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ContraryInvestor

ContraryInvestor

Contrary Investor is written, edited and published by a very small group of "real world" institutional buy-side portfolio managers and analysts with, at minimum, 20…

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At Any Rate

At Any Rate...As we enter the New Year we thought it important to have a quick look back at the character of the equity market in post recession rising interest rate environments. Of course this is exactly the set of circumstances we have been and will continue to deal with over the short to intermediate term of the moment in the current cycle. To the point, in this discussion we want to 1) have a look at historical post recession rising rate environments and how equities performed in each, 2) have a look at how rising interest rates in the current cycle may indeed impact various parts of the economy (corporations and the household sector) quite differently relative to historical experience, and 3) briefly review the most recent large and small business confidence surveys and how the forward movement of interest rates in general may influence the "tale of two economies" theme ahead. Let's get right to it.

First up is the combo chart below that is a look at 10 year US Treasury yields alongside the S&P in every post recessionary environment of the 1960's through the 80's. The vertical black lines inserted into each chart are the official NBER recession termination dates. In every case, equities bottomed prior to the official recession end and were already moving higher as official economic recovery started. Right out of the textbook in terms of a theoretically efficient market correctly anticipating real economic outcomes.

Supposedly common wisdom on the Street tells us that in initial economic recovery periods, interest rates and equity prices can rise in simultaneous rhythm for a time, in essence validating the apparent reality of economic recovery itself. Isn't this exactly what we have been hearing from the mainstream as of late? Cutting to the bottom line, there indeed have been times over the past half century where equity prices and interest rates have risen simultaneously, but recent Street commentary has addressed this relationship as if it were some hard and fast post recessionary rule. Unfortunately that's not the case. Post the recession end in February of 1961, 10 year UST yields rose very slightly as did equities, but equities retested their recession lows within the year. It was not until a year and a half after the recession ended that we saw equity prices and interest rates climb in correlated fashion for a period of time. In the immediate post 1970 recession period, 10 year yields laid flat point to point until the very important equity market peak in 1972, which by no coincidence was the exact point where 10 year yields broke out of their post recession trading range to the upside, ultimately moving to levels thought impossible. At least as we visually interpret the chart, interest rates and equities traded in correlated fashion from early 1978 to the end of the decade. In the eight years prior to that which included two post recession environments, interest rates and equity prices were negatively correlated, not positively correlated. Finally, by the time interest rates hit a secular peak in the early 1980's and began their multi-decade once in a lifetime decline, we still saw this negatively directionally correlated relationship between equities and 10 year Treasury interest rates. Post the first of the double dip recessions in 1980, the minute interest rates started up, equities declined literally until the 10 year yield bottomed in late 1982. Once rates started up again in mid-1983, equities laid dormant until rates peaked in mid-1984 and again declined. In fact, as you look across the entire 1980's decade, interest rates and equities really moved in correlated fashion only in 1987. And that ended well, no?

Very briefly, the snapshot experience of equities and interest rates in the 1990's and the prior decade lie below. Again, as we see life in the top clip of the chart, equities and interest rates moving higher simultaneously in the 1990's was the exception, not the rule.

The largest backup in interest rates during the 1990's came from late 1993 through late 1994, a period where equities laid completely flat. Without question, the periods witnessing the greatest acceleration in equity prices during the 1990's were periods characterized by declining 10 year US Treasury rates. As a final comment, the only period to see a sustainable and coincident rise in interest rates and equity prices in the 1990's was the final year. Of course this was the exact period the Fed was flooding the Street with pre-Y2K insurance liquidity (so we count it as an anomaly). You already know the equity market result in the aftermath of this experience a mere three month later.

Finally experience of the prior decade. First, sorry to have dragged you through all of this, but we believe it was very important in order to make a point. In a bit of summation, as explained and as you can visually see in the collective charts above, over the entire period of the 1960's through the 1990's (four decades), across the bulk of the time measured we have seen an inverse directional correlation between interest rates (using the 10 year UST yield as a proxy) and equity prices. Yes, there were small periods of time where interest rates and equity prices moved together, but these were clearly exceptions, not representative of the rule, so to speak.

