If there was one single event that stood out in the past quarter, it was Federal Reserve (Fed) Chairman Ben Bernanke remarking that the Fed might taper or phase out “quantitative easing” in the near future. Speaking in May, Chairman Bernanke's comments had a distinctly unsettling effect on the markets, which until then had continued to gain ground, building upon a strong first quarter. From that point on, interest rates began to climb and investors grew nervous. The markets became increasingly volatile, setting off a string of eight consecutive swings of more than 100 points in the Dow Jones Industrial Average beginning in mid-June and culminating with a 354-point drop on June 20th. Subsequent to June 20th, the Dow rose a total of 151 points to close at 14,910 on June 28th, the last trading day of the quarter. On a total-return basis, the Dow was up 2.92% in the second quarter, which was certainly a moderation from the 11.93% return in the first quarter.
Although it is quite possible, perhaps even likely, that we'll see more of the same volatility in the near term, I am encouraged by the prospect of the Fed's taper. I think the economy has experienced modest, yet real, improvement and the time has come for the Fed to dial back on quantitative easing. Started in late 2008 and now in its third round, quantitative easing?—?Fed purchases of Treasury and mortgage-backed securities?—?is a stimulus program that supports bond prices and suppresses interest rates. The hope all along has been that quantitative easing would enable the economy to return to normalcy more quickly.
The situation reminds me of an admonition from William McChesney Martin, who served as Fed Chairman under five presidents from 1951 to 1970. During President Eisenhower's first term, Chairman Martin quipped that it was the Fed's job “to take away the punch bowl just when the party gets going.” My fear is that in the current situation, the Fed has continued to spike the punch bowl for too long and the partygoers are getting a bit tipsy. But my hope is that as quantitative easing gradually comes to an end, we'll see interest rates rise modestly and slowly, and the partygoers will all get home safe and sound.
Economy
My outlook has been slowly improving for three main reasons. First, the economy does seem to be gaining traction. Second, and this is a big change, the U.S. budget deficit has been shrinking as a percentage of gross domestic product (GDP). Third, the bond market has sold off, largely in response to Chairman Bernanke's remarks in May regarding the prospect of the Fed's taper over the next several quarters.
Overall, despite the market volatility in June, I am encouraged by what I see as positive developments for the economy. Earlier in the year, many people were concerned about the potential negative effects of sequestration (the automatic cuts in the federal budget). As it turns out, consumer spending has held up. And I think most people are now feeling that the effects of sequestration were not so bad after all.
In terms of economic data, some of the figures are quite surprising. After peaking in recent years at over 10% of GDP, our federal budget deficit is projected to drop to about 5% for 2013. Running a deficit at 10% of GDP is not sustainable, in my opinion. At 5%, I think the deficit is still a bit on the high side, but it's definitely a big improvement. And I'm hopeful that the deficit will soon come down to the 3% vicinity, which is much more reasonable based on historical data. So it appears to me that the country is emerging from the economic jam. Some might argue that we need more deficit spending because unemployment has been sticky on the high side, and I think that's a plausible argument. Nevertheless, progress is certainly being made as indicated by the shrinking budget deficit, and sequestration has had a hand in that. While the car may not be doing 65 and the engine may not be firing on all cylinders, thankfully we are moving down the road.
Although the unemployment rate tipped up recently, which would normally be considered a negative development, there is reason for optimism here too. This is because the labor-participation rate has also increased, contrary to concerns that many of the unemployed are discouraged and dropping out of the labor market. In fact, a growing number of previously discouraged workers are now looking for jobs, which means that more people are counted as unemployed. While this trend increases the reported unemployment rate, it actually indicates an improving economy and increasing optimism among the jobless.
The uncertainty regarding the phasing out of quantitative easing is not whether interest rates will rise?—?they will?—?but whether the Fed can maintain control as they rise. I think most people expect that interest rates will increase, and many people want higher rates, particularly those who are on the verge of retiring and are looking for shorter-term alternatives to equities. Somewhat higher rates would also give small and mid-size businesses better access to credit because banks and other providers of capital would have more of an incentive to lend. Allowing interest rates to rise moderately would signal a true return to normalcy.
