Bond and stock markets are having a summer correction, focused on interest sensitive securities. This has occurred against a backdrop of mixed economic news not just in the United States but also in Europe and China. The US economy crawls forward, the Chinese economy is expanding at a slower rate than in recent years. Europe appears to be at the nadir of its recessionary contraction, but there is little prospect of vigorous economic expansion on the continent, which is constrained by stiffening banking regulation and a soggy real estate market. The basket case nations of Europe continue to force the EU central bank to expand its balance sheet, but it does so at a far slower pace than we have seen under the Bernanke Fed in the United States, suggesting prolonged doldrums across the Pond. European nations suffer from greater unemployment than the US because the unemployed are an entitled class in most nations, and laws that give labor extraordinary power discourage new hiring and new enterprise. A spokesperson for the “League of Unemployed” has a solution: cut the official work week from 36 hours to 32 hours so more people will have to be employed. To this group, Karl Marx had an even better solution, except that it failed the last time it was tested, didn’t it?
Since the USA‘s expansion out of the Great Recession may not be gaining speed, investors are, it seems, retreating from the frantic buying that characterized the first quarter of 2013. The damage has been focused on those instruments that attract income investors: bonds, REIT’s and MLP’s. This is because interest rates have been ratcheting upward since the Federal Reserve Chairman suggested it might back off on the extraordinary level of bond purchases known as “quantitative easing” (QE III) that it began about 10 months ago.
This program was launched under the cloud of a scheduled rise in taxes and the uncertainty generated by a Presidential election. It was continued as the “Sequester” of Federal spending worried policy makers that this might slow or reverse GDP growth. The Fed felt that our US economy (and those of our major trading partners) was unable to sustain momentum without extremely low, long term interest rates. But some observers complain that the Fed’s monthly purchase of $85BB in bonds was distorting the credit markets by keeping interest rates artificially low, something that hurts savers and those on a fixed income.
Right now, I’m not seeing anything to suggest we are experiencing anything other than a normal correction in a bullish stock market. Popular financial commentators like Mohammed El Erian of PIMCO recently listed the challenges faced by the world economy (Financial Times online August 20, 2013.) Without dismissing these concerns, I am reminded that since 19451, the planet has faced nuclear annihilation, untreatable epidemics, innumerable wars (hot and cold), massive military spending, civil unrest, assassinations, runaway inflation, etc. etc. Yet the value of equities has risen nearly 70-fold, shrugging off the stream of never ending worries. Our challenge at Trusted Financial has been to find the right balance between growth and risk while seeking investments with good cash flow in the form of interest and dividends. Since the second quarter of 2009, when we had indications that Fed and Congressional action had staved off a Depression, both the bond and stock markets have had only temporary corrections in a bullish four year trend. I believe this moment is no different. Still, I’ve always known that any significant rise for interest rates would hurt these types of investments, at least in the short run. A rise for interest rates has been warned about for four straight years now. I’m pleased to point out that I refused to take these warnings seriously, and instead have been stocking client portfolios with high grade fixed income investments. The idea was to lock in high yields, while knowing that market quotations might be hurt if a secular trend of rising interest rates took hold. But high unemployment and a sluggish economy suggest to me that while interest rates may have bottomed, we are some years away from experiencing a sustained rise.
With the back up of mortgage rates that followed the general interest rate rise in May and June, some fragility in the housing market has been exposed. The brief boom in home prices and sales volume this past Spring seems to have ground to a near standstill. Just this week a consortium of Federal Agencies that govern banking in this country seriously weakened a provision of the Dodd-Frank act which will make it easier to lenders to make mortgage loans. I suspect this is poor judgment, but it is also evidence that housing enjoys a special place of privilege in the hearts of the nation’s governing bodies.
I do not doubt that the Federal Reserve will take note of any precipitous reversal for housing or for the stock market and that it is committed to keeping interest rates in check by continuing its bond buying. Right now, however, I believe they are hoping to return to a more normal level of activity, preparing to reduce or “taper” QE II bond purchases so as to keep things from falling apart. Unless unemployment begins to rise again and/or we have a poor holiday retail season and/or home prices begin a sustained decline, I believe we will see an orderly return to normal Federal Reserve behavior and stabilization of interest rates at somewhat higher levels. While this process has hurt our clients’ portfolio values, it is likely the precursor to a more sustained and accelerating economy, something that will be excellent for portfolio total returns over the next few years.
Our clients’ investments are of top quality: companies with managements that own a substantial stake in the business, companies with high returns on equity and market leading positions. As for fixed income holdings like bonds and preferred stock, these are virtually all of investment grade quality. The interest payments our clients are currently receiving are higher, often much higher than can be found from newly issued bonds, certificates of deposit or money market funds. I continue to find fixed income instruments of investment grade quality yielding north of 6%. Opportunities abound.
1 The Dow Jones Industrial Average was at about 200 in 1945, now near 15,000. If dividends are added, the returns have been close to 100–fold.