But as we move into the decade of the 2000's, for the first time in what was to now become a total of a half century of equity price and interest rate movement observations, indeed equities and interest rates began to move in virtually simultaneous or highly correlated fashion. This has now been the case across the entirety of the prior decade into the current. We know you get the picture at this point. The whole idea and current Street commentary "illumination" that rising interest rates and rising equity prices are simply no big deal and certainly to be expected finds its consistent real world validation only in the experience of the prior decade. A decade marked by two periods where equity prices were cut in half, residential real estate values imploded unlike any other period except the Depression years, a decade experiencing the greatest magnitude and unprecedented nature of Federal Reserve monetary intervention and Government fiscal intervention, and a decade to witness a generational credit cycle peak. And this is our model of what should be considered "normal" in the relationship of equities and interest rates in the current cycle? We beg to differ.

We believe that as we move ahead, we at least need to keep in mind that the prior decade looked completely unlike anything seen in the prior four decades vis-à-vis the relationship of interest rates to equity prices, but this is exactly the model the Street is currently using to convince themselves and anyone who will listen that it's only "normal". The prior decade was anything but "normal". We're not saying current equity prices are about to run into immediate trouble. We know the Fed is targeting higher equity prices and has so far been successful. We have another 500 billion reasons why equity prices can move higher between now and June. Fed actions distort free market "messages". We simply suggest that investors look at history more broadly and realize the Street is primarily looking in the rearview mirror of the prior decade with so much of what we see in current commentary about the relationship of interest rates and equities.

As bad as this may sound, and maybe we'll look like complete idiots before the current cycle is over, the prior decade in the clarity of hindsight was characterized as having witnessed two of the largest financial bubbles in US history - the equity related dotcom/NASDAQ bubble and the mortgage credit/housing price bubble. Both of these bubbles could not have existed without Fed complicity. Not a chance. The real characterization should be provocation as opposed to complicity. Again, we're not trying to reach for pessimism here, but rather are attempting to "see" the reality of the messages of history. So, here it comes. Is it fair to say that the direction of equity prices and interest rates can indeed be very highly correlated, but only in financial bubble environments? Or maybe more specifically monetary bubble environments? Again, we know it's not fun to hear and maybe we're way off base, but this is sure what it looks like when we take a very long cycle view of life. We suggest this is a viewpoint at least worthy of consideration and monitoring as we move ahead.

Before pushing ahead to the next topic on our lagenda, two more quick comments about the historical relationship of the shape of the interest rate curve and equity price movement over time. In the chart below we're looking at the interest rate spread between 10 year UST yields and 2 year UST yields. Of course alongside is the S&P 500 to represent the movement of equities in the macro. Very quickly, when the red line that represents the yield spread between 10 and 2 year US Treasury rates is below zero, the Treasury yield curve is "inverted" (short term yields higher than longer term yields). This is exactly what we have seen historically prior to recessions. When the red line hits a peak (mid-1992, mid-2003 and now), the Treasury yield curve is what is called "steep". Ok, we've inserted the green colored areas to represent those periods in which the Treasury yield curve travels from the point of maximum "steepness" to inversion. These are the exact periods during which equities have put on their best price performance. They represent periods of official US economic expansion. The puzzle pieces all fit together quite nicely.

What clearly stands out like a sore thumb is the period from early 2009 to present, whereby higher equity prices have been highly correlated with further curve steepness as opposed to the southern trip toward inversion. This is very different than historical rhythms and patterns. It again tells us the relationship between equity prices and interest rates is potentially distorted. And how could this distortion have been created? Look no further than the Fed, who has basically turned the financial markets of the moment into a policy tool as opposed to a free market mechanism of capital creation and allocation.

Lastly, we need to remember the key meaningful distortion of the moment in what you see above is a Fed Funds rate essentially anchored at zero. Historically, yield curve flattening (the trip from steepness to inversion) or interest rate spread compression has occurred via short term (think Fed Funds) interest rates rising and long term rates either staying stable or declining. This we think is the key to the current environment. Yes, equities have risen in the past alongside rising short term interest rates. The Fed has raised rates as economic recoveries have played out. But at the moment, Street "seers" are pointing to longer term interest rates rising, not short term rates. They are not the same as is clear in the chart above. Yes, this is our long winded way of saying the current message of the Street about rising rates being no problem does not tell the whole story of history, just enough convenient snippets to make the case of the moment.

