The Economy, Tapering, Syria, and Emerging Markets

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I began writing Worth Considering as a tool to address questions I see becoming more common either in my Inbox or in the media. This isn’t the forum for lengthy analysis, but will hopefully still convey what I feel are the most important elements of each topic. There are certainly a few current issues becoming the “buzz”, so I will work through some of those in this issue.

But first a quick overview might help provide context.

We recently ended the second quarter earnings season and it was, for the most part, slightly better than most analyst expectations. What stood out as recurring themes were that the United States economy continues to slowly recover and Europe, as we’ve noted previously, is indeed coming more into focus as a positive region for growth rather than a negative.

These earnings results have led to what we’d suggest is “right-pricing” for the US stock market; it is neither cheap nor expensive by most historical measures. According to data compiled by Yahoo and Bloomberg, the current PE for the domestic market is roughly 15 which puts it essentially in-line with historical valuations.

The question now is will the economy begin to pick up enough speed to lift corporate profits, or will sufficient confidence return to the markets to allow for investors to be willing to pay higher prices for the same earnings (this is what is referred to as “multiple expansion” in financial circles). The discounts from a valuation perspective are seen in Europe, where the fundamental economy looks to be recovering, and the emerging markets, where the fundamental economy looks to be weakening.

We’ve also had a few key economic data points released such as unemployment, housing data, capacity utilization and trade balances, to name a few. They continue to support the notion that the US continues to grow at a slow pace. My chosen mascot for this recovery, the Plow Horse, still fits.

We’ve also seen the initial steps in what we think will be a multi-year reversal in the bond market. There will be wiggles in the lines, as always, so we may be due for some temporary bond market strength. But we have little doubt that bonds will yield more in the years ahead which also means lower prices.

There are two primary factors for this. One is that during stronger economic times, investors will always demand more yield (i.e., higher rates of interest) to hold bonds instead of other assets like stocks, real estate, or commodities. The other is the impending tapering (and eventual ending) of the era of Quantitative Easing (QE) by the Fed.

We’ve commented previously about tapering and will do so again here today. Keep in mind that these are comments mostly directed at Treasury bonds. The Corporate bond market isn’t in the same boat on the whole, though we would still avoid long term corporate bonds (10+ years) too.

Of course, the latest entrant to the headlines is Syria. What an absolutely disgusting shame.

If you like being “in with the in crowd”, you’re a pessimist at the moment. The news cycle nearly begs for your fear. In just over a month we’ll watch members of Congress embarrass themselves yet again with how they handle the next debt ceiling deadline. We’ll watch nightly news that shows our military response to Syria and raises the questions of how far things might escalate throughout the region. We’ll hear mean-spirited debates about who should become the next Chair of the Federal Reserve after Ben Bernanke’s term ends. The center of this debate will be just how bad a job this person can do at unwinding the unprecedented size of the Fed’s balance sheet. We’ll hear even more about the Sequester and the Fiscal Cliff, all from the jaded perspective and hidden (or not so hidden) agenda of the particular media outlet you’re tuned in to. We need to always remember that the media is a business, not a public service and they fare best for their own bottom line when they portray things as cynically as possible. I heard a TV personality recently say: “as a journalist, if you’re not scared I feel as though I’m not doing my job.” So as they go about their business of trying to make it a September to remember, I suggest you take refuge in a good college football game or a walk in the cooler air.

We need to recognize our limitations to seeing the future. We also need to recognize its lack of importance. The things we’re addressing here today are likely to carry some weight in the weeks ahead but are highly unlikely to be topics that matter to corporate earnings or economic development in the months and quarters ahead. For all anyone can know, the weight of these issues in the immediate future isn’t even all that great.

On to the most common questions I see:

How will Syria affect the markets?

There’s really no way to know with any certainly at the moment, because the reaction throughout the region will tell the full story. We are working under the premise that the United States will surely strike Syria and not merely make threats. In the end, we don’t believe the Syrian situation will escalate very much. We don’t believe the US will go to extremes in our response. Realistically speaking, however, the fear of what it might become will weigh on the financial markets. This will be purely psychological since the size of Syria economically is miniscule. Recent reports say there are only 20,000 barrels of oil produced in Syria each day. For context, the US produces more than 6 million barrels per day and that number continues to grow (

How will tapering affect the markets?

In the short term – negatively. Beyond that – positively. There is a good deal of concern about the true impact of tapering. It is perhaps the one item that could move the markets the most. Our basic view of tapering is unchanged from what we’ve written in previous issues. We’ve been asked if recent events like Syria might delay tapering. It very well might. But it won’t stop it from happening just the same.

