The Great Rotation
Investors have been liquidating bonds and rotating into stocks as they anticipate an improving economy and higher interest rates. The secular bond rally which began over 30 years ago has likely ended. The money flow into bonds has reversed this year for the first time since the credit crisis began. 10-year Treasury rates have gone up from a May 2 low of 1.6% to a current yield of 2.9%.[i] The NASDAQ return for this century with dividends reinvested is almost zero, specifically, -0.37%, but it is up over 25% year-to-date. [ii] Despite an annual return with dividends reinvested of only 2.7 % this century, the S&P 500 with dividends reinvested is up over 21% year-to-date and now is up 20% with dividends reinvested since its pre-credit crisis high in 2007.[iii]
As the World Turns
Other recent directional changes suggest a nascent yet vulnerable global recovery is underway. The JPMorgan Global Manufacturing & Services Purchasing Manager’s Index showed a slowdown in global markets beginning in 2010 before a convincing uptick last month.[iv] Overall the Eurozone experienced a tiny 0.3% growth in the 2nd quarter; which technically is enough to qualify as the end of its painfully persistent recession. The German stock market, the DAX, yesterday reached an all-time high.[v] The expected result of the upcoming German federal election on September 22 is that Angela Merkel will be re-elected for a third term. If re-elected, it’s likely her coalition, keeping in place the critical German financial backing of the Eurozone, will continue. Emerging stock markets and commodities had been essentially flat since 2010 as global demand slowed and supplies increased. EEM, an exchange traded fund (“ETF”) which represents an index of emerging stock markets, is down 5% year-to-date but that includes a 9% rally so far this month.[vi]
Driving Forward but Looking Backward
An example of a leading indicator is the stock market, which tends to go up as improved earnings growth is anticipated. Another leading indicator, the Institute of Supply Management Manufacturers Purchasing Managers Index, has finally shown an impressive uptick of purchasing managers placing new orders, which anticipates increased manufacturing to fill the orders. Rather than focusing on indicators that are suggesting the economy will continue to grow, the Fed is focusing its attention on two indicators that report what the economy has already done: the unemployment rate and the rate of inflation. A stubbornly low inflation rate has made the Fed fretful that the economy remains vulnerable to deflation. When and if the Fed decides to “taper”– which in this case means to gradually reduce programs that lower interest rates and inject capital into the economy– may have more to do with the Fed looking backward than looking forward.
Removing the Training Wheels
In May, the Fed Chair, Ben Bernanke, indicated that as the rate of unemployment approaches the Fed target of 6.5% — now only 0.8% away — he would begin to taper. Stock markets reacted negatively to his comments — which became known as the “Taper Tantrum”– before bouncing back a few weeks later. The concern is that the Fed’s easy money is the manna keeping the economy from contracting. The first tapering may be announced this Wednesday, September 18, after the Federal Open Market Committee meeting. The Fed is expected to reduce its Quantitative Easing program of buying $85 billion a month in treasuries and mortgages by only $10 billion, all in treasuries. Anything more will be showing greater confidence in the economy than the markets expect and might cause a negative reaction. The question is will the Fed be swayed more by the low inflation rate than the declining unemployment.
The Markets are Yellin’
Bernanke is retiring when his second term ends on January 31, 2014. JPMorgan reports that former Treasury Secretary, Timothy Geithner, is leading the search for a replacement; the nomination might happen as early as the days following Bernanke’s scheduled speech this Wednesday. Despite Geithner’s public comment to the contrary, speculation persists from industry watchers that he could also be a potential replacement upon Bernanke’s retirement. On Sunday, September 15, Larry Summers withdrew his name from consideration for this position. That announcement coupled with industry speculation that Fed Vice Chair Janet Yellin may be the appointee prompted a worldwide market rally on Monday; the industry thinking being that Yellin would likely follow Bernanke’s current strategy and be extremely cautious about the rate of tapering.
To Be Continued
Although both the House and the Senate passed a budget, they have not passed appropriations bills for the 2014 fiscal year. Congress has until this September 30 to pass a short term spending bill known as a “continuing resolution.” Mandatory cutbacks, referred to as sequestration, would be implemented when the government runs out of money, presumably by November… unless, after a Republican led attempt to extract concession such as a change in the Affordable Care Act, Congress kicks the debt ceiling down the road for the 11th time since 2001.
[i] Source:Marketwatch.com – 10 year Treasury monthly performance YTD
[ii] Source:Bloomgberg.com – Snapshot Data – Nasdaq Composite Index
[iii] Source: Bloomberg.com – Snapshot Data S&P 500 Performance
[iv] Source: Institute for Supply Management – 09/03/13 ISM Report on Business August 2013
[v] Source; Bloomgberg.com YTD Snapshot Data – reaching 8,613 as of 09/16/13
[vi] Source: Bloomgberg.com YTD Snapshot Data –for EEM