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 May 2005 The Weight of the World
These are the questions plaguing investors as we head into the seasonally slow summer months. For the first time in over two years, almost all indicators are sending mixed signals. Where's an investor to turn for guidance? It used to be that you needed to look no further than the domestic economy, but not anymore. Markets around the world are now more intertwined. What happens to one often has a measurable impact on the others. So to gauge the state of the U.S. economy, you have to start with its current position in the global economy.
On a relative basis, the U.S. is still enjoying more rapid growth than many of our trading partners. This is true for the sluggish European markets and especially in comparison to slumping Japan. Even countries with booming economies (e.g. China and India) are profiting from interactions with the U.S. Both are reaping the well-documented benefits of U.S. outsourcing. In addition, exports to the U.S. -- especially from China and Japan -- are a major driver for foreign growth. It's not a one-way street, either, as some U.S. industries (e.g. tobacco) are experiencing their greatest growth in foreign markets. Do as We Say, Not as We DoIronically, despite relying on exports to fuel their economies, many of our trading partners are criticizing the burgeoning U.S. trade deficit. Although imports have been flooding the U.S., exports have lagged far behind. As a result, our trading partners find themselves awash in dollars received in payment for their goods.The basic Law of Supply and Demand tells you this should lead to the decline in the value of the dollar, and indeed it has. Foreign firms are seeing their profits eroded when weaker dollar proceeds are converted back into their own stronger currencies. This is why they decry the swelling U.S. trade deficit.
As an alternative, many of these profits are finding their way back into the U.S. financial markets. With the Federal Reserve tightening credit, yields are rising -- at least at the short end of the yield curve. This makes U.S. fixed income investments more attractive to foreign investors while offering them a better return on their dollars. More precisely, the Treasury Department reported that in February, foreigners purchased $84.5 billion in U.S. stocks and bonds. That was down from January, but still well over the $45-50 billion needed to finance the current account gap. As long as foreign funding stays at these levels, a destructive dollar selloff can be avoided. With so much foreign investment in dollar denominated securities, such a retrenchment is in no one's favor. Despite -- or possibly because of -- the Fed's rate increases, U.S. Treasury Notes are still the favored investment of foreign central banks. They bought $42.5 billion in February, the sixth monthly increase in seven months. Stubbornly StickyUnfortunately this persistence works against the Fed's attempts to apply monetary policy. In essence, foreign demand for U.S. bonds is keeping interest rates artificially low.The Fed directly controls rates only at the short end of the yield curve, but typically when they act, rates behave similarly across all maturities. Now, however, longer rates have remained well below where they normally would be at this point in the tightening cycle. Fed Chairman Alan Greenspan has characterized this as a "conundrum" but in light of the ongoing foreign demand, it seems somewhat less than a mystery.
In fact, the Fed itself may be at least partially responsible for the stubbornly sticky rates. Investors don't just demand higher yields because the Fed is tightening or because they fear inflation. They also want to be compensated for the greater risk of holding longer-term investments. The Fed, however, has actually reduced uncertainty thanks to their new found candor. The communiqués issued after each FOMC meeting clearly state the Fed's intent. The governors' interim speeches and appearances have also helped articulate the Fed's position. As a result, investors don't fear surprises like those that roiled the fixed income market eleven years ago. They feel better informed, and this reduced risk leads to reduced yields. To be sure, the Fed's statements are still open to interpretation. In the communiqué following the March FOMC meeting, the Fed acknowledged some modest concerns about inflation. This was a new addition to the statement leading many to think it was foreshadowing sharper rate increases over a longer period of time. Ever since August 2004, the 10-year Treasury Note had traded in a relatively tight range, with yields bounded by 4.0% - 4.4%. After the Fed's statement, however, they quickly spiked up to a high of 4.64% on March 28th. That didn't last long though, as yields quickly fell back into their August-February trading range. What caused this reversal? The prospect of a slowing economy stemming from several disparate sources:
In fact, inflation data was mixed. March's PPI jumped 0.7% although much of the gain was attributable to the brief spike in oils prices. When volatile food and energy were stripped out, core PPI was only up 0.1%, less than the expected 0.2% On the other hand, inflation at the retail level wasn't so muted. March's CPI leapt 0.6% with core adding 0.4%. Some analysts discounted the latter figure since almost half was attributable to a 3.9% increase in hotel room rates, not a key expense for most consumers. When all was said and done, it was clear that the domestic consumer's spending habits were a much greater concern than inflation. As the one constant throughout the 2001 recession and subsequent rebound, any sign that the U.S. consumer was pulling back is a reason to question the odds of a continuing expansion. With the U.S. supplying the lion's share of global demand, this would have implications overseas as well. Sector ShiftEquity investors, fearing the effects of an economic slowdown, sent stocks from their early-March peaks to near-term lows by mid-April. Such a sharp reaction was somewhat surprising since the handwriting was already on the wall for those who took the time to notice.First of all, the "monetary lag" was up in March. There's historically been about a 9-month lag between a change in direction in monetary policy and its effect on the economy. The Fed began its current tightening cycle in June 2004 which would suggest the economy should have begun slowing around March. The data cited above suggests it's happening right on schedule. Secondly, as the year began, analysts' estimates suggested earnings growth peaked in late 2004. Although the consensus for the first quarter of 2005 actually increased from January levels as the quarter went on, it's still below reported 4th quarter results.
