The Peloton Position / 2nd Quarter 2013

When Good News Is Bad News

General concerns about government sequestration and higher taxes have moved into the background. Investors are now contemplating the end of the Fed’s accommodative policies, which some see as necessary fuel for the rally in stocks. When and how the Fed will taper its monthly purchasing of $85 billion of bonds (“quantitative easing” or “QE”) is now the short-term driver of bond yields, currencies, and stock prices. Traders are hanging on each word uttered by FOMC members, and markets react immediately to comments offering clues about the timing or structure of the Fed’s exit strategy.

It is debatable whether QE has helped, hindered, or made little difference spurring economic growth or improving the employment picture. What is not debatable is the fact that many market participants believe that QE is keeping stocks and the economy afloat.  Or at least they perceive that others believe it to be the case, which means that any mention of the beginning of the end of the program—no matter how distant or gradual it might be—starts a stampede toward the exits. Markets are on edge, and perception becomes reality.

Too much emphasis has been placed on the Fed’s role in artificially inflating asset prices—particularly stocks. We examine a scenario that might lead to a slower pace of Fed intervention and what that might mean for equities. Chairman Bernanke has explicitly stated that an unemployment rate of 6.5% (well below today’s 7.6%) is necessary for changing the stance of monetary policy.  He has also been clear that 6.5% is merely a threshold, not a trigger, for tighter monetary policy. To lower the unemployment rate by 1.1%, the economy would have to create approximately 1.7 million additional jobs, and, with merely 175,000 jobs added in May, the Fed is unlikely to reverse its accommodative stance anytime soon. If the economy does accelerate sharply, many positive factors will counteract the eventual loss of QE, including higher corporate revenues, profits, and cash flow, as well as higher aggregate wages and tax receipts.

The good news is that recent economic data suggest accelerating growth is possible. Foremost, housing trends are gaining momentum: new home sales have returned to 2007 levels, average selling prices are rising (April Case-Shiller data reported June 25th showed the largest monthly increase on record).  Additionally, the Philly Fed survey on manufacturing recently surprised on the upside; orders for durable goods in May were stronger than expected; and leading economic indicators remain solidly positive. The irony is that markets’ collective reliance on QE (perceived or real) has become so pervasive that strong economic data is being received as bad news for markets because it could hasten the Fed’s exit. We think that virtually any scenario that leads to the end of QE is fundamentally good for operating companies and stock prices. The Fed will not remove the metaphorical training wheels until the economy is clearly able to ride without them. There may be some initial wobbling, but, ultimately, the economy and financial markets will move more efficiently without the support.

HIGHER RATES, FINALLY?

The way in which the end of QE might negatively impact things is through higher interest rates.  If the Fed stops buying bonds, prices will fall and rates will rise. Most financial industry professionals agree that this not only will happen, but it should happen.  The question becomes at what level will interest rates become a headwind for economic growth?  We think a more natural equilibrium is appreciably higher than current levels and that the economy can withstand a significant backup in rates as long as inflation remains tame.

QE has succeeded in keeping rates low, and we concede that interest rates will be higher without Fed intervention. We diverge from conventional wisdom on the notion that current economic activity and future growth is dependent on artificially low rates. The economic impact of low rates has been muted because the transmission mechanism (lending) has not been fully functioning. QE is achieving its objective of holding rates low, but lower rates are not translating into more economic activity because very few would-be borrowers have sought to increase their borrowings in the wake of the financial crisis and recession. In fact, households and corporations have been massively deleveraging, not seeking additional debt. Small businesses have been loath to draw on credit facilities, and many are continuing to stockpile cash.  Low rates encourage economic growth when capital is lent and then spent— on hiring new workers, building new facilities, or investing in R&D—activities that move the economic needle. Relatively higher interest rates will not stymie economic activity that was not dependent on lower rates in the first place. Mortgage rates will rise and that has implications for new home buyers. Most qualifying current homeowners have already refinanced and locked in a lower rate and payment. Since the crisis, debt levels are much lower throughout all areas of the private economy, so debt servicing costs will not rise in dollar terms as much as they have in other rising rate environments. So, from the potentially negative side, the economy is less sensitive to higher interest rates than it has been in other cycles.

