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 March 2007 Soft Landing
Looking back at 2006, you might have to wonder why investors were so nervous when the market sold off in May and why they kept fretting even as the Dow's gains approached 20%. In hindsight, it was a very good year. Maybe 2007 will end up looking that way, too, but for now, investors are still busy worrying about inflation one day and recession the next. Signs that the economy is slowing raise fears that the Federal Reserve pushed interest rates too far, risking the first recession in over a decade. On the other hand, any minor tick up in inflation leads to the exact opposite fear: lax monetary policy is about to send inflation soaring back to levels last seen in the early 1980s. These two outcomes are fairly incompatible, yet they appear in the headlines each week. Investors can be forgiven for this uncertainty since they're traveling in uncharted territory: They're facing an economy that may actually be experiencing a so-called "soft landing". Like Bigfoot or the Loch Ness Monster, history is full of sightings, but few documented encounters.
What It Is Actually it's proven to be quite a formidable task. That's why soft landings have been so elusive. All economies are cyclical, especially capitalist ones. During periods of expansion, demand runs high and suppliers of goods and services are pushed to their limits. As production moves towards full capacity, prices begin to rise and inflation becomes and issue. At that point, the Fed steps in and raises prevailing interest rates in an effort to temper demand before inflation gets out of control. Unfortunately in the past, the Fed hasn't handled this too well. Until recently, monetary policy has been fairly reactive with rate hikes coming too late to head off inflation and then going too far, often leading to recession. Contrary to what some economists (and central bankers) may lead you to believe, monetary policy is still more of an art than a science. Part of the problem is that until about 15 years ago when Alan Greenspan became Fed Chairman, monetary policy was reactive rather than proactive. When inflation threatened, central bankers held their fire until it was clear that inflation was becoming entrenched. By that time, it was too late to head it off and drastic measures were required. Sharp anti-inflationary rate hikes eventually reined in prices, but at the cost of choking off the economy, ending in recession. Mr. Greenspan (and now his successor Ben Bernanke) took a more proactive approach. Rather than waiting for definitive signs of inflation, the Fed raised rates prospectively to prevent it from becoming a problem. This resulted in more but smaller increases which proved to be more manageable and predictable.
This new approach seems to be working. Not only was the Fed able to thwart any chance of deflation with a string of rate cuts in the early part of this decade, it may also have been able to head off inflation after the recent two years of incremental rate increases. Now as the economy slows but doesn't stall while inflationary pressures ease, could this be the first signs of the elusive soft landing? If so, what does it mean for the months ahead?
Stable Rates That's why the Fed has always kept a watchful eye on inflation. It's also why the Fed will continue to officially state a concern about inflationary pressures even when they're virtually nonexistent since saying otherwise may send the wrong signal to the markets. Many market watchers have misinterpreted this to mean the Fed is solely focused on fighting inflation when in reality, the goal is price stability. Although the talking heads on CNBC often say the markets will root for a cut in interest rates, markets actually fare better when rates are stable. You don't have to be a rocket scientist to see why: Interest rates fall when the economy begins to stall. That's good for bonds because prices move inversely with rates, but this is a much less favorable environment for stocks and the overall economy. On the other hand, rates rise when inflation heats up or the Fed attempts to slow an overheating economy. Under these conditions, costs rise and stocks face stiff headwinds. When prices and interest rates a stable, businesses and individuals can confidently make long-term investments without fear of inflation or deteriorating returns. This is the goal of a true soft landing. Much of the equity runup in the final months of 2006 was attributed to investors anticipating a rate cut. Now it looks like rates will be steady at least until the latter part of 2007. This has occasionally been cited as the reason for periodic market weakness but it's more of an excuse than an explanation. Instead, investors should be hoping for steady rates rather than a cut, and it looks like that's just what they'll get.
