January 2014

Last month, the US Federal Reserve Bank (the Fed) celebrated its 100-year birthday with a $4 trillion balance sheet. The Fed had less than $1 trillion in assets in 2006 before the financial crisis. Janet Yellen is expected to replace Ben Bernanke as the new Fed Chairperson this month.

During its last Federal Open Market Committee (FOMC) meeting, the Fed cut its monthly net bond purchases to $75 billion from $85 billion. Even if it continues to cut net purchases by another $10 billion at each FOMC meeting, another $450 billion of bonds will be purchased this year by the Fed.

While the Fed might stop buying bonds by 2015, it is expected to keep overnight interest rates close to 0%. This outlook has left the two-year US Treasury note yield near 0.4%. A stronger economy has resulted in longer term rates rising. The ten-year US Treasury bond now yields approximately 3%, up from 1.76% at the start of the year and 1.66% in May 2013.

The European Union (EU) cut its main interest rate to 0.25% last November in order to bolster an economic recovery and prevent a return to recession. In December, Standard & Poor’s lowered the EU’s credit rating to AA+ from AAA. Meanwhile, the Bank of England signaled that it might increase interest rates in the second half of 2015 due to a stronger economy.

Japan’s printing of money has sent the Yen exchange rate to a five-year low vs. the US dollar. While the government’s intention is to increase economic growth and create mild inflation, there is a chance inflation could rise faster than expected. The weak Yen makes all Japanese imports more expensive. This island nation is dependent on imports, especially for energy.

Some emerging markets, like India, continue to raise their interest rates in order to defend their currency. This might become a significant problem in 2015 as investors prepare for rising overnight interest rates. Traders have been selling short-term US debt at low interest rates to buy higher yielding emerging market debt. As those trades reverse over the next two years, emerging market debt and currencies could become more volatile.

ECONOMIC OUTLOOK: GROWTH FINALLY ACCELERATES

The first two years of an economic recovery typically experience annual growth rates of 4% or more. The second half of 2013 might have achieved that 4% growth rate (the government will tell us in March). Despite federal government headwinds (including higher tax rates, budget sequestration, national healthcare and debt ceiling negotiations) the US economic recovery has finally taken hold. Low interest rates and continued printing of money provides monetary stimulus.

The second half of the digital revolution has yet to play out. Just as the industrial revolution spanned five decades and brought advances and greater access to luxury items, the technological or digital revolution is bringing similar transformation. Just 30 years ago, few imagined a personal computer in every house. Today, tablets and smart phones are supplementing functionality of PC’s and laptops. The resulting productivity and innovation from the digital revolution will be both destructive to traditional jobs and at the same time rewarding for quality of life, cost containment and efficiency.

Energy independence will keep another $600 million each day inside the US instead of going to the Middle East, increasing domestic economic growth by 1.5% annually. Over the next ten years, energy independence can create 3.5 million domestic jobs.

Half of these are directly related to the extraction, transport, refining and production of energy and related chemicals including the build-out of infrastructure. The other half is from ancillary services for the energy and industrial complex (e.g. retail, hospitality, professional, etc).

Energy independence could occur in just six years and should result in excess supplies of natural gas and basic chemicals. Excess supply should reduce prices. A 10% cut in energy prices typically adds another 0.5% to domestic economic growth and reduces overall inflation by 0.5%. The economic recovery should eventually lead to other price pressures and higher interest rates.

The automobile industry is approaching normal levels, and the domestic fleet is old. Housing has started to recover, but remains well below normal levels. While interest rates remain low today, rising interest rates should slow the growth rate of house and automobile sales in future years.

There are already major corporate initiatives to move manufacturing facilities back to the US. This could prolong the economic recovery.

FINANCIAL MARKET OUTLOOK: POTENTIAL SHIFT IN INVESTMENT FLOWS

With the Fed expected to purchase bonds at a declining rate and the economic recovery accelerating, long-term interest rates are expected to rise this year and next. Short-term interest rates should start to increase by next year as the Fed approaches the end of its 0% overnight interest rate policy. As interest rates rise, bond prices should fall.

Bond mutual funds experienced excessive positive inflows over the last six years. This appears to have ended during 2013. As retirees and others find out that some bonds can provide a negative return when interest rates rise, expect outflows from bond funds to continue. Outflows from the bond market should quicken the pace of rising interest rates.

From 2006 through 2012, actively managed domestic stock funds witnessed a massive outflow. This trend reversed in 2013. As index funds tend to underperform their indices over time, and the baby boomers approach retirement, actively managed equity funds should regain interest. The average investor likes to beat inflation and beat indices. This will be hard to achieve in bond funds and index funds.

Valuation is never a media concern at market tops, which results in an attractive selling point. Currently, the media is awash with valuation concerns, a good contrary indicator. While the market has more than doubled from its excessive low in March 2009, many valuation measures are close to their long-term averages.

FUTURE CHANGES: WHERE TO INVEST

As the US economy accelerates, investors should avoid fixed rate bonds with long-dated maturities. If the 30-year US Treasury bond moves from a 3.75% interest rate today to 5% next year, its market value could drop over 22% (partially offset by 3.75% of fully taxable interest income).

While bonds can perform poorly as “nominal” interest rates rise, stock returns are correlated with “real” interest rates. Real interest rates are nominal rates minus the inflation rate. Thus, a 3.75% 30-year interest rate minus an expected future inflation rate of 3% would result in a real interest rate of only 0.75% (assuming that government reported inflation moves closer to its 100-year average).

As the US exits five years of lethargic growth at best, many cyclical companies appear undervalued. These include firms in advertising, financial services, hotels, information processing and storage.

Some firms should receive a dual benefit from a stronger economy and energy independence. These may include firms in energy service, industrial distributors, industrial manufacturers, integrated energy, logistics and transportation.

As the economy grows and interest rates rise, some stocks can act like bonds and underperform. Many utility stocks could see lower valuation multiples. Investors should focus on companies that can grow their dividends.