Trampled By the Crowd? Logic Briefly Abandoned Creates Opportunity
The past two week slide in asset prices has caused a resurgence of doomsday pundits warning of impending calamity. The negative interpretation of Fed Chairman Bernanke’s comments regarding the U.S.economy’s future upgraded prospects is simply not logical. A careful review of what Bernanke said at his press conference was entirely consistent with what the Fed has said and done in the past. There was no new stance, no new tilt, and no new inference. My view is that his message about the economy was positive, and as logic returns to the market it will be positive for asset prices overall. So, if my view is correct, then what caused the markets in bonds, stocks, commodities as well as other assets to violently sell off?
Let’s review a few of the basic, yet often overlooked, tenets of economies and markets. First, let’s review the Fed and their current stance. The Fed is trying to promote economic growth with price stability to achieve higher employment in the United States. They are the most accommodative now as they have ever been in history. In a normal growing economy there is no need for the Fed’s asset-buying programs. In a normal growing economy we would expect to see interest rates set by the market, a positive yield curve and low inflation. Thus, for us to return to a normal growing economy we would like the Fed to stop the asset-buying programs because the economy has achieved the ability to grow without help.
The truth here may well be somewhat simple; maybe too simple for many pundits and investors to grasp. Let’s just pretend for a moment that we were actually seeing the U.S. economy accelerate growth. What would that look like? What would asset values, interest rates and inflation do under this assumption? In a normal economic expansion we would expect interest rates to naturally rise as the demand for credit increases. We would expect the yield curve to steepen as inflation expectations rise. We would look at credit risk to carry more reward as default rates lag. Growth in corporate earnings, employment and credit should all produce higher multiples in the equity markets. We would expect investment capital to flee asset classes that have low-risk, adjusted-return expectations. Increased inflation expectations would put pressure on high-grade debt instruments and favor the ownership of tangible hard assets.
Well, let’s look at what has happened since Mr. Bernanke spoke. Interest rates, as measured in the “risk free” U.S. Treasury market, have gone up sharply. The yield curve has steepened. Could it be that capital is leaving a market when the expected returns are near the lowest in history, in favor of a place where growth is available? Isn’t the steepening of the curve more logically correlated to an accelerating economy rather than a slowing one? I think a careful examination of what has gone on here is that if we were expecting a slowing, we would expect to see a flight of money to the Treasury market, not away from it. Money is also fleeing other “safe” havens, including the precious metals markets. Could it be that as market fears decrease the need for positive returns become a significant driver and monies are correspondingly redirected to more fertile ground?
The fact of the matter is that U.S. companies have enjoyed – and continue to enjoy – expansion of business, earnings and liquidity. U.S. equity markets still sell at an average multiple, which would lend itself to opportunity for investors. My contrarian nature would note that the greatest opportunities in asset markets often coincide with lows in investor confidence in those markets. We see arguably more love for bonds now than we saw for stocks just prior to the dot-com bust. Logically, we would expect returns in equities will be well above average as the funds flow from asset classes with little or no upside potential to where the opportunities are. As yields rise it will punish the capital that remains in the bond markets and likely accelerate the outflows. This is exactly what we are seeing.
At the end of the day, an end to asset purchases by the Fed is a positive message, not a negative one. The U.S. economy has done very well for most of its history when there were no asset purchases, normalized interest rates and low inflation. What we continue to see in the United States is an expansion that is gaining speed and confidence, we see a housing market that continues to recover and we see unemployment decreasing. We expect to see the Fed continue to leave monetary policy historically easy as they look for expansion and increases in employment. Given this, we would expect to see increased demand for commodities and hard assets. This should support higher prices as inflation expectations rise.
World central banks are feeling emboldened by the U.S. Federal Reserve. They are easing at a record pace, and we would expect to see the natural and logical positive developments in their economic growth. The worry about China slowing is well overdone. Growth in the 7-8% for their economy will likely be the trough and we should see growth pick up in the near future. Their asset markets are priced closer to a level we saw in 2008. Remember Europe? When the European Central Bank (ECB) became engaged and the returns came to investors in both debt and equity markets in double digits!
Market dislocations create risk but also provide opportunity. Nothing we see in today’s markets would lead us to a logical conclusion any different than where we have been in the last four years. We are avid students of the Fed and have been taught to never fight them. If they believe that economic activity in the United States is increasing and they are sticking to their promise to keep the stimulus of low rates and possible asset purchases available, then who are we to argue? What has worked in prior recoveries should continue to work now. In fact, we believe there is a real chance that asset prices might be significantly higher in the following months simply because of the record size of the stimulus.
Our recommendation to clients remains the same. Prudent asset allocation to risk assets is warranted and should provide the best risk/reward potential. Income sources should emphasize credit over duration as the former is highly correlated to economic expansion. Income sources that can rise at least with the pace of inflation should be favored. We suggest a full allocation to hard assets including materials, resources and soft commodities to protect portfolio purchasing power as inflation expectations rise. Investors with large, fixed income portfolios should benefit from the hedging characteristics of tangible assets protection from increasing inflation expectations. There is tremendous pricing dislocation in the markets that can really turn into pay dirt for investors.
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