Our final comment in this section involves the TIPS and inflation expectations. Although we could spend an entire discussion on this point, we'll spare you the lengthy analysis. The Street is trying to convince us that interest rates are rising based on investor expectations of a vibrantly recovering economy. That's the key message from far too many mainstream strategists validating big 2011 equity targets. But, we need to remember that inflation expectations of investors can be measured by looking at the TIPS yields versus like maturity Treasury yields. One can calculate a TIPS breakeven inflation rate. So here's the current bottom line as we see it. If you bring the TIPS yields into the analysis and look at the trajectory of inflation breakeven rates, it is absolutely clear investors are pricing in higher inflation with the higher interest rates we have seen as of late as opposed to supposedly pricing in a big improvement in the domestic economy. The Street seers don't seem to bring this into the analysis at all when pointing to how bullish a sign higher interest rates supposedly are for equities.

Enough, we know you get the key points here. Again, we're not saying equities are about to blow through the nearest guard rail and plummet off the proverbial cliff. But what we are emphatically saying is that Street strategists are not coming clean with the longer term story of the total relationship between interest rates and equities. Neither good nor bad, we simply factor this into our decision making and "filter" the mainstream messages of the moment. We know what the Fed is doing as they have made it clear. We're in no way making the case to fight them short term. So, we participate in Fed largesse of the moment, but remember that so many of the issues that brought us to our current circumstances have been left unresolved for now. And that means risk management remains key. We'll revisit many of those issues again before the current cycle is over. It's all about ebb and flow.

To What Effect?...As we mentioned, we briefly want to look at the corporate and households sectors when contemplating the potential financial market and real world economic outcomes of higher interest rates in the current cycle. Again, we'll make it quick. Important why? We believe it ties directly into the theme of the "tale of two economies" (the dichotomous fortunes of large companies versus those of the domestic small business community). First at bat is a look at household leverage literally at every official US recession conclusion of the last half century. Remember, the Street seers are telling us higher interest rates are fine and dandy as a validation point for better economic growth ahead. Of course the chart below speaks for itself. Never have US households exited an official US recession with a higher level of household leverage as a percentage of the macro benchmark that is GDP. Never. Yes indeed, the Fed has pushed interest rates to generational lows, but to help households in a meaningful manner, households need to be able to refinance debt. We already know QE I MBS purchases in the effort to stabilize housing failed miserably. Lower rates did not induce asset price inflation, let alone stabilization, as has been the case in so many prior monetary cycles. The ability of households to refi mortgage debt has been limited by price deflation. The only way out is debt restructuring, but that would mean that the largest campaign contributors would lose a pound of flesh. Continuing up to the present, that has been a path avoided at all costs. The issue is as we have been screaming about that households need to deleverage and that process has barely begun.

Additionally, given that the US government has been acting to protect its largest campaign contributors in many cases at the expense of the longer term health of the US economy so far into the current cycle, the financial companies were given a year to raise interest rates for revolving credit users prior to credit card related legislation becoming effective. Dropping mortgage rates did nothing to arrest residential mortgage troubles and rising revolving credit card interest rates enacted during the "lead time" simply acts as a margin squeeze on households. So macro interest rates potentially rising from here will somehow validate household strength that will contribute to and further validate macro economic growth acceleration? It just does not pass the smell test in terms of simple common sense and train of logic.

But the combo chart below really tells the story of the potential for impact of higher costs of debt capital. In both cases we are looking at corporate and household "liquidity" relative to liabilities. And what is "liquidity"? All short term financial assets and all bond holdings. We try to be as broad as possible and assume all financial assets with the exception of equities can be turned into "liquidity" in the blink of an eye. Are we looking at the "tale of two private sectors" in this chart? We believe this is exactly the case. We all know corporations are simply flush with cash. More so now than at any time in recent history. Corporations have more liquidity than total liabilities at present. In contrast, household liquidity relative to liabilities is nearer a six decade low as opposed to six decade high as is the case with the corporate sector. Between the two, who will be more impacted by potentially higher interest rates? Not too hard a question to answer, now is it?

