Setting the Scene for 2015

What can investors expect from the Federal Reserve, the economy, and financial markets in the new year?

Market prospects in the coming year would seem to hinge on four major considerations. One is geopolitics, inherently unpredictable but potentially disruptive, especially these days. Another is the Federal Reserve’s plan to raise interest rates along a gentle path beginning sometime in the middle of the year. Third is the perennial question of where value lies within and between markets. Fourth is the state of the U.S. economy. The balance of probabilities on these four fronts favors two broad investment positions. In fixed-income investing, it would seem best to lean away from longer-duration quality bonds in favor of shorter-duration instruments and more credit-sensitive issues, including municipals. Though equity valuations are not what they were, they remain attractive enough to sustain the rally, especially since the economy and, consequently, earnings are likely to continue growing.

A Word on Geopolitics
No investor can contemplate possibilities without acknowledging the risk of geopolitical disruptions. An advance by ISIS (Islamic State of Iraq and Syria) or increased Iranian tensions could easily reverse the oil price relief that most global economies presently enjoy. Korean tensions or a more assertive level of Chinese activity in the East or South China seas could, at the very least, shift Washington’s budget priorities and more seriously threaten a shooting war, either of which would change investment calculations. Another turn in what has been called the Arab Spring could impose vaguer risks on the investment horizon and certainly change relative pricing. More weakening in Japan’s or Europe’s economy or dangerous deflationary effects also could alter investment calculations, pricing, and impose the need for portfolio adjustments. And this is only a partial list.

But investors cannot configure portfolios to guard against, much less take advantage of, all these factors. It is not even possible to assign probabilities to such risks. In this respect, the array of such possibilities, though easy to itemize and identify, are much like the almost equal possibility of disruption from entirely unforeseen events. Rather than twist portfolios within what is tantamount to a random range of possibilities, it would be better to remain alert and nimble to such concerns, while otherwise structure investments around the economic and financial fundamentals, where, however obscure the future, there is a greater ability to discern likelihoods and set probabilities.

Fixed Income   
For the moment, extremely low interest rates and yields in Europe and Japan, along with the economic woes besetting these regions, are driving money into U.S. fixed-income markets. These flows have kept Treasury and agency yields low as well as yields on high-quality corporate bonds.1 But unless the eurozone and Japan truly fall apart, these influences can only last so long. Looking out beyond the next few weeks and months, then, the big bond consideration is the Fed’s clear desire to raise interest rates—“normalize” them, in the words of Fed chairperson Janet Yellen.2

On one side, it would be easy to exaggerate the danger here. References frequently made to the financial havoc created by Fed rate hikes in 1994 are misplaced. Chairperson Yellen as well as various regional Fed presidents have made clear their intention to exercise caution and move rates up, once they start, along a very gradual path. Yellen has further stressed the Fed’s ongoing sensitivity to statistics—meaning that it has no desire to raise rates far enough or fast enough to jeopardize economic growth. Yellen also has indicated that the Fed will not even begin to raise rates until it is confident that the economic recovery can withstand such a move.3 Taking the Fed at its word, then, investors have little or no reason to worry over an economic stall, much less a decline, over this time period. (More on the economy below.)   

Still, if the Fed will surely go gently, its direction is clear. Investors can then be reasonably sure that bond yields will follow short-term rates upward or even anticipate the Fed’s moves as the start date for such increases becomes more certain. This prospect threatens returns in intermediate- and longer-term fixed-income instruments, especially those in Treasuries, agencies, and high-grade corporate paper, which respond to little else but general rate movements. In longer maturities, there is a good prospect of capital losses here sometime during the course of 2015. Since in the interim such assets pay a relatively paltry yield, this class of investments hardly offers much appeal. There are, however, fixed-income avenues that offer better opportunities or at the very least better defense. 

One clear defense against rising yields is to shorten the average duration of a portfolio’s fixed-income holdings. Though a rise in short-term interest rates would hit the capital values of intermediate-term and even shorter-term instruments, longer-term instruments are much more vulnerable. Even if the basis-point change in longer yields is considerably lower than on shorter- and intermediate-term instruments, the price leverage on the longer-term instruments is disproportionally greater.    

A second option would be to reach for more credit-sensitive instruments, where yield spreads offer protection of a sort. Though corporate junk bonds, for instance, carry yield spreads over Treasuries that are slightly lower than they have averaged for the last 40 years or so, these spreads remain wide, considering how default rates among corporate bonds have declined. It seems likely, then, that shrinking spreads on credit-sensitive instruments will absorb much of the prospective rate increases, protecting those who hold such instruments from the capital losses more likely in higher-quality instruments. Adding to their appeal, credit-sensitive instruments also pay holders a much more generous yield. An especially cautious investor might combine these two defenses into a third that shortens duration with more credit-sensitive instruments.4

A fourth option is municipal bonds. These, of course, are suitable only for tax-paying investors; but even at low marginal tax rates, municipal bonds provide attractive aftertax yields, much more attractive than they have been historically. Indeed, even relatively high-grade municipals pay higher aftertax yields than do corporate junk bonds. The root of such value is clear in the headlines about Detroit and Puerto Rico. But despite such notoriety, default rates among municipal bonds are very low, less than one-tenth of one percent in fact, and, more important, lower than on corporate bonds. On this basis, such bonds hold out the promise of absorbing in shrinking spreads much of the yield increases likely in Treasuries, agencies, and high-grade corporate paper, while at the same time paying investors comparatively attractive aftertax yields.5      

Equities and Economics   
In contrast to the complexities facing fixed-income investing, the prospect for a continuation of the equity rally has two things going for it: 1) value remains, even if it is not as overpowering as it was one, two or three years ago, and 2) the economic recovery, though likely to remain substandard next to history, will continue to promote some earnings growth, if not the striking gains exhibited earlier in the recovery.

