From a geopolitical perspective, the world got quite a bit uglier in the third quarter of 2014, and nervous investors around the world headed for safer environs—specifically U.S. large-cap stocks, U.S. Treasuries, and the U.S. dollar. The S&P 500 Index eked out a gain of 0.6% for the quarter, but that performance masked broad deterioration among many other segments of the global equity markets. U.S. small-cap stocks took a drubbing, dropping nearly 10% from their highs in early July. International stocks, as measured by the MSCI EAFE Index, also dove about 10%. The 10-year U.S. Treasury yield moved down to 2.51% as prices firmed.
With the downing of Malaysia Airlines Flight 17 over Ukraine and the ISIS and Ebola crises dominating the headlines in recent months, there was no shortage of negative global drama in the world during the quarter. In the financial world, however, the biggest drama in the quarter was the surging U.S. dollar. The greenback gained 8% versus the euro and 8% versus the Japanese yen, a massive move over such a short period. The resurgent dollar is likely to reshape markets and central bank policies.
A rising dollar has many knock-on effects across the global economy and it is one reason why long-term U.S. interest rates may remain lower for some time. A strong dollar makes life tougher for American companies that sell their products abroad because it makes them more expensive to foreign buyers. But perhaps its most important effect is that it will help to keep a lid on inflation, which is the single most important factor the Federal Reserve is watching as it maintains its very accommodative interest rate policy. A strong dollar makes imports cheaper and puts pressure on commodity prices. Both are deflationary effects that will help to contain inflation and give the Fed cover for keeping rates lower for longer while the labor market continues to improve.
One thing that seems to be a forgone conclusion in the minds of many investors is that U.S. interest rates will begin rising next year. It is true that as the U.S. economy has continued to recover and unemployment has continued to drop, the Fed has less and less justification for keeping short-term rates at zero.
However, U.S. Treasuries are not priced in isolation. They are by far the largest segment of a massive investment grade sovereign debt marketplace, but global investors have a choice as to where they are going to stash their cash and in what currency. Now, given the divergence in the performance of the U.S. economy relative to Europe and Japan along with the strengthening dollar, U.S. bonds may continue to look very attractive to foreign investors for quite some time. Further foreign inflows will help to keep rates low.
Another reason why rates may be lower for longer is that on a relative basis, in the eyes of global, risk-averse investors, U.S. Treasuries actually offer pretty good yields. We tend to think of our interest rates as being low—and they are relative to their historical levels. However, interest rates in the U.S. are substantially higher than in the euro-zone and Japan (German 10-year yields are 0.90% and Japan’s are 0.52%–both only a fraction of 10-year U.S. Treasuries). Because of better current yields and a more attractive currency, foreign money continues to come into the U.S. bond market. If the U.S. economy does continue to grow, the Fed will have no choice but to begin to raise rates. Higher rates along with a rising dollar may continue to keep global funds flowing into U.S. bonds. However, investors should remember that the Fed only explicitly controls the short-term rate—market forces determine the level of long-term rates. Thus, in a world of a strong dollar and strong (relatively speaking) U.S. economy, we could see low long-term rates persist for a considerable period even as the Fed begins to raise short-term rates.
It has now been nearly three years since U.S. stocks pulled back 10% or more from their recent highs. On average it happens ever year to 18 months. Despite the volatility in the markets in the past several weeks, the outlook for U.S. businesses continues to be solid. Margins are high, balance sheets are strong, companies are efficient and earnings are projected to continue to rise into 2015. However, one thing U.S. companies, as a whole, are not doing is investing in their future growth. Indeed, in 2014 they are projected to spend 95% of their profits on dividends and share buybacks. There is still a 2008 financial crisis mentality in many executive suites around the country, and the low risk play for companies producing excess cash is simply to increase dividends or buy back stock. The average age of fixed assets in 2013 was 22 years (Source: Commerce Dept.), which is the highest level since 1956. Thus, at some point companies will simply have to begin investing in themselves again. A renewed focus on capital spending could provide nice fuel for both our economy and the capital markets in coming years.
Despite the pain U.S. small-cap stocks endured in the quarter, the business environment for small companies in the U.S. has actually improved relative to the outlook for their larger, multi-national cousins that make up much of the S&P 500 Index. First, the U.S. economy has begun to look distinctly better than the many foreign economies—and most U.S. small caps are predominately focused on U.S. markets. Second, energy prices have dropped significantly in recent months, giving a cost break to U.S. businesses and helping to put more disposable income into the pockets of U.S. consumers. Oil (West-Texas) is now below $90 per barrel, reflecting very high inventories due to the shale oil boom in the U.S. and apparent investor sentiment that Middle East supplies are unlikely to be disrupted seriously by the conflict with ISIS.
All in all, a strong dollar, lower energy prices, an accommodative Fed and an improving labor market continue to provide a constructive backdrop for U.S. equities. Stock valuations are about 10% to 20% above historical ranges—depending on whose figures you use—but still remain attractive relative to yields on bonds and cash.