US: Look to the Fed
Is the US on the verge of changing its monetary policy outlook? With improving domestic conditions, a “good” state of inflation and mature growth in financial markets, we see the Central Bank as one of the most important economic actors in the year ahead.
In Nassim Nicholas Taleb’s best-selling book The Black Swan, the outspoken risk analyst and investor begins by discussing his childhood in Lebanon – a childhood upended by the outbreak of civil war in the 1970s. Looking back, Taleb is struck by the way many adults he knew at the time were constantly telling him that the conflict - which ultimately lasted 17 years - would be over “in a matter of days”.
Even as the fighting ebbed and flowed and took utterly unexpected turns, they remained confident they understood what was going on. No matter how many of their forecasts turned out to be wrong, they continued to proclaim that the turning point was near and all the country’s problems would soon be over.
This overconfidence in our understanding of events and our ability to foresee their consequences is common among participants in difficult situations. We become certain of our assumptions and disregard new information that contradicts or challenges them.
While the ups and downs of investing cannot be compared to life in a war zone, it’s no surprise that we frequently see this same tendency in financial markets. Right now, many investors may be in danger of falling into this trap with regard to the prospects of the US economy and the intentions of the US Federal Reserve. There is a degree of complacency regarding the outlook for interest rates and the prognosis for credit markets that is at odds with a more critical and unbiased look at recent data and events.
The US Economy is Reaching Escape Velocity
Overall, the outlook for the US economy is increasingly encouraging. At Pioneer Investments we expect GDP growth to rise to 3.4% in 2015. However, it should be noted that the composition of the growth will be more significant than the exact number.
We think government expenditure, which has been a drag on growth in the last few years due to spending cuts, should begin contributing to growth again from 2015. Meanwhile, consumption should be expanding slightly above its long-term trend, helped by an improving labour market and a moderate pick-up in earnings and disposable income.
Deflation, which is a potential threat in some regions of the world such as Europe, seems not to be a danger in the US. While CPI has dropped to around 1% on a number of occasions over the past couple of years, this is mainly due to beneficial falls in commodity prices. Inflation in service prices – which, unlike commodity prices, are determined by domestic economic conditions - has been approaching 3% recently1.
In other words, the trend is towards “good” disinflation rather than deflation, which is a positive development for the economy. Meanwhile, deleveraging appears to be over: bank credit is now growing at an annualised rate of around 7%2. With the unemployment rate dropping towards the 5.5% level at which employment cost pressures have historically picked up, there is scope for wage inflation to start kicking in over the next year or so.
We believe this is promising for growth, but these trends seem hardly compatible with interest rates remaining zero-bound for much longer. Yet investors do not seem to be taking account of how these new developments are altering the monetary policy outlook.
In our opinion, it’s evident that the Fed is having internal discussions about switching to a less dovish stance, as is demonstrated by the individual Federal Open Market Committee (FOMC) members’ expectations for the future path of interest rates. Comparing releases from December 2013 and September 2014 clearly shows rising FOMC expectations for 2015 and beyond.
However, investors’ forecasts, as measured by the Fed Funds Rate futures curve, are lagging behind this shift. This means that when a catalyst such as wage inflation finally forces the Fed’s hand, it may move faster than investors are expecting. Since the market is not prepared for this, there is a significant risk of overreaction.
Our analysis of past Fed tightening cycles has shown that while long-term interest rates do not always rise, the interest rate curve flattens dramatically (in other words, short-term interest rates rise much faster than long-term ones). We believe this time is unlikely to be different and our investment teams are positioned to manage this shift.
Credit Markets: Relatively Expensive, but in a Good Corporate Environment
Turning to the US credit markets, our fixed income specialists agreed that this asset class is experiencing extended valuations in some areas and a deterioration of quality issuance. However, they think that a good corporate environment, supported by improving economic fundamentals in the US, should continue to validate a constructive view on the asset class for 2015.
Some warning signals may be read in new corporate issuance that has shown a downward migration in credit quality in recent years, with BBB-rated bonds accounting for more than 30%3 of issuance this year, versus 25% in 2008.
At the same time, gross leverage is nearing the peak of the last cycle.
Valuations look relatively expensive across all categories, including US investment grade corporates, high-yield, bank loans and mortgage-backed securities. Spreads versus US Treasuries are around half a standard deviation to one standard deviation below their long-term averages4 meaning credit spreads are quite low compared to historical Average.
This reflects the “reach for yield” that has been a feature of markets in recent years, due to the low interest rate environment. Assets invested in bond vehicles have more than doubled since 20085.
Unfortunately, this has taken place at a time when underlying market liquidity is dropping, partly due to new regulations that are restricting the ability of investment banks to hold bonds in inventory and act as market makers. We believe this could put the market under pressure in the case of a sudden change in sentiment.
In the event that rising interest rates drive large outflows from credit markets, liquidity may not be sufficient to allow investors to exit in an orderly manner. This is an example of how changing circumstances can create new risks whose implications are not widely understood, and deserves close scrutiny by investors who have embraced these asset classes in the search for higher yields.