While the credit markets, as reflected in interest rates and spreads, were roiled by Chairman Bernanke's remarks, the equity markets were less affected overall, despite the increased short-term volatility. Credit investors seem to believe that today's fledgling economic strength is merely the by-product of quantitative easing and that once it is tapered, the economy will grind to a halt. On the other hand, equity investors apparently regard the limited economic improvement as genuine and accept Chairman Bernanke's remarks as further evidence of normalization. This divergence of opinions implies that one of these two investor groups is likely to end up being disappointed. My view is that equity investors have it right, and I am growing more confident that our recovery is sluggish but genuine.
I believe that Chairman Bernanke's indication of reduced Fed intervention is a step in the right direction. He's saying that the Fed is going to slowly back out of asset purchases, even if this disrupts the markets to some extent. The reality is that some disruption is a positive development for our long-term economic health. The Fed has to break the artificial cycle of “printing money” to support bond prices and keep interest rates low. Just the same, we shouldn't be surprised by those who complain loudly that Chairman Bernanke is taking away the punch bowl too soon. But from my perspective, this more-sober behavior is long overdue.
Looking abroad, Japan captured worldwide attention when Prime Minister Shinzo Abe unveiled “Abenomics,” an unprecedented mix of monetary stimulus, additional government spending and pro-growth policies that include devaluing the yen to provide Japanese exporters with a competitive advantage. There is some concern that Abenomics could introduce a global round of competitive currency devaluations. In my opinion, this is unlikely because Japan has borne other countries' currency devaluations for many years. So I think Prime Minister Abe is simply playing catch-up. I doubt that other countries will retaliate. Instead, I believe they will let Japan have its due.
The longer-term fear is that Abenomics could lead to inflation. My view, however, is that aging populations around the world create enormous pressure to keep inflation in check. Inflation is terrible for senior citizens because they tend to have little debt and their incomes are relatively fixed. If prices go up, many seniors would be in trouble. For young people, inflation decreases debt burdens while wages tend to go up. This creates an intergenerational challenge that I think will be resolved to the benefit of seniors because the demographic shift is in their favor. So for Japan, Europe and the U.S., I don't think much inflation is on the horizon. This also leads me to believe that Prime Minister Abe's policies will be relatively successful.
Markets
The steady gains recorded by the S&P 500 Index in the first quarter and through mid-second quarter were interrupted starting in May by Chairman Bernanke's talk of a reduction in quantitative easing. Despite the ensuing volatility that accelerated into June, the S&P 500 finished the second quarter with a positive return of 2.91%. Meanwhile, bonds continued their decline, with the Barclays Capital U.S. Aggregate Bond Index down 2.32% in the second quarter after a modest loss in the first quarter. Given my belief that it is only a matter of when, not if, interest rates rise, I once again caution investors about the risk of principal erosion in bonds?—?particularly in bonds with longer maturities.
For the 12 months ended June 30, 2013, the S&P 500 was up 20.60% in a remarkably smooth ascent overall, the recent volatility notwithstanding. As equity markets have advanced, concern has grown among some investors that valuations have become less attractive. By one measure, the Shiller P/E Ratio, which considers current stock prices relative to inflation-adjusted earnings over the past 10 years, valuations appear elevated. Throughout the second quarter, the Shiller P/E was over 20, a level that is high by historical standards. In the last 10 years (encompassing two recessions), however, real earnings grew by only 3.6% per year. In the prior 10 years, real growth was about 6% per year. My view, therefore, is that earnings in the last 10 years were somewhat depressed, and that the Shiller P/E is likely to decline and appear more attractive as earnings rise going forward.
The reasonableness of overall stock valuations depends in large part on whether the economy is headed back to normal. If that happens, we can expect to see higher growth rates among companies, which would make stock valuations more attractive. Apart from some SaaS (software-as-a-service) companies and some less economically sensitive companies that I consider expensive, I continue to find many stocks trading at price-to-earnings (P/E) ratios of about 15, based on projected 2014 earnings. To me, that's somewhere in the mid-range of valuations, maybe on the high side of the mid-range, but I wouldn't say these stocks are overvalued. In addition, these are stocks of what I believe are excellent companies with strong competitive advantages and top-notch managements. I would start to worry if I saw signs of excess in the economy or if I could only find second-rate companies trading at reasonable P/E ratios, but that's clearly not the case today.
Sam Stewart is chairman and chief investment officer of Wasatch Funds. This commentary originally appeared on the firm's website.
