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Royce Funds Charlie Dreifus - What Does An Improving Economy Mean For Stocks and Bonds

August 25, 2013

As late summer arrives, the Federal Reserve continues its delicate balancing act of wanting further recovery without causing a bubble. The latter is being done in some measure by communicating the central bank’s intentions to gradually withdraw monetary support.


However, even that communication alone, as we saw in June, can send interest and mortgage rates surging, with the resultant slower economic growth. A tricky balance, indeed, though the market seems to be leaning towards doubting the Fed’s ability to stop easing. I still want to stress, however, that the stock market has been trending higher as long as the Fed’s balance sheet has been expanding. Even with tapering its balance sheet would still be expanding, just not as rapidly.

Clearly concerns about tapering have receded, as have rates. Thus the Fed, by talking up and down its tapering intentions, can cause a contained self-correcting, short-term up and down move in the markets as well as, perhaps to some degree, in the economy. Since May, the 10-year Treasury has gone from yielding 1.62% to 2.74%, a 23-month high, before receding a bit. The rise in rates has, to a significant degree, resulted from the expectation of a tapering of the Fed’s bond purchase program.

Some believe as I do that the first move, as well as subsequent tapering, is likely to be a baby step, because removing such a large amount of excess reserves has no precedent. The Fed obviously wishes to avoid any serious disruptions to the economy and the markets.

Better-than-expected earnings in the most recent reporting period were off of reduced expectations. Revenue growth remains elusive. In my opinion, the remedy continues to be more strategic, inter-industry mergers with their resultant synergies. With a strong dollar and declining budget deficit, the case for higher P/Es is making the rounds. This is in addition to the energy silver bullet.

Obviously QE cannot last forever and once bondholders incur additional losses, their loyalty will be tested and we will see if the long-expected rotation into equities really does develop. Simply stated, rates are poised to rise over time.

Pension funds and endowments face another challenge that could prompt more equity exposure. Namely, it is hard for them to earn, say 7.5%, with any liquidity when nearly half their portfolio is in alternative investments.

Fed Chairman Ben Bernanke has stated that the widely used target for the unemployment rate—7.4% currently—overstates the strength of the labor market. This gives me even more conviction that the stated objective of bringing the unemployment rate down to 6.5% is a soft target; I believe the real objective is an even lower rate. The Core PCE (consumption price deflation), the Fed’s preferred inflation index, remains well below its target.

Our economy continues to look better, while the global picture (exclusive of China) also seems to be gradually improving. So far, consumers seem unaffected by higher gasoline prices, although the price of gasoline, now at $3.63 a gallon in the U.S., could become a problem as it has been above $3.50 a gallon less than 10% of the time in the past 37 years (since 1976). One must assume some of the currently elevated prices are due to concern over what is occurring in Egypt.

Some believe the improvement in the U.S. economy is becoming increasingly self-sustaining, owing to the cycle of housing strength leading to employment gains, etc. All of this is happening while inflation remains tame. Stronger equity and housing markets have led to sustainable economic growth through the wealth effect mechanism. The Fed is obviously taking that into account when considering tapering.

Goldilocks is alive and well. We have seen “just good enough” economic data coupled with low inflation, which results in “win/win” outcomes. The U.S. economy is not weakening but also not accelerating, which is not the stuff that prompts tapering. Yet employment seems to be improving, producing subpar productivity and earnings growth.

Most forecasters do expect an improvement in the economy as we progress through the second half. However, one is also reminded of the expression, “Be careful of what you wish for…” When the economy really starts moving ahead smartly, the central bankers will no doubt reduce accommodation. Perhaps that will be the signal to lighten up.

Pessimists fear that stock market sentiment has run ahead of economic fundamentals while optimists argue that equities are a predictor of economic prospects. Straddling these views are those who are committed because there seem to be no viable alternatives. Still, it is sobering when one reflects on the mere $1.3 trillion of economic growth off the 2009 lows compared with the $12 trillion improvement in equity values.

Stock prices have risen so much that many feel there are not a lot of future returns left. It is true that to some degree we are flying without navigation regarding the proper multiple. Yet we may be in a period similar to markets last seen in the 1980s and 1990s when we experienced both non-inflationary growth and rising share prices. An economy that experiences non-inflationary growth typically sees expanding P/Es.

Market valuation indicators remain somewhat elevated in my view, but they are not necessarily too high for the financially repressed environment in which we find ourselves. More cyclical sectors are improving relative to the market as a whole and particularly versus financials. This makes sense, as rates are rising in part because of the ongoing economic recovery. I would welcome a timely pause or correction.

Another development in the U.S. equity markets has been the decline in the number of listed companies as well as the total number of shares outstanding. While there is not a scarcity, supply has shrunk in the face of greater demand. One need also reflect on the fact that U.S. equities equal about one-third of the world’s total equities, with Japan the next closest at about 8%.

Interestingly, even the central banks are buying equities, which might be the ultimate comment regarding “don’t fight the Fed.” So far, however, the predicted grand rotation from bonds into equities has not been so grand. Most of the money taken out of bond funds has gone into money market funds. If equities continue to rise, as I expect they will, more equity funds will be bought, albeit at higher levels.

Earlier in July we witnessed the longest winning streak by the Nasdaq 100 since 1990—14 days: a longer streak even than what took place in the 1999-2000 tech bubble. The underlying strength in the market cannot be ignored. The market’s advance has been broad based. In fact, the S&P 500 equally-weighted index is outperforming the cap-weighted one. Cyclically biased companies are generally also doing well.

Small-caps remain favored in the marketplace for, among other reasons, their U.S.-centric business and earnings that suffer no currency hits as well as being available for dividends without the repatriation issue.

I still believe that companies need to acquire competitors in order to grow earnings in any significant manner. In today’s environment it is cheaper to buy companies than through organic growth from capital expenditures.

I remain focused on dividends, not yield. Demographic data regarding the growth of U.S. retirees suggests that investors will be seeking bond-like stocks, particularly given risky fixed-income alternatives. Bond-like equities should provide reliable, and hopefully growing, cash dividends produced by stable profit streams. In contrast to bonds, these securities should also offer some inflation protection.

Such high quality companies, particularly those with high returns on invested capital, should be able to raise prices in order to retain their real earning power, which should allow them to raise their dividends, which should in turn produce a hedge against inflation-driven increases in the cost of living.

My search for decent-yielding, dividend-growing, predictable cash-flow-generating, high-quality companies, not excessively-priced companies, continues unabated. Some view Apple’s debt-financed dividend hike as a turning point in the move towards higher payout ratios. I see more dividends being paid and remain committed to my dividend growth search.

As profit margins become more difficult to sustain, I also suspect earnings quality will become more important.

As investors now start to look towards the end of the summer, much is ahead for September. Will the Fed implement some form of tapering at its September 18-19 meetings? German elections will occur on the 22nd, with potentially important consequences for the eurozone.

In Congress there is talk of a group of Republican senators who might be willing to implement a deal with the Democrats on taxes and spending. This appears not to be factored into the market beyond the lesser concern in general about the deficit. While no doubt still far apart, should we get some better thought-out, pro-growth investment tax solutions, it would further enhance the attractive outlook for U.S. equities.

I also hope to benefit, as other stocks pickers would, from the 20-year low in global market correlations. In that environment stock pickers should have an easier time to potentially outperform.

Link to Royce Funds: _http://www.roycefunds.com/

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Canadian Value

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