There’s a whole lot to think about in the markets at the moment.
While the Fed decision to not raise interest rates at the FOMC meeting in mid-September was greeted with volatility and down moves in the equity markets, Janet Yellen’s speech on Thursday at UMass – in which she made the indirect case for a hike later this year – reversed the trend. The corresponding 200+ point move up by the Dow, John Boehner’s resignation, Volkwagen’s headline shocker and Caterpillar’s unnerving guidance provided a whole lot of food for thought for the weekend. So, here’s what we’re thinking:
Investor sentiment around interest rates has been extremely revealing. The equity markets, essentially, have made it clear that they want a raise. Understandably so, given it would signal a robust US economy, a follow-through of the Fed mandate, and importantly, certainty around the cost of capital. By several metrics, the labor market is showing signs close to full employment, while inflation gauges including core CPI and core PCE are at 1.8% and 1.2%, respectively – moving closer to the 2% target. With Yellen’s speech, it’s fair to say that the hike is not too far out.
At this stage, we’re thinking buybacks and M&A activity – and the corresponding impact on stock prices – needs to remain on top of investors’ minds. Companies have taken massive advantage of the low interest rate environment to utilize debt to reduce outstanding share counts – and all’s well as long as investors don’t get deceived between long term and short term gains. Per Barron’s, over $1 trillion has been returned to shareholders by S&P 500 firms in the past year – the highest level since 2007. What’s important, however, is that the amount is more than the firms generated in free cash flow over the same span. The EPS impact has been significant, with 20% of companies reducing share counts by 4%, and adding the same 4% to EPS, as Barron’s notes. So, if rates rise, the buyback party should, in theory, reduce, and how companies adapt and invest money in a more expensive world remains to be seen – especially given that international conditions remain bleak. Caterpillar’s reduction in guidance and the announced layoff of nearly half of its workforce is a resounding reminder that the world economy is entering a new era.
M&A activity, meanwhile, is set to surpass the $4.3 trillion record set in 2007 this year as well – again, undoubtedly fueled by low interest rates providing cheap financing for deals. The corresponding premiums factored into stocks are hard to dissect, but certainly exist. The consumer staples sector, for example, remains a prime suspect as a beneficiary of this activity, in our opinion. The sector was trading at 18.7x forward P/E at the end of August, higher than its 18.4x 15-year average (JP Morgan data). Sure, it pays a hefty dividend, and has therefore been a favorite for hungry investors parched by low-yielding bonds. However, with negligible organic top-line growth, a strengthening dollar hurting overseas revenues and rapidly changing consumer tastes moving away from colas and packaged products, does the sector actually deserve the premium? Kraft, Heinz, and other firms’ shareholders in the sector have been rewarded handsomely through M&A activity. A downturn in M&A due to more expensive financing would certainly cause headwinds for target firms in the equity universe – the extent of which might only be understood after-the-fact.
And finally, there’s the bond market – a truly fascinating asset class that doesn’t get nearly the attention or respect it deserves from equity investors. Credit spreads for investment grade as well as high yield bonds have slowly been widening, with the WSJ noting on Sunday that ‘the US corporate bond market is starting to flash caution signals about the broader economy’. The root cause filters back to the same subject as above – concerns regarding companies’ ability to pay back the ‘massive debt load taken on in recent years’ with low interest rates, according to the WSJ. Granted, leverage ratios remain far, far below pre-crisis levels, but global growth isn’t nearly enough to provide a helping hand this time if things go downhill. Consumption might come to the rescue as the year goes on, but caution should prevail as interest rate hikes come closer and markets get choppier.
What it means for you: The world of higher rates is a storied one – not seen in several years in the US, and not remembered by many of today’s investors and bankers. In the past higher rate era, emerging markets were driving global growth through capital expenditure, infrastructure development and commodity consumption. On a broader level, corporate profits, as denoted by McKinsey Global Insights and The Economist, tripled in the phase between 1980 and 2013, rising from 7.6% to 10% of global GDP – with Western firms capturing over 60% of it; remember that all of this occurred while 10-year treasury yields averaged around 4%. Today, overseas growth is slower and international firms are far more prominent, with the 50 largest emerging market firms doubling the portion of their revenues coming from abroad in just a decade. With increasing competition, among numerous other factors, profits are set to decline back to the 8% range in the next 2 decades, according to MGI. Investors – large and small alike – will need some time to figure out the right prices for assets once rates go up, and also to understand long term implications in the new global economic landscape of higher rates, slower growth, and more diversified revenue sources and firms. The point? Have patience with your investments and be set to ride out the potentially rough seas ahead, because that the world economy today is far less charted than one may think it is, although as fascinating as ever.
