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Expectations: If Greenspan Gets His Way, The Stock Market....
(From BARRON'S) "Don't
fight the Fed" is one of the oldest adages on Wall Street. But as the Federal
Reserve embarks this week on one of the best-telegraphed series of interest-rate
increases in history, the markets seem surprisingly unshaken.
The stock
market has been quietly creeping up, although this past week the Standard &
Poor's 500 index was unchanged at 1135. The S&P 500 is now up 2% this year
and has risen 5% from its May low, when rate fears peaked. Economically sensitive
stocks are rallying, and even the traditionally rate-sensitive financials are
perking up.
Other major market indexes also have been doing better. The Nasdaq
composite rose 39 points to 2025 last week and now has gained 1% this year. The
Dow Jones Industrial Average fell 44 points in the five sessions, to 10,372, leaving
it down 0.8% for the year. Bond prices have rebounded, trimming yields a bit from
their peaks. The benchmark 10-year Treasury note, which hit 4.87% two weeks ago,
finished Friday at 4.65%. Total returns on bonds have been about flat this year
because modest price declines have been offset by interest income.
By
repeating his mantra that the Fed will raise short-term rates from their current
rock-bottom level of 1% at a "measured" pace, Fed Chairman Alan Greenspan
has sought to induce this confident calm in the markets. Because Greenspan
and other Fed officials have been talking about the prospect of rate increases
for well over a month, the interest-rate futures markets now are forecasting
a steady rise in short rates, to 2.25% by the end of 2004 and 3.75% by year-end
2005.
"We have never entered into a Fed tightening campaign with
an entire
rate-hiking cycle already priced in," Merrill Lynch economist
David Rosenberg wrote recently in a report, "The Case for Bonds." This
contrasts with a decade ago, the last time the Fed moved aggressively to raise
short rates. In 1994, when the Fed began lifting short rates from what was then
viewed as a low level of 3%, the stock and bond markets were caught off-guard.
Short-term rates then doubled to 6% over 12 months, a sharper-than-expected jump.
This time may be different. "My feeling is that we have a shot at breaking
1200 to 1250 on the S&P 500 by the end of the year," says Jim Paulsen,
strategist at Wells Capital Management in Minneapolis. "Short-term rates
may go from 1% to 2%, but if corporate profits are rising at a double-digit pace,
investors may say: `Give me stocks.' "
The 1994 example colors investors'
expectations because stocks fell after the Fed began lifting rates. Yet, after
three other Fed tightening actions starting in 1986, 1988 and 1999, the markets
were higher six months later. The record, however, isn't as good after 12 months,
Merrill Lynch data show. In earlier decades, moreover, stocks weren't hampered
by rising rates. "If you look at the 'Fifties and 'Sixties, the economy picked
up, rates went up and so did stocks," Paulsen notes. The
impact of higher short rates on the financial markets and the economy also may
be muted because short rates are starting at such a low level. As Barron's Roundtable
member Scott Black observed in last week's issue: "Who cares if Alan Greenspan
raises short-term rates by a quarter or half a percentage point? A yield of 1.5%
to 1.75% on federal funds is still a sign that the punch bowl is open for drinking."
(William McChesney Martin, the Fed chairman in the 1950s and '60s, famously said
the job of a central banker is to "take away the punch bowl just when the
party gets going.")
The questions remains whether Greenspan, the economic
Maestro, can orchestrate a slow, steady rise in short rates or will have to pick
up the tempo.
Nearly all the financial economists on Wall Street are betting
that the Federal Open Market Committee, the Fed policy-making arm, will raise
the federal-funds rate, the benchmark overnight rate, by a quarter percentage
point to 1.25% at its meeting Tuesday and Wednesday. A bigger, half-point rise
would be a shock that could send stocks reeling. The funds rate is a primary determinant
of other short rates.
Most are betting that the Fed follows that quarter-point
move with another quarter-point hike at the subsequent FOMC meetings in August
and September.
These expectations are priced into the fed-funds futures markets,
where investors can bet on future Fed moves. The markets are discounting quarter-point
rate increases at most of the FOMC meetings over the next 18 months.
"The Fed probably wants to get to 3.5% to 4%," says Jim Bianco, head
of Bianco Research in Chicago. "The issue is, how long does it take them
to get there? Does it happen in nine months or 18 months?" If the Fed can
proceed at a gradual pace, and stop when short rates stand around 4% -- hardly
a punitive level by historical standards -- the stock market could shrug it off.
Whether the Fed can follow its preferred gentle upward path will depend
largely on the strength of economy and, more importantly, inflation. Inflation
has accelerated markedly this year, driven largely by higher food and energy costs.
Consumer prices jumped 0.6% in May and have risen at a 4.6% annual rate in the
past six months.
Despite those ominous increases, Fed policy makers continue
to play down the inflation risks. The central bank's hope is that inflation trends
down to 2%. The
78-year-old Greenspan told Congress earlier this month that inflation is "not
likely to be a serious concern."
