signs the economy is gaining traction:

(1) Private sector demand — i.e. GDP minus government spending — has been growing at a 3% rate for the past couple of years despite fiscal drag at the federal, state and local levels. Overall government spending is now 3% below its end 2008 level and 7% below the level in 2009-10. Taking into account additional cutbacks in spending and expected increases in tax revenues, the Congressional Budget Office is forecasting the federal budget deficit will shrink to 4% of GDP this year, down from 7% last year and a peak of 10% in 2009.

(2) Residential housing is on the road to recovery, as reflected in a pickup in new housing starts, decline in the inventory of unsold homes and 10% price appreciation nationally over the past 12 months. This sector, along with autos, typically leads economic expansions and has wide-ranging effects on the economy: It is the single most important asset for homeowners and a key determinant of household net worth, which is now approaching its record high in 2007. As an increasing number of homeowners discover they now have positive equity in their homes, they are becoming eligible for refinancing at low rates.

(3) Financial institutions are more willing to lend to businesses and individuals. Following a two year hiatus in which bank lending contracted, U.S. banks have been growing their commercial and industrial loan book for the past two years, but have been reluctant to increase real estate loans or consumer loans. However, the latest Federal Reserve report of banks' lending standards indicates that they are now relaxing their conditions and seeking to increase market share. If so, this could be a precursor of increased hiring and cap-ex spending by U.S. businesses, as well as stronger demand for housing.

(4) Corporate profits and balance sheets continue to improve. Apart from low interest rates, the key driver of the stock market rally since March of 2009 has been the doubling in corporate profits from the lows reached in 2008. Skeptics, to be sure, contend there is little room for profit margins to expand and they point to the recent slowing in top line growth. Nonetheless, the majority of companies have continued to beat analysts' estimates of corporate profits, as U.S. businesses have figured ways to make money in a moderate growth environment. With respect to credit markets, moreover, default rates remain close to record lows and debt coverage ratios are solid.

My bottom line is that the Fed's policies unquestionably are a catalyst for risk assets, but households, companies and financial institutions have also made considerable headway adjusting to the 2008 financial crisis. Therefore, the risk of a relapse or "double dip" is considerably diminished today.


The Test Ahead: A Shift in the Fed's Stance

One risk for the stock market is the possibility that the Federal Reserve could begin scaling back quantitative easing, possibly as early as late summer or fall. Until recently, I thought the Fed was unlikely to shift its stance anytime soon, because unemployment at 7.5% is well above the 6.5% threshold the Fed is targeting while inflation is well below the target of 2%-2.5%.

During the past week, however, several Fed officials have stated a preference for phasing down the QE program later this year if the economy continues to perform satisfactorily. Thus far, however, the troika that has the greatest influence in shaping policy — Chairman Bernanke, Vice Chairman Yellen and NY Fed President Dudley — have not signaled they are on board at this time. In this regard, Chairman Bernanke's Congressional testimony this week did little to clarify his position.

If the Fed were to begin phasing down its program, we would expect market volatility to increase, and the stock market could experience a pullback. However, I do not foresee the beginning of a bear market, because any change in Fed policy would occur against a backdrop of an improving economy.


Investment Implications

Weighing these considerations, we continue to favor stocks over bonds in our balanced portfolios on grounds that bonds are very expensive while stocks are reasonably valued and improving fundamentals suggest the stock market has further upside potential. We also believe that bond yields will gravitate higher over time, and are therefore underweight duration in our fixed-income portfolios.