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

I would like to briefly touch on 3 topics today...(1) The economy, (2) Fed policy and interest rates, (3) The stock market:

 

The economy: In our beginning of the year webcast, I laid out the general case for the economy in 2013 to be slightly stronger than 2012, particularly in the second half. That last part is never a particularly bold forecast given that first quarter GDP is on average the weakest. Last week’s release of 3rd quarter GDP showed the economy growing at 2.8 %, up from 2.5% in the 2nd quarter and 1.1 % in the 1st. But 2012 GDP growth overall came in at 2.8 % according to the Bureau of Economic Analysis, which means 4th quarter GDP will have to come in ahead of 4 % in order for 2013 to be stronger than 2012 – doubtful(!).

 

Why not stronger growth? The current expansion is about half as strong as average, and there are two reasons for this, which are often treated as competing explanations in the press. The first is the private sector deleveraging that occurs following financial crisis-led recessions. Private sector debt relative to income typically overshoots its trend leading up to a crisis, and then has to come down following a crash in the economy and markets. That’s exactly what has happened here in the U.S., but this private sector deleveraging - which has been going on for five years now - largely looks complete. The second explanation for weak growth has to do with policy uncertainty on the fiscal (tax, spending, regulation) side. That too has come down, but uncertainty remains high in the financial and healthcare sectors as the implications of the Dodd-Frank Act and the Affordable Care Act continue to unfold. That’s important because the healthcare sector and the financial sector combined comprise about 30 % of the S&P 500 by capitalization, a proxy for the economy.

 

Fed policy and interest rates: In our last webcast I talked about the “term premium,” which Bernanke describes as “the extra return investors expect to obtain from holding long-term bonds as opposed to holding and rolling over a sequence of short-term securities over the same period.” It is this portion of interest rates that the Fed’s bond buying programs have influenced the most. The Fed’s purchases have lowered the term premium, and when it was believed last summer that the Fed might taper its bond buying program, the entire impact of these Fed programs was reversed. It (the term premium) has since come back down some, as the Fed did not taper in September. But when the Fed does taper we should expect the same 100 to 150 basis points increase in longer-term interest rates, but that’s it.

 

What would cause rates to rise further? In order to get a large (200 basis points plus) and sustained rise in interest rates beyond a reversal of the term premium, you would have to have an increase in expected inflation. Inflation expectations have remained surprisingly well anchored under Bernanke’s watch, and my biggest concern with Janet Yellen is whether or not the markets will accord her the same confidence. That’s not something we can know right now; we have to watch as it unfolds. I’ll be keeping an eye on the three things that matter here, (1) the exchange rate, or the value of the dollar relative to other currencies, (2) the dollar price of goods and services (I prefer the “core” measure of inflation), and (3) long term interest rates themselves (the price of current dollars versus future dollars).

 

The stock market: Looking long-term, the stock market follows the economy in an upward trend punctuated by macroeconomic shocks. An upward trend implies that reaching “all-time highs” has no real meaning (it happens all the time!), and that’s how I would react to press headlines to the contrary. But without getting into all of the technical minutia, I will say that I listened to a compelling call last week from my old group at Credit Suisse that uses a tremendous amount of current and historic company data in order to derive an “equity risk premium.” That in turn is used to gauge whether market valuation levels are high or low relative to history, given the cash flows that companies are generating. Remarkably, that measure has now converged exactly onto historical averages, which is to say that the market is neither cheap nor expensive. Now, no measure of market valuation is perfect, including this one, but it is my favorite – it is based upon the most exhaustive proprietary data base in existence that I am aware of – and I believe it has had a good track record for anchoring one’s equity market views.