In addition, without growing domestic or foreign demand for U.S. goods, higher interest rates and energy prices are cutting into both profits and margins. Corporate earnings typically slow at this point in the economic cycle, and these factors are exacerbating the decline. Investors aren't abandoning stocks, but instead are growing more defensive. Sector returns show a clear rotation out of cyclical stocks into more defensive issues. According to Baseline data, year-to-date through April 18th, the three poorest performing sectors of the S&P 500 were Tech (-13.1%), Consumer Discretionary (-10.8%), and Telecom (-10.7%). On the other hand, the top performing sectors were Energy (+10.9%), Utilities (+4.4%), Healthcare (+1.3%), and Consumer Staples (-1.1%). All three at the bottom are cyclical sectors while with the exception of Energy (having a good year for obvious reasons), the other three top performers are defensive. The increasing popularity of dividends provides additional evidence of investors' defensive nature. Back in the go-go days of the late-1990s, dividends were frowned upon since investors believed profits were better spent reinvesting in the company's business than being paid out to shareholders. Presumably this would lead to further share price appreciation, a tax-deferred return as opposed to currently taxable income. Now, following the Bush tax cuts, dividends are taxed at the same favorable rate as capital gains. After the scandals at Enron, WorldCom, Tyco, etc, many investors prefer to actually receive their share of reported profits in quarterly dividend checks instead of trusting its investment to the firm's management. Consequently, more companies are now paying dividends and those that already were are increasing their payouts. Even so, the average dividend is still well below the historical average. The S&P 500's yield is currently only 1.8%, not much to write home about. Nevertheless, based on capital appreciation alone, stocks of dividend-paying companies have outperformed those of non-payers. In 2004, the 380 dividend-paying stocks were up 16.7% while the non-payers only gained 12.2%. Through April 18, the difference is even greater in 2005: -4.1% vs. -12.3%, respectively. With investors becoming more defensive, dividend-paying stocks are perceived as being "safer". Defensive GrowthOddly enough, stocks with the heftiest dividends aren't the ones doing the best. Year-to-date through April 18th, those with above average yields (>1.8%) are down 5.3% while those paying below average dividends are off only 3.0%.What's up with that? You might think the larger the dividend, the safer the stock, but apparently you'd be wrong. Taxes explain some of it. Many of the highest yields belong to real estate investment trusts, commonly known as REITS. Since they pass rents and mortgage payments directly though to shareholders without being taxed at the corporate level, the majority of their dividends don't receive favorable tax treatment, making them less attractive to investors. Also, some of the highest yields come from some of the riskiest companies. The yield is calculated by dividing the annual dividend by the stock's share price. Now think back to what you learned in fourth grade math: The yield will be high if either the dividend itself is large or the share price is low.
Companies that see their share prices fall, also see their yields rise. Some of the S&P 500's highest yields are the result of depressed share prices. For example, on April 18th, GM had the fourth highest dividend in the 500 (7.7%), but its financial woes are well documented. With the major rating firms threatening to cut its bonds to junk status, how safe do you think that dividend is? For that matter, how safe do you think the stock is? At the other end of the spectrum, many of the firms that just started paying dividends have yet to make it up to the average. This is understandable given that the widely accepted "signaling theory" holds that the way a company handles its dividend offers insight into management's view of the future. All else being equal, an increase in the dividend can be viewed as the result of growing profits, a good sign. On the other hand, a cut in the dividend implies the opposite, a bad sign. Given this, companies are often slow to increase their payouts for fear of running into a rough period when a cut may be necessary. Rather than risk that, they limit dividend increases to amounts they are (reasonably) certain to cover. A number of growth stocks -- especially in the Tech sector (e.g. Microsoft and Intel) -- are just beginning to pay dividends. Most have yields below the S&P 500 average. With growth again outperforming value, investors may be seeking these "defensive growth stocks", bolstering this segment of the market. After the late-March to mid-April selloff, the entire equity market may be ready for a bounce. Without major fundamental or economic developments, however, such a rally would only be a short-term development. Range-bound trading is the most likely scenario for the coming months, possibly all the way through summer. Seasonal factors typically slow trading in the summer but not volatility as thin volume exaggerates daily movements. This summer may even be slower than normal as investors digest declining earnings growth, higher interest rates, and continuing sluggishness overseas. Nevertheless, it is important not to confuse the slowing of the expansion with the ending of the expansion. Earnings can't accelerate forever and consumers can't keep spending nearly 100% of their income. At some point they peak and then begin to slow. That may have already happened, but it doesn't mean corporate profits have to immediately deteriorate. Instead, they can continue growing, but at a decelerating pace. That's not the definition of a recession or even an economic slowdown. In fact, after lowering estimates, economists still expect 2005 to produce 3.5% domestic GDP growth. That might not set any records. It may not support our trading partners to the level they've come to expect, yet there's no need to fear non-inflationary growth here in the U.S. Search this site! Just enter you key word or words:
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O IS IT OVER? HAS the long-running economic expansion finally come to an end? Is it time to ditch both stocks and bonds and head for the safety of cash or even gold?
