April 18, 2005
For anyone without access to a Magic 8 Ball, the interest rate environment has certainly been difficult to decipher over the past 12 months. In fact, Fed chairman Alan Greenspan even referred to it as a “conundrum” during his semi-annual testimony to Congress in February. Specifically, he was referring to an unexpected flattening of the yield curve. Although the Fed had been successful at raising short-term rates, long-term rates had actually fallen. In fact, during 2004, the 3-month Treasury bill yield rose by 1.3%, while the 10-year Treasury note yield fell by 0.16%, resulting in a flatter yield curve (see chart above). This unusual confluence of events reflected confidence in the Fed’s ability to control inflation and a lack of concern about future inflation. In addition, credit spreads, i.e. the difference in yield paid on corporate bonds relative to U.S. government bonds, also declined, reflecting an increased appetite for risk. The Fed’s stated goal since last June has been to reduce monetary stimulus, thereby resulting in lower potential inflation and reduced investor risk appetite. However, through February, the Fed was clearly not accomplishing both these goals, hence Greenspan’s comment to Congress. Since the Chairman’s February report to Congress, however, investor appetite for risk has dramatically declined and inflation expectations have increased. So, what caused this reversal and what are its implications?
The Fed began to inject monetary stimulus into the weakening economy via Fed Funds rate cuts at the onset of the 2001 recession. Additional rate cuts were made in order to ensure economic stability following the terrorist attacks on 9/11 and to encourage continued consumer spending. Importantly, particularly in 2003, many of the Fed’s rate cutting activities were geared toward increasing investor risk appetite and avoiding deflation. These actions proved very successful as the economy recovered vigorously from the recession. However, in June of 2004 the Fed noted that economic growth was strong enough to begin reducing the monetary stimulus that was in place and they began to raise the Fed Funds rate (see chart page 3). This action apparently did convince the market that the Fed had inflation under control, but it did not have the desired affect of reducing investor risk appetite. As a result, risky and interest rate sensitive asset classes continued to perform well for much of 2004.
Two major events occurred in March of 2005 that appear to have changed the tide. First, General Motors announced a significant shortfall in projected 1st quarter earnings and subsequently lowered its earnings outlook for the year by roughly 75%. Intense competition from more efficient foreign car makers as well as continued problems meeting pension obligations are at the heart of GM’s problems. This announcement caused the credit rating agencies to consider lowering the rating on GM debt to the “junk” level. Following GM’s announcement, other auto firms, including Ford Motor Co., also lowered their earnings outlooks. Quickly, credit spreads widened considerably as investors began to recognize they were not being adequately compensated for taking such high levels of risk. Furthermore, it appeared that the market was finally coming to grips with the fact that rising short-term rates have historically reduced liquidity and slowed economic growth. Such a scenario increases the odds of failure for low quality companies and the securities they issue. Hence, risk aversion increased.
The second market turning event occurred at the Fed’s March 22nd FOMC meeting, where Fed members raised the Fed Funds rate by 0.25% to 2.75% and indicated a heightened concern about potential inflation. In addition, the Fed expressed a willingness to continue to raise short-term rates as long and as high as needed to combat potential inflation. This seemingly newfound concern about inflation, coupled with a hawkish approach to rate hikes, rattled the markets and caused investors to discount greater inflation expectations. Ultimately, long-term rates rose, with the 10-year Treasury note jumping to as high as 4.65%. The 10-year note yield has fallen back below 4.3% as of mid-April, but that doesn’t diminish the importance of the message sent by the Fed.
The weak performance of the stock market thus far in 2005 is largely due to the aforementioned decline in risk appetite and increase in short-term inflation expectations. A lower appetite for risk reduces investor demand for many of the risky assets that had led the markets in 2003 and into 2004, while increased inflation expectations raises the odds that interest rates will continue to move higher. And, as mentioned previously, higher interest rates lead to slower economic growth.As far as the Fed is concerned, their work is far from done. Recall that the Fed Funds rate was lowered 13 times, by 5.5% total, between 2001 and 2003. Although we don’t believe the Fed plans to go back to a 6%+ rate, we do think that their goal is to push the rate up to a level which is considered neutral to economic growth, i.e. neither accommodative nor restrictive. As a result, we expect the Fed to continue raising rates at a 0.25% clip until they reach 3.75%. At that point, future rate increases will be dictated by specific data on the economy, including employment, inflation, and consumer spending. The financial markets are not likely to gain much in the way of momentum until investors are convinced that the Fed is finished raising rates. Looking back at previous Fed rate hike cycles, including the 1994 cycle, it’s clear that investors prefer a stable rate environment to a rising rate environment.
However, even after the Fed has stopped raising rates, we don’t expect the economy and stock market to take off. Recall that we are coming out of a very strong two-year economic recovery, during which the economy grew at a 6% nominal rate and stocks rose almost 60% while interest rates and inflation were running at generation lows. The tailwind of unusually low interest rates and inflation are clearly behind us, and only companies with reasonable valuations and consistent earnings growth are likely to find favor with investors going forward. A lower tolerance for risk will lead to gains for high quality companies, while greater inflation expectations will drive capital out of interest rate sensitive stocks and into companies with exposure to hard assets, like commodities, energy and capital goods.
Although it’s refreshing to see investors becoming more rational, it appears that the pendulum may have swung too far in the direction of risk aversion during the month of April. On top of inflation and interest rate concerns, a handful of corporate earnings disappointments as well as some weaker than expected retail sales data have led investors to become concerned that the economy may be headed back into recession. We have been forecasting for some time that economic growth would slow from roughly 5% to 3% in 2005 and that corporate earnings growth would slow from 20%+ to less than 10%. However, the markets seemed shocked by this development. As a result, investors are ignoring the signs of continued economic strength, that so far include strong earnings reports from bellwethers GE and Bank of America as well as continued strength in the aerospace, lodging, and transportation industries. They also appear to be ignoring what are now a relatively inexpensive market and a still accommodative interest rate environment. Furthermore, investors seem to be forgetting where the real global growth is coming from – the emerging economies of India, China, Brazil, et al. Ultimately, investors will look back at periods such as this and recognize them for what they really are – good buying opportunities.
So, strap yourself in and get ready for a volatile market over the next several years. Prudent, long-term investors will be able to weather the storm and even earn healthy profits without the use of a Magic 8 Ball, but investors looking to make a quick, easy buck will likely be faced with their own personal conundrum.
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