Again, the world is not about to come to an end, but this tells us that drinking the current Street kool-aid that rising rates is no big deal is dangerous to apply as a macro comment. To be honest, the impact of rising interest rates to large corporations may be as negligible in the current cycle as has been the case in modern history. They are flush with liquidity and have little need to borrow regardless of interest rate levels. In fact, a good number of corporations have issued large bond deals simply to capture the lowest nominal interest rates of a life time. They have no specific plans or need for the money as they are simply betting they will never see these rates again. Any CFO who isn't issuing longer dated paper at current rates should be fired. So unlike prior cycles whereby corporations would feel the bite of higher interest rates in a relatively timely manner, we'd venture to say rising rates will have a lesser impact on corporate outcomes over the short to intermediate term than has been the case in the entire post war period. In a sense they have become interest rate immune on the funding side of the equation for the time being.

But for US households and their financial flexibility in a rising interest rate environment, the shoe is decidedly on the other foot. Bottom line being, the impact of rising interest rates on the US private sector is not homogenous, but rather dichotomous. It's the "tale of two private sectors" that we believe necessarily dovetails right into the "tale of two economies" theme. It's households we need to focus upon when thinking about the implications of higher interest rates, not the corporate sector. And that leads us right into our final mini-topic of the day - recent corporate optimism surveys that continue to support the tale of two economies theme.

Chasing Our Tales...We fully realize we've covered these wonderful CEO, CFO and small business optimism surveys quite heavily over the recent past so we'll roll through this in short order. It's very important to briefly look at the surveys that hit the tape recently. Why? Because we saw a very much dramatic rebound in large company optimism and a marginal improvement for the small business crowd. The very meaningful rebound in the CFO and to a lesser extent CEO surveys tell us a few things. First, the large company outlook ahead is anything but dim. The $300-400 billion of additional debt the Government will take on as part of the tax break extension legislation will indeed help to increase US GDP next year. It's very much economy supportive, at least temporarily. Secondly, the big rebound in large company optimism tells us reported earnings will not disappoint near term. In fact, maybe quite the opposite. So, with additional government stimulus and the Fed still on a money printing rampage, good reported corporate results over the next six months should not be the issue to derail equity price trajectory. You can easily find the CFO and CEO Business Roundtbale data on the net, so we'll spare you the charts.

But at least for now, the theme of the tale of two economies still very much resonates as per the data from the recent NFIB (National Federation of Independent Business) survey. The report showed us an optimism level high not seen since 2008, but it is clear where we stand relative to historical experience and that is on the recession lows of the early 1990's and early last decade. It's simply modest change at the margin we are now seeing. Again, we'll spare you a chart review.

In conjunction with the marginal improvement in headline small business optimism, we continue to see small business job openings and cap spending plans stuck in the ranges they have carved out over the last two years, near three decade lows. To be honest, we expect these numbers to break to the upside as we move into 2011. We guarantee you improvement will be met with Wall Street proclamations that everything is getting back to "normal". But of course the key is to remember that small business optimism is incrementally climbing out of a very deep hole. We're still miles away from what would have been considered "normal" in prior cycles. The key watch point ahead will be perceptions. Although we'll see nominal number improvement in such things as payrolls, will investors focus on the nominal improvement only? Or will they remember the US needs roughly 250,000 new jobs monthly just to stay even, so to speak? This is an example of exactly what we need to watch for as we move into the New Year. And for the first six months of the New Year, the Fed liquidity tailwind will continue to blow strongly.

We know the small business community is very dependent on domestic final demand. In essence, they are very dependent on US households relative to their larger company brethren. And as mentioned above, households are the portion of the US private sector least immune to higher interest rates. This is the circular linkage of importance.

So in brief summation, we need to be careful about drinking the Wall Street kool-aid that higher interest rates are to be expected and in fact embraced as a sign of economic vitality. The distortions in the current cycle tell us to at least question prior cycle relationships Street "seers" have extrapolated into the current cycle. The sector most vulnerable to higher rates is the household sector, the key sector that will determine small business vitality, or otherwise. By contrast, indeed the large corporate sector is in very good shape. The very noticeable rebound in CFO and CEO optimism is not to be ignored as it applies to the reality of corporate earnings that lay ahead. The message is that earnings will not disappoint for now. And that means the unprecedented nature of continued Fed sponsored liquidity can easily act as a meaningful backstop to financial asset prices as we move into the first half of 2011. The investment theme of the tale of two economies remains alive and well as we move into the second year of this thematic story unfolding.

 

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