Climbing The Wall Of Worry

It was another great year for stocks. The equity markets were up 14 percent in 2014 following a 32 percent gain in 2013. Since March 2009, the market rally has only experienced minor disruptions with the S&P 500 tripling from its lowest point. Clearly, Fed policy has provided a tremendous tailwind for the market. At the same time, U.S. companies are profit-seeking missiles – taking advantage of low interest rates, weak labor markets (which are starting to strengthen) and tax benefits from generating profits overseas.

As we enter 2015, the Fed has ended its quantitative easing program and the market is focused on when the Fed will start raising interest rates. It seems pretty clear that, barring a setback to our economy during the first half of 2015, the Fed will start raising rates in either the summer or fall. While the “when” question seems to be getting all the attention, the more interesting question is “how high?” Several members of the Federal Open Market Committee (FOMC) have indicated the Fed funds rate will be above 1 percent by the end of 2015.

Yet, looking at the Fed funds futures contract, the market is forecasting that the Fed funds rate will be closer to 0.6 percent by the end of 2015.
A 0.5 percent or 0.75 percent Fed funds rate is probably more realistic. The Fed has a dual mandate: both full employment and stable prices with an explicit target of 2 percent inflation. There is no question that the labor market has strengthened. We’ve added an average of 241,000 jobs per month for the first 11 months of 2014 and this has emboldened the Fed to raise rates. Of course, the 5.8 percent unemployment rate masks the fact that many people have dropped out of the labor force and many others have accepted part-time work even though they want full-time employment.

While we could argue about the meaning of 5.8 percent unemployment, certainly labor markets are much stronger than the 10 percent unemployment in 2009. This alone justifies a Fed funds rate above 0 percent. However, we have to question how quickly the Fed can raise rates when inflation continues to be significantly below its 2 percent target. Low inflation is a reflection of tepid demand, which is not exactly the environment that screams for significantly higher rates.

Recently, the inflation issue has become even more interesting as the price of a barrel of West Texas Intermediate oil has dropped approximately 50 percent to $53 from its 52-week high of $101. The price of oil will most likely result in lower headline inflation numbers. The Fed may well argue that the lower inflation rate is a transitory issue and that moderate inflation will resume from these lower levels.

The sum of all of these issues is that the Fed is anxious to raise rates. It wants to recognize that the economy is recovering. However, in the face of low inflation, it will be hard to raise rates too quickly. One of the Fed’s greatest fears is that it will raise rates and then have to hurriedly lower them again. Also, it’s important to recognize that the two most vocal FOMC hawks, Dallas Fed President, Richard W. Fisher and Philadelphia Fed President, Charles Plosser, are both retiring in March. In other words, the two loudest “we need to raise rates immediately” voices on the Fed will soon be fading echoes. Once they retire, we don’t believe rates will increase too rapidly, as long as the Fed doves remain in control.

It’s also important to recognize that a higher Fed funds rate simply results in higher short-term rates. There is no guarantee that longer-term rates will rise. Longer-term rates tend to respond to inflation and, as mentioned above, inflation has been low. We also have to question how high our 10-year Treasury yield can rise when the German 10-year bund is yielding 0.5 percent. In a world of global money flow, foreign investors may be attracted to our higher interest rates (and stronger dollar), leading to continued buying of our bonds. This has the potential to keep bond prices high and yields low. With all that said, it’s hard to see much upside for bonds, while downside risks certainly exist.

As we watch for risk in the markets, we have our eyes on the high-yield “junk” bond market. This is where we often see the first signs of weakness. Recently, we’ve seen higher rates for energy companies with significant debt. Debt issued by energy companies comprises approx-imately 15 percent of the junk bond market. The market is debating whether lower oil prices are simply a short-term issue reflecting weaker global growth or whether the tremendous increase in supply, largely as a result of fracking, is a permanent change. See the chart on page 3. Our guess is that the answer lies somewhere in the middle – both factors are at play.

THE EQUITY MARKETS
When we think about stock prices, we look at returns as a combination of three factors: earnings growth, multiple expansion/contraction, and dividends. Earnings growth is expected to be in the 7 percent range for 2015. Valuation multiples appear to be reasonable; certainly not cheap, but nowhere near the bubble days that marked the end of the last century. The S&P 500 price-to-earnings multiple of 18 is on the higher end of a “fairly valued” range while the dividend yield is 2.0 percent.

Equities continue to be helped by money flowing into this asset class. Some commentators have referred to the last five years as the “most hated bull market ever,” a reference to the fact that some investors have sat on the sidelines, fearful of repeating the pain they experienced in 2008 and 2009. These investors have been slowly returning. In addition, many international investors have flocked to the U.S. because our recovery seems stronger than other developed nations. Japan is back in recession despite implementing a tremendously accommodative monetary policy and Europe is teetering on recession. There is fear in the emerging markets due to the strengthening of the dollar. While many emerging markets enjoy the benefits of a weaker domestic currency, which allows them to export more, there’s concern that capital outflows could cause a run on their currencies. This has led some nations to raise their interest rates – protecting their currency, but slowing their economic growth. It may be fair to say that the U.S. is the tallest person in a room full of short people.

The markets still have plenty to worry about. Domestically, we worry about the threat of lower inflation, the potential of the Fed losing credibility if inflation turns down, the potential loss of higher paying energy jobs, the impact of the stronger dollar on U.S. exports and earnings from abroad, as well as the impact of $50 oil on S&P profits. Internationally, we’re concerned about slowing growth in China, potential recession in Europe, Japan’s fiscal/debt problems, and increasing geopolitical un-certainty. You might have heard the old saying, “the market climbs a wall of worry.” We currently have plenty to worry about! Ironically, if we didn’t have anything to worry about, everyone would have already loaded up on stocks, and the direction of the market would likely be headed south.

Our expectation for 2015 is higher short-term interest rates, continued low longer-term rates, and moderate, yet attractive, stock returns. Of course, the best expectation is for the unexpected – finding out what surprises we’ll have this year.