The Capital Flight from Safety: It is Not About Tapering it is About Growth
Since Ben Bernanke’s comments seemed to unleash the bond vigilantes on June 19, we have seen a reversal in money flows that have used the U.S. Treasury market and the gold market as a “flight to safety trade.” Recent volatility in the U.S. equity markets, a coup in Egypt as well as renewed difficulties in Europe have not been met with a flight of money into the U.S. Treasury bond markets. Although many Federal Reserve (Fed) governors have attempted to clarify Bernanke’s comments as a “no change” in policy, the selloff in bonds has indeed been a bloodbath. Is the significant rise in bond yields simply a market presumption of tapering of quantitative easing (QE) or could it be what we would normally expect with a growth spurt on its way for the U.S. economy?
·What did Ben really say? What we heard when we listened to Ben’s comments was an observation that the U.S. economy was doing better and that expected growth in the second half (2H) of 2013 for the U.S. economy would be better than expected. We did not hear that the Fed changed their story. Logically, it would be crazy to withdraw their support in the form of asset purchases until they are convinced that the U.S. economy can grow on its own. The Fed has a history of staying too easy too long and we believe this time is no different. Removal of QE is a huge positive for the U.S. economy and would be a large boost for risk assets. Even after QE is history, the zero percent interest rate policy that the Fed will engage “long after the recovery is in place” is still very stimulating to the U.S. economy.
·Will rising yields hurt the housing and equity market recovery? Rising yields are generally correlated with economic growth. Growth in the economy means growth in the demand for credit. With banks loaded with capital to lend, this would be positive for the financials that supply credit at higher yields. Housing will grow because the pent-up demand has not been met. Mortgage rates are still near all-time lows and the housing affordability index is still very attractive. Equity markets like economic growth. In fact, history shows us that as the economy heats up the equity market doesn’t fade because of rising rates. In fact, we believe the recent rise in the U.S. equity markets reflects the forward look by the markets likely seeing the growth in 2H U.S. earnings.
·Is the Great Rotation starting? We believe it is. The flight of capital from the bond markets is not so much a statement of the credibility of the issuers in the market, but a general lack of potential reward as compared to the record duration risk linked to bonds. Money that is invested in the bond markets is generally there because it is risk adverse and looking for income. When the volatility begins to increase, any yield is wiped away quickly and losses quickly emerge. Selling is almost instantaneous and significant into a market in which dealers have greatly scaled back their capital. Could this be a buying opportunity? Maybe in the short term, but in the longer term a better U.S. economy tends to support higher interest rates and lower bond prices. We believe that investors who have been holding their breath in the bond markets have likely run out of oxygen. The Fed is trying to push money into risk assets…don’t fight the Fed. We see the balance of 2013 as supportive for equities and we see the flight of funds from bonds flowing toward equities.
·What about gold and commodities? Is the commodity “super-cycle” over? We don’t believe the super cycle that began in 2000 is over. We think that as long as global central banks are actively engaged in extremely easy policies that are designed to increase inflation expectations, that tangible hard assets will be a good place for investors. We are not “gold bugs;” however, we believe that the pullback in gold and other commodities should be bought. It is likely that as global economies recover and continue to receive monetary stimulus that demand for commodities and gold will increase. Current equity prices of industrial metal miners are at or close to levels seen at the market bottom in 2009. This is not a popular call but we think this is a good entry point.
Conclusion - We believe the recent flight from safety is supportive of the markets looking forward at more substantial U.S. economic growth. We believe that the best years for returns in the bond markets are behind us and that the market is telling us that the Fed will be forced to gradually withdraw record easing over the next year or so. We believe that their position has not changed and that history shows us that they will stay too easy too long. The housing market and employment markets will continue to heal and possibly at elevated rates versus what we have seen. Inflation expectations will rise globally as accommodative policy will continue until the inflation targets are met and likely overshot. In our opinion, this will support demand and prices for global commodities which should be bought now.
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