Why a Normalized Yield Environment Marks the Return of Capitalism
As it has for the past few years, sentiment once again shifted dramatically in the second quarter and volatility returned to the markets. However, unlike the previous few years, it was the bond market that felt the brunt of the pain as speculation that the Federal Reserve may soon pull back from its unprecedented stimulus efforts fueled a one percentage point jump in 10-year Treasury yields during the final two months of the quarter.
After gaining 12.4% in the first quarter of 2013, the Russell 2000 Index advanced 3.1% in the second quarter, finishing the first half of the year with a 15.9% gain. At the same time, the CBOE Volatility Index (VIX), after hitting fresh lows in March 2013, spiked 33% in the second quarter—the largest increase since the third quarter of 2011.
In the span of one quarter, we have transitioned from a world in which the idea that interest rates would remain indefinitely low to one in which the shift back to a more normalized yield environment is now center stage.
From our perspective, the end to the easy money bias that has been in place for several years presents an attractive environment for active managers with an absolute orientation like us, as underlying fundamentals and less-leveraged balance sheets should become increasingly more important.
We have long thought that the ongoing efforts to reflate the economy through numerous quantitative easings and a zero interest rate policy would have unintended consequences. To be sure, the actions of the Fed have been distorting asset pricing and valuations in the equity market in a number of ways. Many of the fundamental qualities we hold so dear, for example, seem temporarily suspended in an investment world where highly-leveraged businesses are benefiting from the ability to restructure their debt, lower funding costs, and extend maturities.
The unintended consequence of leveling the playing field has given lower-quality companies the luxury of time, which in a normal environment they would not have. It would not surprise us to see these trends reverse as tapering is implemented and monetary stimulus is slowly trimmed back and ultimately withdrawn.
To be clear, our balance sheet scrutiny is paramount to our process, particularly our focus on risk. To that end, we have always chosen to focus on companies with high operating leverage. Our measure of financial leverage centers on the ratio of assets to stockholders' equity, looking for a two-to-one ratio for non-financial companies.
This is an important part of our ongoing search for a company's “margin of safety.” If a company is carrying too much debt, it impedes its own ability to meet the challenge of out-of-left-field occurrences such as lawsuits, the loss of a major customer, or overseas currency crises.
A conservatively capitalized company, especially a smaller company, can better weather these storms because it has the necessary financial reserves to do so, while a company with too much debt on the balance sheet runs a greater risk that stormy weather will turn into a hurricane.
We also view financially strong companies as well-positioned to grow. The assets of these companies are derived more from retained earnings than paid-in capital, i.e., they have the ability to self-fund their own success as a business.
Of course, transitions are never easy. Shifting back to a more normalized yield environment is likely to be marked by increased volatility and pockets of uncertainty. Stock prices have begun the transition from their reliance on monetary policy to fundamentals, which is a process we believe will stress the importance of companies with strong, less-leveraged balance sheets, excess cash flow generation, and the ability to self-finance.
We look forward to a more normalized yield environment that could usher in that long-awaited flight to quality.
Important Disclosure Information
Francis Gannon is a portfolio manager of Royce & Associates, LLC. Mr. Gannon’s thoughts in this essay concerning the stock market are solely his own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.
The Russell Investment Group is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group. Russell 2000 Index is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index. The CBOE Volatility Index (VIX) measures market expectations of near-term volatility conveyed by S&P 500 stock index option prices.