We’ve also been asked if tapering will kill the housing recovery because it would likely lead to higher mortgage rates. We’re not quick to make that same assumption. This is because the Fed knows how vital the housing recovery has been – and will need to continue to be – to the overall economic recovery. The Fed has flexibility on exactly how they go about reducing their overall purchases. They can taper only the size of treasury bonds they buy and leave alone the amount of mortgage backed securities (MBS) they buy each month. This is exactly what we expect to see happen. There is evidence that supports the idea that buying MBS has given the Fed the most bang for the buck.

According to a piece put out by the investment arm of Allianz, arguably the most critical paper released at the big annual Jackson Hole economic conference last weekend came from Arvind Krishnamurthy, who presented on the transmission of unconventional monetary policy. The most thought-provoking finding in his research was that purchases of MBS have been more impactful in lowering MBS yields than the purchase of Treasuries has been on lowering Treasury yields. In other words, MBS purchases are more focused, more effective and should continue. With this in mind, we think the impact of tapering on the housing market will be limited.

How will the change in the Chair role at the Fed affect the markets?

Boy how I long for the days when most people couldn’t even tell you the names of the Treasury Secretary and the Chairperson of the Federal Reserve! In any event, there appear to be two lead candidates for Bernanke’s job – current Vice Chair Janet Yellen and past Treasury Secretary Larry Summers. Rightly or wrongly, the investment community seems to believe they would approach the end of QE (tapering) differently. The thought is that Yellen would move more slowly throughout the process and Summers might take more of a ‘rip the Band-Aid off’ type approach.

Nobody knows, of course; but if that were to be the case, shorter term investors would seem to prefer Yellen and those with a longer term mindset might like Summers more. We say this knowing it is somewhat like splitting hairs because we think either candidate would take a data-dependent stance. Sure, Summers might taper in larger increments initially, but if the economic data didn’t hold up, we think he’d pause the process just as would Yellen or Bernanke or anyone else in that role. So in the end, the Fed Chair is important; but this particular changing of the guard isn’t likely to produce any stark contrast.

Why have the emerging markets been hit so hard this year – particularly recently?

This is really a lesson in avoiding what are known as “value-traps.” A value trap is simply something that looks cheap, but lacks any sort of catalyst to unlock that value. In the end, what was perceived as cheap initially either stays cheap or finds a way to get even cheaper. This has been the story of the emerging markets lately. Investors need to know that the emerging markets thrive on foreign capital inflows. From an investment perspective, they live and die based on whether or not developed nations are currently plowing money into them in the hopes of higher returns than what they can achieve at home. It makes very little difference what the PE ratios, dividend yields, or other economic metrics might be in the emerging markets if there is no money flowing in to provide liquidity in their markets and give them that extra capital they need to ramp up their next leg of development.

At the moment, Europe has its hands full dealing with its own complicated agenda, and the idea that there will soon be even less cheap capital sloshing around in the US due to tapering means these emerging markets are not about to see already weak capital inflows grow. We mentioned earlier that these markets are trading at discounts to their historic valuations. While this is true, they are not getting their lifeblood of foreign capital, their currencies are under pressure, and they seem to yet again be under the leadership of questionable governments.

Make no mistake – this does not mean investors should outright avoid these markets. It means there is no need to make them any more than a peripheral piece at the moment. But when they move, they move quickly. Investors with a multi-year time horizon need to have exposure to these markets. For all their faults, they do have a history of outperforming developed markets over longer periods. Looking at six months in these markets is a sure way to lose money. Looking at them for 3, 5, and 10 year periods is quite the opposite. They are down, but not out.

The takeaways:

  • The list of certainties in life has grown. It is now death, taxes…..and bombings and tapering. Thankfully markets react worst to the unknown and not the well telegraphed. Nevertheless, there is a lot of weight, mostly psychological but still valid, on the markets at the moment.
  • Since the markets appear to be “right priced”, I would suggest that this current pause will be a pause that refreshes. I expect it to last a little longer, and then give way to the upward trend.
  • Don’t shun the emerging markets permanently. They have been the world’s worst performers for a while now. The US happens to have been the world’s best performer for a while now. Over the course of time, this won’t hold up. I’d much rather own a geographic blend recognizing that the current trends don’t stay in place in this world. This is normal and healthy. If it weren’t, we’d still be wearing platform shoes and listening to the Bee-Gees. What more proof could there be to not hold too tightly onto the present?

Jeff Winn, International Financial Advisor based in Orlando, FL

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