The market still offers value. The S&P 500® Index,6 for instance, offers a price-to-earnings multiple about where it has averaged for the last 35–40 years. On that basis, even a cautious view of the market would label it fairly valued, able, at the very least, then, to follow earnings. With nominal domestic revenues likely to expand about 4.0% in the coming year, gross earnings, with modest help from continued operating leverage, look likely to come in at close to 5.0%. Net share buybacks should put the per-share earnings gain at 6.0%. Without any expansion in multiples, stock prices could track this earnings growth and so put in a similar 6.0% gain. Since on top of such price gains stocks also offer a dividend yield of about 2.0%, a conservative expectation would put equity gains at about 8.0%—not the impressive figures of past years, to be sure, but respectable nonetheless.7

Prospects improve when viewing equity valuations relative to bonds or cash. On these bases, stocks offer better than fair value; in fact, they look cheap. There are, of course, a host of metrics for such comparisons. There is no space here to go through all of them, but since they all agree, there is no need to do so either. The most straightforward comparison of dividend yields with rates on cash can illustrate. As already indicated, the S&P 500 pays a dividend yield of about 2.0%. Deposit rates vary, but generally pay about 25 basis points (bps), some 175 bps less than stocks. Historically, cash pays 200 bps on average more than dividend yields, not less, as is the case now. Such measures, and others of greater complexity and greater obscurity, speak not just to still attractive equity valuations but also that such favorable value comparisons could easily survive both further stock price gains and the moderate rate increases contemplated by the Fed.8

Meanwhile, prospects for continued, albeit moderate economic growth should spare equities the threat of recession and declining earnings, thus allowing them to realize their value. To be sure, all the forces that have kept the recovery subpar to date remain in place. Both company managements and lenders remain inordinately cautious, as a legacy of the pain of the Great Recession and in response to the continuing ambiguities of Washington’s active regulatory policies as well as the remaining uncertainties left by ambitious past legislation. But neither is there anything pre-recessionary about this economy, and it would be an economic downturn, not slow growth, that would prevent markets from realizing their value.

Three reference points at least direct clearly away from recession and toward continuing growth9:

1) The housing market is improving, not rapidly, but durably. The statistics record growth in sales, construction, and real estate prices. These are a long way from where they were before the housing bust of the Great Recession, and at their slow pace of advance, they will take a long time indeed to recover those highs. But in this context, the important thing is that the economy has never fallen into recession when real estate is improving, even if only slowly.

2) Corporate balance sheets are in great shape. There is, in fact, not a hint of excess. Nonfinancial corporations, according to Fed statistics, have checking account deposits equal to as much as 10% of their total liabilities, not even counting time deposits, money market accounts, and other cash equivalents. To be sure, managements are proceeding cautiously. They are neither hiring nor spending on expanded capacity nearly as aggressively as they once did. But recessions do not result from caution. They occur when companies are squeezed and have no option but to cut back, and with so much cash on its balance sheets, corporate America is far from squeezed.

3) Households, too, have improved their finances. The burden of debt service on aftertax income has fallen in the past two to three years, from about 20% to just over 15%. Though incomes have grown more slowly than they might because hiring has proceeded at a slower pace than in past recoveries, overtime and upgrading have allowed greater gross income growth for those who have jobs. So, although payrolls have expanded at an annual rate of only 1.5–2.0% during the past couple of years, aftertax incomes from wages and salaries have expanded at closer to 4.5–5.0%—not enough to create a consumption boom, but certainly enough to sustain an economic recovery.

Recap
If the great geopolitical issues of the day impose more uncertainty than usual, two factors make the economic and financial fundamentals look remarkably clear: 1) the Fed intends to raise interest rates, slowly and cautiously, but upward nonetheless, and 2) equity markets still show value, and continued economic growth, even if slow, should enable them to realize it. The first of these two considerations makes longer-term, quality fixed-income instruments less than attractive, though credit spreads remain attractive enough for investors to find good protection with more credit-sensitive instruments, especially municipal bonds, particularly in shorter durations. The latter consideration indicates that the equity rally should carry on, although likely not at the impressive pace it has put in to date. 

1 Department of the Treasury.
2 Federal Reserve.
3 Ibid
4 Data from Bloomberg.
5 Ibid.
6 The S&P 500® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries. An index is unmanaged, does not reflect the deduction of fees or expenses, and is not available for direct investment.
7 Data from Standard & Poor’s.
8 Ibid.
9 Data for point 1 come from the Department of Commerce and the National Association of Realtors; data for point 2 come from the Federal Reserve; and data for point 3 come from the Federal Reserve, the Department of Labor, and the Department of Commerce.