"Kee" Points with Jim Kee, Ph.D.

In a nutshell: Reactions to Fed tapering are overdone; China slowing is a reality.

 

We’ve had a pretty good pullback in the markets, as stocks are down about five percent over the past month and bond yields are up about 80 basis points. As for stock pullbacks, the only antidote I know of is to step back and stare at a stock market price chart (S&P 500, Dow, etc.) in order to see just how normal recent market behavior is when viewed against history. The main driver of the pullback this time has been the somewhat dubious notion (in my opinion) that “good news is bad” in that stronger U.S. economic growth will move forward the date at which the Federal Reserve reduces its $85 billion per month asset purchase program. As discussed in prior Kee Points, that means a higher underlying real rate (reflecting growth) and an increase in the “term premium,” which is the main component of interest rates that the Fed is directly influencing. With inflation expectations still very well anchored, that means 10-year Treasury yields somewhere in the 2 ½ to 4 percent range. For the record, the Fed stated that “the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economy recovery strengthens,” meaning “the target rate for Fed funds (short-term interest rates) will remain in the 0 to ¼ percent range as long as unemployment remains above 6½ percent and inflation two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and inflation expectations continue to be well anchored.”

 

As for China, I saw last week for the first time a six percent growth number mentioned by a legitimate, informed research house (Gavekal). Their fear is of a policy mistake in China resulting in over tightening of credit markets there. Interestingly, that’s probably the right thing for China’s long-term economic performance as it might help correct and/or prevent resource misallocations. There’s more to it, of course, including the specific and unique institutional arrangements of China’s banking system (too much to go into here!), but near-term it could mean lower growth than the consensus seven to eight percent range. Gavekal refers to this as mainly a growth shock, not the financial Armageddon purveyed by the doom and gloomers.

 

My take: Three and a half percent 10-year Treasury yields will not appreciably slow growth and capital spending, drive stocks down, or kill the housing recovery. Housing prices and construction overshot, beginning in the early 2000s (markets typically overshoot and then undershoot the general trend). It took 5 years to work off the excess, which has largely been accomplished, so I expect the recovery in housing to continue. And as I’ve discussed in prior Kee Points, the fact is that strong stock market runs over the past 15 years have coincided with increasing interest rates. So I don’t expect interest rate normalization to kill stocks. But not so for bonds! Rising rates – regardless of what is driving them – result in lower bond prices.

 

Investment strategies: Lower growth in China creates challenges for commodities and globally cyclical industries like mining. That includes commodity-based economies (some in Latin America, Canada, Australia, etc.). So exposure to foreign equities should be based on fundamental, company-specific analysis, not broad global GDP bets. U.S. equities should still produce positive returns, which is indeed the expectation of the bulk of the more credible Wall Street (and other) research firms. As for bonds, owning high quality individual bonds in a laddered portfolio with a fairly short duration is the best way to invest in the current environment (which is, an environment where rising interest rates drive bond prices lower). By owning individual bonds you are not forced to sell your bonds at a discount, as happens to bond mutual funds when they are faced with investor redemptions (pull-outs). And laddering ensures that you have bonds maturing periodically, meaning the principal is paid back in full (that’s where the high quality part comes in!) and can be reinvested at the increasingly higher rates.  

 

Let’s leave it at that for now, watch the markets this week, and see if these pendulum swings settle down a bit.