Higher interest rates also have several positive effects that are less often discussed. Lenders and savers will benefit, bank profitability will increase due to a wider net interest margin spread, the rate of return corporations and households earn on their huge cash hoards will increase, and retirees will see their investment income grow as maturing bonds are reinvested at higher yields. Baby Boomers are retiring in huge numbers daily, therefore higher levels of investment income will impact consumer spending trends.

Rising rates would become a problem if accompanied by uncontrolled inflation. But, despite the unprecedented actions by the Fed, inflation indicators remain docile. The anticipation of higher rates has caused the U.S. dollar to appreciate. This, in turn, has broadly weakened commodities prices—which are dollar-priced in international markets—including copper, iron ore, gold, and, to a lesser extent, oil. China, which has been the net buyer of most of the world’s commodities for years, appears to be slowing, which puts additional downward pressure on input prices. With no inflationary pressure on the raw input side, it is difficult to envision a big uptick in pricing pressures. Similarly, wage inflation has been nonexistent due to the remaining slack in the domestic labor market.  Finally, the Fed’s exit will, by definition, withdraw liquidity and dampen any inflation expectations that might have been brought about by its extraordinary flooding of the system with liquidity.

SEEING OPPORTUNITIES

Currently, we’re focused on broadly encouraging economic data in the U.S. and some identifiable trends that might offer opportunities. At this point in the cycle, we think the housing industry is investable due to a number of underlying demand drivers. Housing has rebounded meaningfully since it became ground zero for the financial crisis, but we think it is still early in a multi-year expansion.

Monthly “Housing Starts” reports the number of new homes under construction. From 2000-2006, 1.5-2.0 million new homes were being built annually (see Figure 1 below).

New Housing Rates in the United States

Source: U.S. Department of Commerce, United States Census Bureau

During the downturn, activity plummeted to 500,000 units and remained depressed while a glut of unsold inventory was worked off. Today, the unsold inventory of new homes stands at just 4.1 months of supply, which is the lowest level since March 2005. And, although housing starts have virtually doubled from the bottom, they still remain well below historical trends.

It takes approximately one million new homes each year just to keep pace with the rate of family formation. In addition to base underlying demand from family formation, several other factors strengthen the thesis for a growing housing industry. First, multi-generational cohabitation (for lack of a better term) increased during the recession. Kids moved back in with Mom and Dad; sometimes Grandma and Grandpa did too. As the economy recovers, these arrangements of necessity will naturally unwind. Second, even with a recent increase in mortgage rates, “home affordability” remains very high. Rental rates have risen to the point that the “rent vs. buy” decision is skewed decisively toward buying. Third, meaningful immigration reform could provide another demand driver. Finally, prices are rising and existing homes are easier to sell. This makes the labor pool more “mobile,” which allows individuals and families to move for job opportunities instead of being trapped in houses they couldn’t sell.

We think that housing starts will continue to grow for the next several years, returning to 1.5 million annual units at some point, which would be very positive for construction materials companies, building supply companies, home goods retailers, tool and equipment manufacturers, and freight transportation companies.

Two other huge swaths of the American economy are also booming—autos and energy. Like housing, both have strong underlying positive momentum and multiple growth drivers that point to long, sustainable expansions ahead. This is bullish for the overall economy. Housing and autos, two huge American industries, are shifting from rebound mode into sustainable expansions. Energy exploration and infrastructure creates new jobs, but, even more importantly, energy independence makes the U.S. a more attractive place for domestic and foreign companies to base new operations and to expand.

Quantifying this optimism, we are forecasting S&P 500 earnings of $110/share this year. If we assume some valuation headwind from rising rates, offset somewhat by an upward revaluation for top and bottom line growth, a P/E ratio of 15.5 would not be outlandish historically. (Figure 2 illustrates historical profit support for equities.)

Corporate Profit vs S&P 500

This earnings/valuation combination provides a target of 1,705 for the S&P, which is more than 8% above the level at the time of this writing (9% including dividends). After a choppy period leading up to the Fed’s reduction in QE, stocks have plenty of fundamental support to resume the earnings-driven uptrend.

 

The Peloton Position is a compilation of original insights and writings by Peloton Wealth Strategists. This issue features articles by Matthew K. Bradley, Executive Director and Chief Investment Officer.