Wednesday, July 9, 2014

Are Rate Hikes Going to Pop the Equity Market (not yet a) Bubble?



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FYI…I thought I’d share a few bigger-picture thoughts on issues that are serving as a backdrop to some portfolio shifts that I have under consideration. 



Fixed Income is not something that you’ve heard me talk much about for some time.  I have not had any in the strategies since yields had gotten too low to argue for a  good risk/return payoff.  Cash appeared to be the better option, leaving ‘powder’ dry to take advantage of equity market selloffs, either broad-based, or on selective issues.



Recently, especially with the improving US employment data, there’s increasing talk about the Fed’s targets on employment and inflation getting closer to being realized, and in turn, expectations are growing for a sooner-than-had-been-thought rate hike by the Fed.  As you can see in the following chart of 2yr Tsy yields, the rates have nearly doubled in recent weeks to approximately 0.50%.  One key issue worth considering is whether this is the beginning of a meltdown in the fixed income markets, which have been at historically low yields and tight spreads (especially high-yield) for quite a while, or whether the sell-off in fixed income and in turn the rise in rates will be limited by the automatic-stabilizer impact that higher rates will have on slowing the economy and taming inflation (if any).  Financial market literature and research is riddled with various versions of this debate.  Most notably, in my mind, is the recent introduction of a new term into the financial markets speak:  MACRO PRUDENTIAL POLICIES.  To be fair, it’s not entirely new in the academic literature, but for main-street-Wall-Streeters to be throwing around the term with seeming fluency, one has to take note.  In essence, Yellen, and Draghi, both went out of their way in speeches last week to counter the criticism laid upon them by the BIS who said that the overly easy monetary policies of central banks are setting the stage for another financial crisis as asset prices rise and bubbles ensue.  Yellen and Draghi countered by saying that rate hikes were too much of a ‘shotgun’ approach, and that in order to mitigate systemic risk of financial instability, central banks have to use targeted, rifle-shot macro prudential policies (code for regulations, supervision, stress tests, capital levels, etc). 

(Cont’d below….)



The focus at this point has to be on just how far Yellen and Draghi go into turning the rhetorical battle into actual practice.  To be sure (or as sure as one can be) continuation of the Fed’s tapering is widely anticipated and, as I mentioned, the timing of the Fed’s first rate hike has also been brought forward.  But the Fed is well aware of the impact that higher rates has on the economy, witnessing the slowdown in the housing sector that we saw since last year when long rates and mortgage rates climbed.  That, in and of itself, may be the limiting factor in keep the Fed from raising rates too far too fast.  Likewise, on the long-end of the curve, higher long-term rates wouldn’t be surprising, but just how far long rates climb is likely to be tempered by an environment of relatively slow economic growth (for ’14, trend growth in the US of roughly 2.0-2.5% is still a wished-for outcome!) and minimal signs of inflation (though rising oil, food and other commodity prices have to be watched closely).



We started this year with 10yr yields closer to 3.0%, and as they’ve fallen, equities have continued their rise to historic highs (see first chart below).  We also have a situation where, from a valuation perspective, equities are not quite yet in nose-bleed territory, but they’re not far from it! (see second chart below from DecisionPoint on StockCharts.com which shows where the S&P would be priced based on trailing 12-mth earnings at various P/E ratios.  It shows current actual S&P levels at near 20x, which has historically been considered the ‘overvalued’ zone).









From a strategies perspective, I’m remaining defensive on equities, taking profits on some positions that appear to have overstretched, but continuing to look for seemingly oversold opportunities in the market to add to our positions.  If the markets continue to take short rates higher, I will be looking to add short term investment grade corporate bonds if they appear to be oversold. 

In coming days, I’ll be updating more specifics on individual assets and on other portfolio considerations.  Stay tuned….

Best,

Ed

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(Please note: This article is solely meant to be thought provoking and is not in any way meant to be personal investment advice. Each investor is obligated to opine and decide for themselves as to the appropriateness of anything said in this article to their unique financial profile, risk tolerances and portfolio goals).
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