The Fed’s December meeting combined an announcement of tapering with a dovish message on forward interest rate guidance. Although it did not drop the unemployment threshold from 6.5%, it did use new language confirming that the target rate will be held near zero “well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal.” The Fed’s finesse has allowed it to simultaneously get off the hook of permanent quantitative easing (QE) while increasing financial-market confidence on two points: 1) The program for getting rid of QE within a year; and 2) The extension of the criteria that is holding interest rates at zero. Moreover, by showing more confidence in the strength of economic growth the Fed may increase corporate enthusiasm, thus persuading businesses to plow more of their strong cash flow towards investments (i.e., capital expenditures) rather than stock buybacks. Zero percent interest rates act to subsidize corporate profits, drive up asset prices and encourage risk-taking. We could be at the very early stages of a broad transition from strengthening asset values to better spending power by businesses and consumers. Monetary policy will stay extremely easy to ensure this process takes hold.
This year, through the end of November, the S&P 500 is up over 29%. Since 1870, there have been 30 times when annual U.S. stocks returns exceeded 25%. Of these occurrences, 23 were followed by another year of positive returns with a mean of 12%. In other words, based on the historical experience, there are good odds that we will see another year of positive stock returns in 2014. On the other hand, those who believe in reversion to the mean will say that a negative year is overdue. Historical experience aside, there are solid supports under the bull market, suggesting that it has further to run. We are still operating in an environment where monetary conditions are hyper stimulative, inflation is extremely low, and corporate profits will accelerate. This environment ferments asset bubbles, which is why there is potential that equity prices move into bubbly territory next year.
Stock market corrections tend to be triggered by widespread fears of an imminent recession. It’s hard to see a significant correction ahead if the big worry is that better-than-expected economic indicators might cause the FOMC to taper QE by $10 billion to $15 billion per month. Just because there are too many bulls and the Fed has started tapering doesn’t mean that stocks can’t close out the year at a new record high. If that happens, stock prices might continue to rise early next year, although a sideways move for technical price consolidation would be nice.
Within fixed income, those sectors that can extract extra yield while maintaining short duration should be clear winners in an environment that will see flat to rising rates over the next five years. Corporate sector health is robust and aggressive Fed policy and improving growth mean that corporate credit has room to improve on a multi-year investment horizon. Thus, we continue to believe that the corporate loan sector offers the right mix of credit and short-term exposure.
Growth has languished at a below trend pace since the Great Recession and throughout this period it has seemed reasonable that it should move back above trend over the subsequent 12-24 months. Yet every year, these hopes have been dashed by the repeated downgrading of economic forecasts. However, after five years, the U.S. deleveraging cycle is drawing to a close with mounting evidence that 2014 could finally break the disappointing growth trend of the past several years. Reduced levels of political uncertainty should play an important role in reinforcing the recovery. Similarly, the Fed’s more singular focus on forward rate guidance should provide markets with greater clarity on liquidity conditions over the medium term and help boost investor confidence.
Michael Ashley Schulman, CFA