Thoughts from our Domestic Equity Team
Over the past month, the stock market has been choppy and has given back some of its year-to-date gains. The sparks for this pullback include Fed Chairman Bernanke’s comments on May 22nd about the concept of tapering, or scaling back on the amount of assets purchased every month from the current $85 billion level of quantitative easing (QE). In subsequent communications from the Fed, the concept of gradual tapering was reinforced in the context of improving economic conditions and the need to transition back to a more ‘normalized’ interest rate environment. While Bernanke did not indicate an imminent policy change, he did state that tapering could occur as soon as later this year assuming that the current trajectory of economic data continues, and that QE could end entirely by mid-2014.
This Fed commentary marks an important shift in messaging, and the potential end of QE in mid-2014 is earlier than many investors believed likely. The current round of QE was initiated in mid-September 2012, and since that time the ten-year U.S. Treasury yield has ranged between roughly 1.6% and 2%, with short term rates pinned close to zero in line with Fed policy. After the May 22nd Fed comments, this yield range was breached to the upside and sent bond investors into a bit of a panic regarding the future trajectory of interest rates. Following the June 19th comments from the Fed, rates on ten-year Treasuries pushed even higher and currently sit near 2.6%.
This change in yields and the pace at which it has occurred has created shockwaves that have rippled throughout the global capital markets, where the US dollar is the world’s reserve currency. Immediate impacts include a stronger dollar and its mirror image, weaker currencies elsewhere, particularly in emerging markets. In addition, many fixed income investors are scaling out of bonds, pushing yields up and inflicting losses on many recently purchased positions. In a cruel twist of fate, the same easy money Fed policy that encouraged risk taking and leveraged bets on various assets is now inflicting pain due to the higher rate environment and undoubtedly is causing many of these trades to be unwound. Not only have bonds sold off due to this recent interest rate shift, but ‘bond proxies’ such as utility, telecom, and other high-yielding stocks have also declined in value. Many investors who could not find attractive yields on bonds sought better yields on dividend-paying stocks over the past several years. But as yields on government bonds move higher, stocks become incrementally less attractive to some investors.
In addition to the change in Fed messaging, we are also faced with a Chinese economy that continues to decelerate and weak conditions in Europe. Moreover the continuation of the “all-in” monetary and fiscal policy shift in Japan is creating its own shockwaves as a result of the impact upon Japanese markets. All of these collectively create the potential for negative secondary and tertiary effects that may not be fully appreciated or understood by investors. This is why we have elected to change the contours of the All Cap Core portfolio slightly, shifting some theme weights and adding some risk tools.
We know from other periods in history where interest rates moved up sharply that homebuilding stocks have underperformed dramatically. For this reason, we have changed the composition and reduced the weighting of Roosevelt’s All-Cap Core portfolio’s “Reconstructing Housing” theme. On the flip side, a steeper yield curve is the result of interest rates moving higher on the long end of the curve, and we know from history that such environments have often been beneficial for financial services companies in periods when inflation is not an issue. In response, we have modestly adjusted the weighting of financials.
As we reflect upon what Chairman Bernanke said in his comments and what the FOMC indicated in their press release, notwithstanding the market’s skittishness described above, we are left with a fairly bullish outlook on the U.S. economy. While we believe that interest rates are likely to normalize in a higher range compared to where they have resided over the past nine months, it is important to consider that in the 12 months prior to mid-2011 the ten-year Treasury yield was in the 2.5-3.5% range and no one was overly concerned by the level of rates at the time. As well, despite the shift to higher mortgage rates, affordability levels for home buyers are likely to remain near record levels. Ultimately, if rates shift back to a more normal, higher level because of an improved economy, such a change is positive. However, we are somewhat concerned that the shift in rates has been a bit too abrupt and potentially destabilizing. This concern has been reflected in the All Cap Core portfolio by the addition of risk tools. (Please click here for important disclosure information regarding "risk tools".)
Submitted by: John Roscoe - Senior Portfolio Manager
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