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James Nesci
Senior Vice President
Chief Wealth Management Officer
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Alan D. Segars
Vice President
Investment Management Officer
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No matter the maturity, interest rates are at exceptionally low levels. At the short end of the yield curve, rates are anchored by the Federal Reserve’s maintenance of a near-zero Fed funds policy. Further out on the curve, 10- and 30-year bond yields have reacted to tame inflation and sovereign debt concerns. Recently, weak economic data have added to the bullish sentiment on bonds. On the equity front, prices have failed to maintain the upward momentum exhibited between February and April. This price action (or lack of it) coupled with the added risk of owning equities has been partially responsible for weak flows into equities and light trading volume. At the same time, despite extraordinarily low rates, investors have piled into bond funds. Looking ahead, will investors be relatively better off with lower-yielding bonds or riskier, but potentially higher-return, equities? We will build the case a block at a time.
1: THE EXTENDED PERIOD OF EXCEPTIONALLY LOW RATES WILL GET EXTENDED.
Federal Reserve minutes indicate that the Fed funds rate will remain exceptionally low for an extended period. But what does that mean in months or years? We can answer that by assessing in quantitative terms what the Fed’s two mandates imply for the timing of an increase in the funds rate. In other words, when is the Fed likely to take the “punch bowl” away? The Fed’s two mandates are controlling inflation and maintaining economic growth. These objectives can be tested by determining the extent to which core inflation (ex food and energy) and the unemployment rate influenced the funds rate over time. Our statistical correlation of these variables during the 21 years between 1989 and 2009 resulted in an 80% R-squared. The analysis suggests that presently the funds rate should be a negative 2.5% given 0.9% core inflation and 9.5% unemployment. A negative funds rate is, of course, impossible, but the negative conclusion indicates the difficulty the Fed faces in raising rates. Our inflation and unemployment rate forecasts through 2011 suggest the former will remain low and the latter will stay high. Consequently, we believe the Fed will not raise rates until late 2011 or early 2012. Consensus expectations anticipate the tightening cycle will begin in the first quarter of next year. If we are right, the investment implication is that investors will have to either extend maturities (buy longer-dated bonds) or buy spread product (such as corporate) to get higher yields.
2: THERE IS A PALPITATING HUNGER FOR HIGHERYIELD AND SAFE INVESTMENTS.
From the retiree to the corporate treasurer to the emerging market investor, the demand for investments that offer a decent yield and are safe and liquid is quite strong. The cash pile in corporate coffers, household savings and bank balance sheets is well advertised. Excess demand for safe assets on the part of emerging market investors is less widely publicized. Emerging market savings flows, which approximated $10 trillion last year, are largely accommodated via investment in developed markets. This stems not only from the magnitude of the savings flows but also from a shortage of safe investments in emerging markets. As developed countries (gradually) rein in their deficits, the supply of sovereign debt securities will increase at a slower rate. In those circumstances, US and other sovereign debt yields could remain low, thus encouraging investors to seek the higher yield of investment grade corporate bonds.
3: CORPORATE CREDIT SPREADS ARE LIKELY TO COLLAPSE FURTHER.
A combination of low short rates, low Treasury bond yields, a shortage of safe investments, and mounds of cash seeking safety and yield, will likely result in corporate credit spreads narrowing further. Our investment grade spread projection model, which is driven by the ISM Non-Manufacturing Index and Capacity Utilization, indicates further moderate spread compression. Barring a collapse in economic activity, the riskier (versus Treasury debt) spread product investment should pay off.
4: EQUITY RISK INCREASED SIGNIFICANTLY DURING THE LAST DECADE.
Equities are often viewed as a hedge against inflation. During the last decade (2000-2009),not only did equity returns trail the CPI, but the probability distribution of risk, known as the standard deviation, increased from 11% (one standard deviation) during the 1982-1989 secular bull market period to 19%. Several adverse events, such as recessions, financial crises and bursting asset bubbles, undoubtedly contributed to the lower return-higher risk outcome. These circumstances perhaps explain investors’ current aversion to equities but also beg the question as to whether challenges of this decade will result in the last decade’s bear market continuing.
Asset Allocation Recommendation
We made no changes to the Asset Allocation Model this month. We continue to underweight equities and international developed bonds and are neutral domestic bonds. We are overweight emerging market debt and MLPs.
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MARKET CLOSES
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| S&P 500 Index - 1,115.01 |
Dow Jones Industrial Average - 10,525.4 |
10-Year Treasury Yield - 2.99% |
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The Wealth Management Group of The Provident Bank has prepared this commentary for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or a solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security or pursuing a particular investment strategy. Any opinions expressed herein reflect our best judgment as of the date of this publication and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and may involve general market risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements.
The opinions, views, and information expressed in this commentary regarding portfolio holdings are subject to change without notice. The information provided regarding portfolio holdings is not a recommendation to buy or sell any security. Portfolio holdings are fluid and are subject to change based on market conditions and other factors. Investors should consider their individual circumstances, investment goals, and risk tolerance prior to making an investment decision.
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