The Market Cats Living With Dogs

May 27, 2003
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GRAND RAPIDS — The financial markets are topsy-turvy, with better returns in the fixed income market than in the stock market — a relationship not seen since the Great Depression.

“That’s the financial market equivalent of cats living with dogs. That’s just not supposed to happen,” Mitchell Stapley, chief fixed income officer of Fifth Third Investment Advisors, told investors last week at Fifth Third’s Economic and Financial Market Outlook luncheon at Frederik Meijer Gardens.

The most fundamental question is how does an investor get a 7 percent return, the kind of year-end return most investors are happy with, Stapley said.

Typically, the first choice would be to invest cash in a money market account. But given that interest rates are at a 46-year low, investors would only get a 1.25 percent yield on their money market fund.

“If you want 7 percent and want it in cash, you have to go to bonds,” Stapley said. As of May 15, the yield on a 5-year treasury note was a low 2.5 percent. To get that 7 percent return, interest rates would have to go even lower.

If interest rates go down, the price of the bond goes up, and that’s the capital appreciation an investor needs as a kicker for that 2.5 percent to get up to 7 percent, Stapley said.

“So I need to have interest decline in the next year down to 1.33 percent so I get a 4.5 percent price appreciation to give me that 7 percent return. That works if we have a deflationary outbreak in this country.”

Stock valuations are much more attractive than they’ve been in a long time, with a current dividend yield based on forward earnings of about 1.8 percent, he said.

“That 1.8 percent yield you get off of dividends in the S&P 500 is better than the yield on money markets. All we need then is a little over a 5 percent price appreciation to get that 7 percent.”

Stapley thinks it’s doable, given companies’ year-end and first-quarter financial results. If the economy begins to recover, stocks will earn 7 percent, he said.

The stock market has had a wild run since the beginning of war with Iraq, with returns of 18 percent to 22 percent between mid-March and mid-May.

There have been four stock market rallies of more than 18 percent in the last three years, and the market ended lower following each of those rallies, Stapley pointed out.

“We really need to have the fundamentals improve to keep this positive return that we’ve seen going.”

The country has some hurdles to overcome, specifically a cyclically weak economy. The economy isn’t generating new jobs or demand for capital goods and equipment, and it’s growth rate of 1.4 percent to 1.6 percent is too close to zero for comfort, Stapley said. The economy could easily slip into another recession.

Second, there’s substantial over capacity, he said. So much capacity was created during the late 1990s and into 2000 that it’s still being worked off, and that causes a drag going forward.

Third, the United States is still learning how to deal with the impact of China and India in the world economy and the deflationary forces they’re letting loose on the business community here, Stapley said.

Consumer spending, which was growing at 6 percent in the fourth quarter of 2001, slowed to 1.4 percent in the first quarter of this year. Consumer spending pulled the country out of the last recession, but the loss of 2 million jobs since then, the war in Iraq and the economic slowdown have taken a toll on the consumer, Stapley said.

Consumers are saving now and paying down debt, which is good for the long term, but for the short term it’s a drag on economic growth.

The one bright spot — and the real reason why the Federal Reserve won’t raise interest rates anytime soon — is that low interest rates are still pulling people into the housing market, he said.

Business capital spending had been gaining momentum last year and was up 2.3 percent by 2002’s fourth quarter, but it plummeted again in the first quarter of this year. Whether it’s a soft patch that’s going to last another quarter or whether it’s going to stretch to the third and fourth quarters remains to be seen.

High-yield bonds saw a return of nearly 24 percent in the past six months, the best six months ever, he noted. That shows companies can borrow again and that risk-taking access to capital markets is back, he said. Risk-taking has filtered into the equity markets, too, and IPOs are beginning to appear again.

According to a survey by the National Association of Purchasing Managers, in the manufacturing sector orders, inventory and production are off and the jobless recovery is getting worse.

But a “big positive,” particularly for manufacturing, is that the dollar is down about 15 percent from last year, which makes U.S. goods much more competitive against goods produced overseas, Stapley pointed out.

“A 15 percent decline in the dollar is incredibly important to get the economy going again and helping the equity markets out with better earnings.”

However, on the downside, if foreigners who have invested tremendous amounts of money in both the U.S. stock market and bond market begin to pull out because they’re losing money on the depreciating dollar value of their assets, then interest rates could go higher and choke off the hoped-for recovery.

Interest rates have room to go lower, which Stapley said would be “incredibly positive” for businesses in lowering the cost of borrowing.

The federal government has a deficit of close to $300 billion and is spending money “like a drunken sailor,” which is normally an economic stimulant. But the nearly dollar-for-dollar increase in spending at the federal level is being offset by cutbacks in state and local units of government, Stapley said.

Two weeks ago the Federal Reserve acknowledged deflation and said the risk of deflation poses the greatest threat to the nation’s economic growth. Stapley said that in 20 years in the business, he has never seen the Fed in an Open Market statement talk about deflation.

If there’s not an upturn in economic activity in June, he predicts the Federal Reserve will lower the federal funds rate another 50 basis points when it meets June 22.

“I think we can avoid deflation, but I think you’re going to see low interest rates for a while.”

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