Mitch Zacks, Senior Portfolio Manager at Zacks Investment Management: “The S&P 500 gained 2.4% in the second quarter. Like many equity investors, I am anticipating that the second half of the year will be far more volatile than the first half. The reason for the volatility is that interest rates are going to be rising, which will play havoc with the fixed-income markets, and the stock market will likely suffer collateral damage. In the end, my best guess is that the S&P 500 will end 2013 roughly 3-4% higher than current levels due primarily to the strengthening economic recovery.
Fluctuations in interest rates will remain center stage in the second half of 2013. Usually, the ten-year treasury yield should be about 200 basis points, or 2%, above the inflation rate. Right now, as of the end of June, the ten-year treasury is yielding 2.5%. The problem is that inflation is not even close to 0.5%. Most likely, depending on how it is calculated, core inflation is running around 1.1% annually and projected to rise to around 1.5% in the third quarter of 2013. This is below the Federal Reserve’s target of 2% and is also substantially below the average inflation rate we have seen in the U.S. The current low inflation rate implies that the ten-year treasury should be over 3%. The reason the ten-year rate is not that high is because the Federal Reserve is buying $85 billion dollars of treasuries and mortgage backed securities each month in order to artificially keep interest rates low.
From 1914 through 2013 annual inflation has averaged 3.35% in the U.S. This implies that when the economy returns to normal, the yield on ten-year bonds are likely to at least double from 2.5% to 5%. The 5% number is arrived at by estimating that inflation will return to historical norms of 3% and, in the absence of bond buying by the Federal Reserve, the ten-year treasury will price itself so it yields around 2% above the inflation rate.
If we estimate that the yield on a ten-year treasury will increase from 2.5% to 5% over a three year period, this implies that ten-year bond prices will fall roughly 23% over this three year period. Effectively, if inflation returns to historic levels and the Federal Reserve stops its bond buying, investors holding treasuries are going to have their heads handed to them. This is all dependent on rising inflation driving rates up to historic levels. There really are two factors holding inflation back.
The first is the absence of wage inflation. There has never been an extended period of time when we have had price inflation without wage inflation. Fortunately for the bond market, wage inflation has been completely absent over the past few years. I believe that globalization is the primary reason wage inflation has remained low. Workers now must compete in a global wage market which is keeping downward pressure on wages. However, while this might extend the period of low wage inflation, eventually the wages in the developing countries must begin to rise, and correspondingly wages in the developed countries will go up as well. Additionally, once the economy starts growing above 2 to 2.5% per year, we should start to see unemployment decline and as a result wages will start to rise.
The second big factor keeping downward pressure on inflation, and thus nominal interest rates, is information technology. Fifteen years ago, goods were bought in local markets. Now, consumers using their smartphones can find the absolutely cheapest producer of almost any good. From cars, to books, to refrigerators – it is now very easy to find the absolute cheapest provider of any good a consumer wants to purchase. This global competition keeps prices low, and may have caused a permanent downward shift in inflation. I doubt this permanent shift. My experience has been that when people begin to think that something has permanently changed, chances are better than not that this time it is not that different.
I believe that inflation will begin to materialize sooner rather than later. Most importantly, GDP growth will probably begin to reaccelerate and effectively grow at an annual rate above 3% in 2014. With the economy improving, the massive monetary stimulus that is being undertaken by the Federal Reserve and other central banks must result in inflation. When this inflation hits, it is going to come on stronger and faster than most investors are expecting. Any increase in inflation is bad news for both the fixed income and the equity markets, but it will hit the fixed income markets much harder.
An investor still needs to keep some form of fixed income in their portfolio to hedge against the possibility that the economy does not recover and corporate earnings begin to contract. However, I would recommend at this stage in the cycle to be leaning more towards equities as opposed to bonds. here were some signs this past week that the recovery in housing remains on track. Several measures of home prices show double digit annualized gains. More importantly, new home sales rose and pending home sales also crept up. The higher home prices are serving to keep consumer sentiment near a six-year high. Likely, as a result of increasing home prices, people are feeling wealthier which explains why orders for durable goods rose more than expected in this past week. The consumer seems to be doing the lion’s share of the economic recovery, with the buying by individuals offsetting the pull back in government spending as a result of the sequestration. Additionally, energy prices remain very low.
Despite positives, because of rising interest rates, the strengthening dollar and the weakening equity markets, it is likely that near term GDP growth rates are going to come slightly down. This brings us to the state of equity markets. Now the stock market is unfortunately in a damned if you do, damned if you don’t, state. If the economy recovers stronger than expected, it will likely cause some inflation and the Federal Reserve will be forced to taper their bond buying sooner than expected. This would be a negative for the market. If however, the economy weakens substantially, earnings estimates will be pulled back and the market will sell-off.
To head higher, what the stock market really needs is an economy that is neither too weak, nor too strong. If we see such a goldilocks type of economy, the stock market will continue to benefit from improving earnings due to a growing economy and lower interest rates due to the continued easing by the Federal Reserve. It is starting to look like a narrower and narrower band that economic growth must materialize in for the market to continue at the rate it has in the first half of the year.
As a result, the probability of disappointment is growing and I would not be surprised to see some selling in the second half of the year. At the end of the day, the right course of action is to keep your eye on the long-term and ignore the quarterly, or even yearly, fluctuations in the market. Thus, for the investor with the time horizon of several years, a market pull-back represents a buying opportunity.
Unfortunately, the chances of such a buying opportunity materializing are growing. My best guess is that the economy will surprise investors by growing too fast, inflation will come on too quickly, and the Fed will be forced to taper. The market will sell-off in the short-term, but the growing economy will ultimately push the market higher as earnings growth will come in stronger than expected.
I continue to like dividend paying stocks as rates remain low, but would give a bias towards those dividend payers that are more cyclically positioned – financial dividend payers should continue to be attractive as the yield curve steepens. I don’t think now is the time to be overweighting utility companies and it is very clearly not the time to be increasing fixed-income exposure.
While we are likely going to see some volatility and selling in the immediate future, the key is to make sure you are positioned so that despite pullbacks, you can continue to hold equities. Over the long-run, these quarterly fluctuations in the market that we spend so much time worrying and analyzing about, really amount to noise. The key, as always, to making money in the stock market is to be able to hold stocks for a long period of time and not to overreact to market fluctuations”.
Mitch Zacks, Senior Portfolio Manager at Zacks Investment Management, oversees the management of billions of dollars for private clients. He wrote a weekly column for the Chicago Sun-Times and has published two books on quantitative investment strategies. He has a B.A. in Economics from Yale University and an M.B.A. in Analytic Finance from the University of Chicago.
Disclosure: This communication is for informational purposes only and nothing herein should be construed as a solicitation, recommendation or an offer to buy or sell any securities or product, and does not constitute legal or tax advice. The information contained herein has been obtained from sources believed to be reliable but we do not guarantee accuracy or completeness. Do not act or rely upon the information and advice given in this publication without seeking the services of competent and professional investment, legal, tax, or accounting counsel.
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