Scott Colyer, Chief Executive Officer and Chief Investment Officer, Advisors Asset Management
5 Major Themes in Q4:
- Fed Taper Actions Only Result in Petty Larceny vs. Grand Theft for Bondholders. Bonds Get a Bid as Investors’ Taper Fear Dwindles Giving Rise to Yield Greed
- China and Europe Get A Bid As Growth Is Rekindled
- Natural Resources & Energy Continue to Outperform for Balance of 2013
- U.S. Economic Activity Set To Accelerate into 2014; U.S. Corporate Earnings to Follow
- Equities Still the Place To Be
Amid the angst surrounding the Fed’s anticipated tapering of asset purchases this month, we believe the result will be a tailwind for bond investors rather than additional pain, at least in the short term. There are significant reasons why the Fed will go “taper lite” and extend the amount of time it takes to complete the current quantitative easing (QE) activity. As the market fears subside that the Fed’s “Taper Caper” will rob bondholders of more value in the short term, the greed for yield will likely take over. Is there a chance that bond prices can bounce in the short term? Yes, there is – and let me explain why.
The Fed has spent the last five years and trillions of their own balance sheets to support a very fragile U.S. economic and market recovery. Although the Fed is known for keeping policy too easy for too long, this time they will certainly choose to stay in easing mode because the risk of a reversal is higher now than at any time in history. The United States is leading the world in recovery. That recovery is based on cheap money and credit that is slowing easing over time. For the Fed to opt for any strategy that would possibly slow the recovery in housing or automobiles is just not logical. This is not merely our speculation but the words and deeds of the Fed governors themselves. There is a very good chance that there may be no taper this month.
The Fed understands that the interest rate markets generally lead the Fed, rather than the Fed having to lead the market. What we mean here is that interest rates in the longer term correlate positively with inflation and deflation. Thus, in periods of deflation, long-term interest rates tend to fall and the opposite is true in periods when price inflation is rising. Have interest rates risen this year because the Fed was engaged in “Taper Talk” or because the U.S. economic engine is speeding up?
We suggest that the market smells a recovery and a coming rise in inflation expectations. We believe this because both equity and bond markets tend to be forward looking and we think they are both telling us that expansion is on the way. What we normally look for in economic recoveries is actually happening. We see a yield curve in the United States steepening, which is usually coincident with economic growth. As the demand for credit expands, the price of credit will rise. Credit metrics are improving with each quarter that passes. U.S. equity markets have been on a tear this year, which also tends to be supportive of increasing U.S. economic growth. After years of record-setting central bank easing, it seems logical to us to expect an equally impressive, albeit long-awaited, recovery.
The economic story may actually be bigger than we are giving it credit for. Globally, many central banks now feel empowered to engage in the same easy money policies that have worked for the U.S. Federal Reserve. These Fed “copycats” include, the Bank of England, Japan, the European Central Bank (ECB), China and, most recently, Brazil and Australia. All of these countries are spreading cheap and abundant easy money around with the outspoken goal of generating an increase in economic aggregate demand and rising inflation expectations. We are not looking to predict the longer-term effects of these actions, but to merely point out that logically you should expect that the immediate effects will likely mirror the United States. We feel that investors should expect a marked increase in the economies of Europe and China. We think that these areas are timely for putting money to work. Further, we believe that the construction renaissance in the United States will begin to place demand on basic materials and energy that will be followed by a larger global increase. We note that many of these companies are selling at levels around the market lows of 2009 and should be accumulated. Recent insider buying further strengthens our resolve.
We would conclude with a word about inflation, or lack thereof. We concede that inflation is not an issue in today’s economic climate. In fact, the world is suffering from a continued threat of deflation which has served to embolden the printing presses of global monetary authorities. Inflation is proving to be a harder thing to generate than most had thought. We note that any time in history when fiat currency creation was put into high gear, the result is always inflation. Extreme results, such as were seen in the German Weimar Republic and more recently in Zimbabwe, include failure of the currency in total. Could the end game be different this time? Do pigs actually fly?
Although we are pretty sure how to create inflation, we are a bit cloudy on how much currency dilution is enough to get the ball rolling. The answer might likely come too late as the last dollar printed proves to be one too many. Just as we have learned that it is more difficult to defeat deflation than we thought, we would remind our readers that it was incredibly painful to defeat inflation back in the late 1970s and early 1980s. We call this to your attention only to note that hard assets, such as real estate, materials and other commodities, tend to be good hedges for fixed income portfolios. We believe that when investors recognize that many “alternatives” were really not good alternatives to the more traditional investing methods, the use of hard assets as hedges should prove a valuable place to be. When the world is engaged in a race to debase currency, we think that some metals/resources/commodity exposure is warranted.
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