The word “paradox” defines a person, situation, or action having seemingly contradictory qualities or phases. That also sums up the performance of financial markets so far in 2014:
- The U.S. economy is recovering from its winter freeze and the Fed is pursuing a path to normalize monetary policy, yet the 10-year Treasury yield has fallen to 2.6%.
- The Dow Jones Industrial Average recently reached an all-time high, yet the small-cap Russell 2000 Index is at its low for the year, and year to date more than 8 out of 10 U.S. stocks are down by an average of almost 14%.
- The U.S. and European economies are accelerating, but China appears vulnerable. In fact, the global economy looks more fractured than it has in some time.
What’s behind these market paradoxes and what might it mean for stocks and interest rates? My conclusion: Bond yields may stay lower than is generally expected and stocks may remain stuck in this sideways range for a while, which could ultimately be a launching pad for higher prices.
The interest-rate paradox
With the 10-year Treasury falling to 2.57% in early May, how can interest rates be this low if the Fed is exiting quantitative easing (QE) and giving guidance that it will raise rates some time in the next year or two? All this while the economy is clearly accelerating from its winter slump. Only a year ago, the mere suggestion of a taper sent markets reeling. Now the Fed is actually tapering, yet with the opposite effect on yields and spreads.
Why are bond investors sanguine about the coming rate cycle? One reason is the Fed is unlikely to hike rates for at least another year, and slowly at that. More importantly, there has been increasing talk among academics that the “equilibrium rate”—the level of short rates that would be considered “neutral” (neither accomodative nor restrictive)—may not rise to anywhere near where it has gone during past rate-tightening cycles. An equilibrium rate in “normal” times might be around 4% or 5%. This time, the expectation is that the Fed funds rate will only be raised to 2% or 3%.
With sluggish growth and very low inflation, that will probably be sufficient to normalize policy. With the lower projected short-rate ceiling, and absent inflationary pressure, it makes sense that long yields have not risen the way they otherwise might have in anticipation of a coming rate cycle.
The equity market paradox
About the expert
So far this year, the major equity market averages have traded sideways. The S&P 500 started the year at 1,848 and as of May 9 it stood at 1,878, for a modest gain of 1.6%. But while stocks may appear quiet on the surface, they have not been so quiet underneath. The Dow has set new all-time highs in recent days, but the broader market remains near its lows for the year and the Russell 2000 Index is down 8.5%. The rotation between sectors and styles has been violent. High-flying momentum stocks in the social media and health care industries have gotten hit as investors rotate into the more value-oriented areas of the market. Think of it as a “momentum vs. valuation” rotation.
It can be misleading to consider only the headline averages when evaluating stock performance. In the first four months of 2014, the S&P 500 declined 5.8% from its highest point to its subsequent lowest level (which in this case was from January 15 to February 5). But consider how the 500 names in the index performed during this time: 84% of them declined more than the index itself, and by an average of 13.7% (see chart below). This dispersion was worse than what occurred in the 2013, 2012, and 2011 corrections. In those instances, the S&P 500 had a drawdown of 5.8%, 8.7%, and 19.4%, respectively, and the percentages of names that fell more than the index were 72%, 66%, and 68%, respectively, by an average of 10.0%, 15.9%, and 28.4%.
So far, for equities, 2014 has been a bit reminiscent of 1994, a year characterized by a rate-tightening cycle that the S&P 500 appeared to shrug off, trading sideways for nine months and never declining by more than 8.9%. However, like now, a lot was going on beneath the surface at that time. During the nine months that the market flatlined, 94% of the index constituents performed worse than the benchmark itself, by an average of 26.7%. That is why the 1994 cycle was known as a stealth bear market: quiet on the surface, but plenty of action below.
So, what does it mean when small caps and momentum names give up their leadership, and more conservative, value-oriented stocks take over? Some might argue it is a sign of an aging bull market that has already exceeded the typical market cyle lifespan (four years). Narrowing breadth is often a sign that a cyclical peak is coming. However, like 1994, which turned out to be a springboard to a powerful rally in 1995 and beyond, perhaps 2014 is just a healthy rotation and a way to clear the decks for the next advance.
My guess is the latter. Fidelity’s equity research team expects 6% to 9% earnings-per-share (EPS) growth for 2014—not bad given how deep into the cycle we are (five-plus years). And while the forward P/E ratio has risen from below 10x in March 2009 to 16x at the recent high, valuations remain within historically reasonable ranges, especially amid such low inflation. Another reason equities may go sideways for a while is that the market has now gained 22.2% (annualized) since the 2009 low, and in 2013 it gained 32% on only 5% (EPS) growth. This lopsided rally caused the trailing P/E to expand to 18x. In other words, the market needs to digest how far it has come, and that suggests a sideways consolidation that may persist for a number of months.
The global growth paradox
The stock market is holding up well considering China’s economy is slowing, perhaps structurally. (Read Viewpoints: Keep an eye on China’s economy.) With China as the locomotive of the global economy since 2009, one would be forgiven for getting more bearish on growth if China’s boom has ended. But, as China shifts from being an economic tailwind to a headwind, it appears the U.S. and Europe have taken over as the global growth engines.
An important development in China is that its credit boom seems to be peaking, evidenced by the fraying in its so-called shadow banking system. Think of it as China’s version of the U.S. subprime credit boom leading up to the housing bubble in 2006. While the ratio of traditional bank lending to GDP in China has been steady at 143%, once you include the shadow lending market, that ratio grows to 200%. A good portion of these shadow lending practices has been on the speculative side, and we’re increasingly seeing cases of trust loans and corporate bonds defaulting or needing bailouts.
One would hope Chinese policymakers will not let this turn into a credit crisis akin to the fate of the U.S. subprime bubble almost a decade ago. Nevertheless, as bad loans either default or get rolled over, it does suggest the amount of new credit going into the real economy will decline, and that could mean slower economic growth. The question is, what does this mean for the rest of the world? China has been the marginal growth engine for the world since it embarked on its massive infrastructure stimulus program following the global financial crisis in 2008. Therefore, a structural slowdown in China could provide some headwinds for global growth.
In the rest of the emerging-market (EM) space, exports of raw materials to China have been declining, while imports have continued to rise as a result of domestic credit booms fueled by the easy money policies of the major central banks. Our EM team and other senior investment managers recently noted how little the China-related contagion has spread to the U.S. and other developed markets. (Read Viewpoints: Can emerging markets stage a turnaround?) In fact, the downside pressure that a China slowdown puts on certain commodities may be a plus for developed markets, as it lowers inflation. Nevertheless, the recent problems in China’s shadow lending system as well as other negative headlines coming out of EMs (Crimea for one) makes it difficult to envision U.S. P/E multiples rising for now. (Read Viewpoints: Emerging-market outlook: opportunity).
Sideways for now
All in all, my sense is that the market needs a rest. Normally, that might mean a 10% to 20% correction, but with earnings growth positive, valuations reasonable, inflation and interest rates benign despite the coming rate cycle, and the U.S. economy accelerating from its winter slump, it may just mean a sideways trading range for a few months. After five years of 22% annualized gains, that’s really not such a bad deal. Sometimes investors just need to be patient, and 2014 may well turn out to be such a year.
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