US equity indices pushed higher in the third quarter of 2013 despite investor concerns about the onset of tapering by the Federal Reserve (Fed). As it stands, both real GDP (gross domestic product) and core inflation measures appear to be running below the initial forecasts of the Fed for 2013. Nevertheless, government bond yields have risen significantly on the prospect of a reduction in the USD 85 billion of monthly purchases of Treasuries and mortgage-backed securities, with the 10-year US Treasury bond yield climbing to just above 3 per cent. Mortgage rates have also risen on the back-up in Treasury yields, and corporate bond spreads widened over Treasury bonds.
The strong reactions of bond investors to the Federal Open Market Committee statement on 22 May, indicating the Fed would begin tapering quantitative easing, constituted, in the Fed’s estimation, a tightening of financial conditions. The increase in interest rates introduced the possibility of a new drag on US economic growth and a further shortfall of core inflation relative to the 2 per cent target. Indeed, some softening in US home sales became more evident as the summer progressed. Consequently, in mid-September, the Fed elected not to initiate the tapering of quantitative easing. This has eased equity and bond investor concerns, and allowed equity indices to push to new highs.
We have previously raised the issue that central banks may have backed themselves into a corner and will need to maintain efforts at repressing interest rates longer than investors currently anticipate. Once they elect to depart from quantitative easing, and eventually normalize policy rates, central banks will inevitably expose bond investors to potential losses. We have described this as an adversely skewed risk/ return profile for long duration government bonds in developed markets. After the recent experience with the Fed’s tapering announcement, bond investors are alert to the problems that occur when long bond yields have been pulled down to low nominal levels. Small increases in yields result in large capital losses, and the coupon on the bond is not enough to cover these losses. Central banks are likely to extract themselves from interest rate repression in a very slow and cautious fashion as this exit problem becomes more apparent.
Bond investors are also likely to require a higher risk premium as a result. Already, the US has seen very large redemptions in bond mutual funds as individual investors realize their exposure to this adverse risk/ return profile. Low inflation and slow growth news in the US has not prevented these redemptions. But investors are not going to be able to achieve their desired returns by sitting in cash or near cash instruments. Nor are they likely to pursue real estate investments as aggressively if they are concerned about an eventual normalization of interest rates. While equity fund inflows have been slow so far, the odds are investors will increasingly conclude that, to achieve their return objectives, they will need higher equity exposures.
This shift in portfolio preferences toward equities is still likely to occur even in a slow growth environment. Third-quarter results are pointing toward a real GDP gain that will be below 2%. Real consumer spending, which comprises over two thirds of US real GDP, has drifted below 2 per cent this year (as displayed Figure 1). Fear of fiscal restrictions derailing the US consumer in the spring were misplaced, but it is equally clear that higher equity and real estate prices have not been sufficient to generate an acceleration in consumer spending this year. While the unemployment rate has drifted lower, monthly payroll gains remain stuck below 200,000, and much of the job generation is still skewed toward part-time work. Falling labour force participation rates are contributing more to the unemployment rate decline, with younger workers either electing to go back to further education, or finding difficulty entering the labour force.
2013 real GDP growth is tracking in the 1.6 per cent-1.9 per cent range, which is below initial expectations for the year. 2014 real GDP should improve to the 2.4 per cent-2.6 per cent range as several factors come into play. First, fiscal headwinds should diminish relative to 2013, perhaps by as much as a full percentage point of GDP. Second, growth trends have begun showing mild improvement in the UK, the euro zone, Japan and China. This should assist US export growth and help improve the US trade deficit, which so far has shown better results only on the petroleum side of the balance. Third, if the Fed is likely to remove quantitative easing only slowly, interest rate increases will tend to be moderate and the housing sector will continue its recovery into 2014. Fourth, we should begin to see more replacement demand for capital goods in the developed markets. The non-residential investment share of GDP remains quite low in many developed markets, which is particularly an anomaly in the US given the high corporate cash flow generation. New orders data from the Institute of Supply Management have shown strong gains through the summer and the Philadelphia Federal Reserve survey has also shown an improvement in new orders, although both of these surveys have yet to be confirmed by core non-defense capital goods orders growth.
Operating earnings growth for companies in the S&P 500 Index has been making a slow turn so far this year; stronger growth prospects in 2014 should enhance this improvement. The consensus of analysts is for S&P 500 operating earnings to deliver a 10 per cent year-on-year gain by the final quarter of 2013, yet revenue gains are expected to be only 1 per cent. After a 3.5 per cent year-on-year gain reported in the second quarter, we believe a 5 per cent-7 per cent full-year 2013 earnings gain looks more likely. In the GDP accounts, we are also finding evidence of improving momentum in after-tax corporate profits. 2014 consensus estimates for S&P 500 operating earnings currently project just over an 11 per cent gain, while 8 per cent-10 per cent is probably more realistic given the still moderate global recovery we currently anticipate. Even under our more conservative earnings growth expectations, US equity valuations appear near historical averages.
To conclude, US equities appear to be supported by several factors: a Fed that will be slow to withdraw unconventional monetary policy; moderate economic recovery prospects at home as fiscal drag diminishes; improved foreign demand for US products as the euro zone, UK, Japan and China deliver better growth in the coming quarters; and a still benign inflation outlook. Bond investors are coming to terms with the adverse risk/reward profile in developed market sovereign bonds arising from unconventional monetary measures. As such, with valuations neutral, we should begin to see a more defined shift in portfolio preferences towards equities in the coming quarters.