Market Rates The current interest rate pattern reflects this prediction. Looking back over the past 20 years or so, when the Fed moved the short-term Federal Funds rate, the 10-year Treasury yield tended to move in a mirror image albeit at a higher level (see Chart 1, above). This pattern was broken in 2004 when the Fed embarked on the most recent tightening campaign. Instead of rising with the Fed Fund's rate, the 10-year Treasury remained relatively stable and even fell. We'd submit that this reflects investors' confidence that the Fed has inflation under control to such an extent that they see little if any inflationary pressure over the next decade. This is exaxtly what you'd anticipate if the Fed just pulled off an economic soft landing. While that's good for the economy, it's not necessarily anything for fixed income investors to celebrate. The good news is that inflation isn't expected to erode the value of their bonds, but the bad news is that stable rates won't allow them any capital gains. In the recent past when interest rates were at 6%, 8%, or even over 10%, simply collecting bond coupons offered a good return. But in today's low interest rate environment when even a 30-year Treasury yields less than 5%, there's precious little to be excited about. Such is the price of stable, non-inflationary growth.
Earnings Finally Mean Something Of course if the Fed truly has engineered a soft landing, it really doesn't matter if this is true or not. If inflation is under control, businesses can't count on higher prices to bail out underperforming operations. Earnings growth will be dependent on real growth, generally from top-line revenues. Companies that can achieve that are those best positioned for success in a low-inflation environment.
This would tend to favor larger companies that can draw upon a number of product and service lines. Smaller companies that may be dependent on a sole offering will face greater challenges. Defensive companies -- those that can expand sales in any type of economic environment -- are also better positioned. These tend to be the traditional "growth" companies found in the consumer staples or healthcare sectors. It doesn't matter how fast (or slow) the economy's growing, you still need toilet paper, razor blades, and prescription drugs. On the other hand, consumer discretionary stocks often struggle in such an environment as consumers delay purchasing big ticket items like cars and appliances. So far, this shift into larger, more defensive company stocks really hasn't taken place in 2007. Instead, riskier small and mid caps still lead the way, while value stocks are still outperforming growth. Could it be that investors still aren't sure the Fed has guided the economy to a slower, steadier pace? As in 2006, investors are still seeking risk. Yield spreads between low-quality junk bonds and Treasuries are at historical lows. Stocks of low quality small companies are outpacing blue chips. Emerging markets are raking in investment dollars while larger, more developed markets are seeing more modest inflows. Sometimes, what ought to happen and what is happening diverge. This situation can persist for quite some time (just recall the profitless internet stock boom of the 1990s) before reality finally sets in. This could be one of those times. History suggests the U.S. stock market should provide a high-single digit return this year. According to data from Ibbotson Associates, stocks have historically appreciated roughly 6% a year. Dividends added about 4% resulting in the oft-quoted 10% average return. But now, dividends on the S&P 500 are less than 2%. Add that to the average 6% gain and you have an 8% expected return. Could returns exceed this prediction? Sure they could, especially if earnings come in above expectations or P/E levels expand. Analysts currently expect the S&P will break its four-year string of double-digit earnings growth. Even so, they still look for an 8% increase. If that's true -- and estimates have recently been below actual results -- then share prices could rise by a similar amount. Add a 2% yield to that and you're back at the historical 10% total return. Should earnings growth falter, however, this scenario becomes more unlikely. P/Es tend to expand when stocks are undervalued. Some analysts argue that stocks are still "cheap" by historical standards. However, Baseline reports that the S&P 500 currently trades with a P/E of 16.9x earnings. Given that the historical average is right around 15x, stocks look fairly valued, not "cheap". Of course prices can still rise if P/Es expand, but in a slow, steady growth environment, there's little reason to believe this will occur, or at least not to a significant level. Those expecting this to happen may either be engaging in wishful thinking or simply not be familiar with what to expect in a slow-growth environment. So while a soft landing may be just what the doctor ordered for the economy and the markets as a whole, some will benefit more than others. At the very least, it calls for a different mindset and perspective from investors who have grown accustomed to volatile markets and higher levels of inflation. It's a worthwhile change. Search this site! Just enter you key word or words:
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INDSIGHT IS A WONDERFUL thing. It always makes the world look like a much simpler and and often better place. With the benefit of hindsight, it's hard to remember why there was always so much to worry about when things generally turned out pretty well.