It's unclear whether Greenspan will
get his wish. His critics say the central bank kept short rates too low for too
long based on the far-fetched idea that the U.S. was in danger of overly low inflation
or outright deflation. Now that inflation is starting to stir, it may be tough
to control it. One of the reasons corporate earnings growth probably ran at a
20% pace in the first half of this year is that companies finally have some pricing
power.
"The Fed overstayed its welcome. It should have moved to raise
rates a while ago," says one of those critics, Joseph Deane, the bearish
manager of the Smith Barney Managed Municipals Fund. "Between now and the
end of next year, the bond market will take it on the keister." Deane thinks
the "neutral" funds rate should be 4% to 4.5%. His view: The reported
inflation figures understate actual price increases in "the real world."
He says that "the question the Fed members ought to be asking themselves
at this week's meeting is, where do we want to go
in the next 1 1/2 years
and how do we get there."
Indeed, more than the inevitable rate decision,
Wall Street will be looking for clues from the Fed this week about the future
course of rate hikes. Most likely, the FOMC will vow to stick to its plan to maintain
its "measured" pace of tightening.
Deane also wonders about the
financial leverage that has been facilitated by a super-low 1% short rate. "There's
a significantly larger carry trade now than in 1994," Deane argues, referring
to purchases of longer-term, higher-yielding securities with cheap, short-term
credit.
The carry trade typically refers to bond speculators, but the biggest
practitioners may be banks and thrifts that have bought large amounts of mortgages
and other fixed-income securities with borrowed money to sustain their profit
growth. Some thrifts have been stung, such as New York Community Bancorp, whose
shares are down 26% this year to 21.
The prevailing view is that the bond
market won't get hit much as the Fed tightens, because long-term yields already
have risen as much as 11/2 percentage points. Deane, however, says "the 10-year
Treasury will likely be between a 6% and 6.5% yield by the end of 2005."
If long-term rates do rise, mortgage securities -- a perennially
underappreciated
bond class -- probably will hold up best. Jeff Gundlach, a bond portfolio manager
at TCW Group in Los Angeles, notes that based on a key risk-return relationship,
the Sharpe Ratio, mortgage-backed securities are tops among all major asset classes.
Mortgage securities now yield about 5.5%.
His view is that the "world
can withstand 3% short-term rates; 4% is a little dicey and 5% is tough."
If short rates do hit 5%, many bond investments made in recent years will incur
"negative carry," meaning their yields will be exceeded by the cost
of financing them.
Among equities, financial stocks, now the biggest sector
of the market, are apt to be affected by the speed and magnitude of future rate
increases. While most financial firms insist their profits haven't been artificially
inflated by low short rates, the reality may be otherwise.
Financial stocks
account for 20% of the S&P 500, but the earnings contribution of the sector
is 30% because financials tend to have lower price-earnings ratios than the overall
market. The average financial P/E is around 12 times forecast 2004 profits, against
17.5 times for the S&P 500 itself.
The actual effective financial
contribution to S&P earnings probably is closer to 35%. General Electric,
for instance, gets nearly half its profit from its financial unit, GE Capital,
and Ford Motor and General Motors have produced most of their profits in their
financial divisions.
As the table shows, there have been few outsized moves
among the major
financials. One exception: Countrywide Financial, the country's
top mortgage originator, has surged as investors realize the company is less vulnerable
to higher rates than had been believed.
Shares of insurers, particularly
the property-casualty companies, have risen as investors focused less on the impact
of rising rates on their big bond portfolios and more on their ability to invest
insurance premiums in higher-yielding assets as rates rise. It also has helped
that many insurers began the year with P/Es of 10 or lower. Conventional
wisdom is that it pays to avoid financials when rates are rising.
But, barring
a major rate increase, the financials could confound the doubters.
Valuations
on stocks such as Citigroup, J.P. Morgan Chase and the major brokers are relatively
modest and probably discount a slowdown in earnings growth. If financial companies
can demonstrate that their profits are less sensitive to ates than is commonly
perceived, they could win higher P/Es. The
markets also may overrunning the Maestro. During 2002 and 2003, one of the most
profitable trades among hedge funds and other speculators was to bet that the
interest-rate futures markets were too pessimistic about the outlook for short
rates. Speculators purchased Eurodollar futures, fed-funds futures or call options
and benefited as short rates failed to rise. Investors can still play his game,
but it's tougher now because the Fed is committed to boost rates. The
only
likely questions are the timing and the extent of the move.
These markets
now discount 2.25% fed funds by year end and a 3.75% rate by the end of 2005.
If you think short rates won't hit those levels, buy Eurodollar or fed-funds futures
or calls on them. Bears who believe the Fed will have to raise rates more aggressively
ought to sell these contracts or buy puts.
Expectations about short-term
interest rates can be evanescent, however. Just three months ago, the markets
were anticipating short rates rising only a quarter point by year end to 1.25%.
Three months from now, the interest-rate markets could have an entirely new configuration.
So could the currently placid stock market.
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