We see another nascent risk in recent currency trends. The dollar has historically tended to go through cycles of strength and weakness: it enjoyed a decade of strength in the nineties and a decade of weakness in the 2000s. Recent movements indicate a potential shift back towards a period of strength, despite calls by US policymakers for a weaker currency6. Rising interest rates could well reinforce this. The threat of “currency wars” is, in our view, a development of which investors need to stay abreast.
The main question, therefore, is why investors have not yet started to respond to the risk posed by the Fed’s shifting views. Their response continues to be asymmetric, implicitly betting on continued low rates. Weak economic data is met by further rounds of Treasury bond buying, while stronger data is generally shrugged off with little tendency towards rising rates.
This, in our view, reflects a consensus dovish positioning and could raise fixed income vulnerability in the coming months. The brief but sharp sell-off that we witnessed in October may be a small, early warning of what we can expect once participants can no longer deny the reality of a change in monetary policy stance.
A Selective Focus on Equities
US equities remain significantly more attractive than bonds on valuation grounds, according to Pioneer Investments’ credit and equity teams. The ratio of investment grade bond yields to the S&P 500 earnings yield is more than one standard deviation below average on both trailing and forecast earnings7. Nonetheless, equity conditions are becoming more challenging and it will be important to pay close attention to certain factors and themes in 2015.
For example, the strength of the domestic economy is one of the starkest contrasts between the US and the rest of the world. To us, this supports a focus on stocks exposed to US growth, while also retaining a global perspective.
This divergence is also likely to lead to a slowdown in the process of globalisation, as companies reassess their priorities and investment plans. Investors can expect to see an increase in domestic opportunities as rising US growth makes expansion at home more attractive.
Meanwhile, the recent strength of the US dollar has implications for which sectors are likely to outperform expectations. Historically, dollar strength has tended to be positive for industries such as healthcare, financials, consumer discretionary, consumer staples, industrials and information technology. However, it is usually very challenging for materials. This suggests to our team that investors should be very cautious of commodity stocks and also of commodity-dependent economies.
The one major sector in the US that has not yet fully recovered after the global financial crisis is housing. We think this should present opportunities as it begins to normalise in 2015 and our US equity team is beginning to look at these opportunities.
The shale gas revolution remains an important theme, despite the recent fall in the oil price, as natural US gas prices remain low by international standards and are likely to rise over time. On the other hand, it's worth noting that while low energy prices are good for the US economy, the low oil price may produce a lot of disruption for energy companies.
It’s also extremely important to appreciate the extent to which the internet and the “winner takes all” environment are shaking up the global economy. It’s notable that many of the top 20 companies in the S&P 500 are very young - something that is unmatched in any other country and demonstrates the dynamism of the US economy. Investors would need to have exposure to these winners and consequently should pay attention to major trends, rather than simply focusing on the near-term outlook for growth.
With bonds expensive and growth starting to pick up, we believe it’s also likely that investors will increasingly focus on the income potential for equities. This is likely to favour large cap stocks, which are significantly more attractively priced than smaller ones: the S&P 500 trades on a price/earnings ratio of around 18 times, versus around 25 times for the S&P Small Cap 6008. Other factors in favour of large caps include the fact that multinationals have large amounts of cash outside the US, which they may be able to repatriate in the event that policymakers can agree on tax
reforms, and solid levels of share buybacks at many firms.
Large cap stocks tend to be relatively defensive, so a large cap bias may remain a relatively conservative way to take a long equities strategy. There are definitive arguments for being moderately conservative in the current environment. While economic growth is improving, investors need to be conscious of two headwinds.
First, the US population is ageing and the baby boomers are coming to retirement. This means that the proportion of investors adding to their holdings
relative to those drawing down their investments is becoming less favourable, which will put downward pressure on market valuations. Second, the bull market is relatively mature: having run for about 70 months it’s now the fourth-longest bull market since 1928 and significantly in excess of the average of 58 months.
Overall then, equities look to us to be the most compelling opportunity in the US markets. They offer a more potentially attractive combination of risk and reward than fixed income and credit markets, which may be in danger of some upheaval as a less dovish Federal Reserve undermines their current forecasts.
However, it’s important to have realistic expectations for returns. Pioneer Investments’ equity teams believe that the exceptional returns of recent years are unlikely to be repeated but that moderate returns are still achievable.
1 Source: Bloomberg, data available as of November 30, 2014.
2 Source: Federal Reserve. Data as at Q3 2014. http://www.federalreserve.gov/releases/h8/current/#fn1
3 Morgan Stanley Research, Yield book, Bloomberg, Deal Logic. Data as of 31/7/14.
4 Standard deviation is a measure of the dispersion of a set of data from its mean. The sentence means that credit spreads are quite low compared to historical averages.
5 Source: Strategic Insights. Data as of October 31, 2014.
6 Source: Federal Reserve officials’ comments on US dollar, as of October, 2014.
7Source: Pioneer Investments on Bloomberg data. Data available as of November 30, 2014.
8Source: Bloomberg, data as of December 1, 2014.