Stock and bond markets are recovering from the spasms felt May 22 to June 24. This week we take a close look at what just happened; review a provocative article on why bond yields may drop further; and re-state the case for investing in Emerging Markets, which have not rallied at the same pace as domestic equities.
What Just Happened? Market spasms from May 22 to June 24 look pretty weird to the writer, particularly since diversification generally worked well during the past decade. This spring a host of asset classes fell all at the same. Diversification didn’t help; what’s the explanation?
The author, of the firm GMO, identifies the explanation as “valuation risk”. While risk is a multifaceted concept, “valuation risk” is associated with an unexpected change in a valuation input—this time the “discount rate” on an investment whose value is rising. The discount rate is a fundamental input used in estimating values of any asset and is linked to interest rates. The relationship is that, generally, as rates rise, prices fall. “It As background, the author explains that the current situation of low returns on cash “has increased the relative attractiveness of pretty much all asset classes other than cash and, as a consequence, their prices have risen….and this gives today’s markets a vulnerability that has not existed through most of history. Today’s valuations only make sense in light of low expected cash rates. Remove that expectation, and pretty much every asset across the board is vulnerable to a fall in price, as the rising real discount rate plays no favorites.” “May’s shock to the real discount rate came not because inflation was unexpectedly high or because growth will be so strong as to lift earnings expectations for equities and other owners of real assets, but because the Fed signaled that there was likely to be an end to financial repression [low interest rates through official government policy] in the next few years. And because low cash rates have pushed up the prices of assets across the board and around the world, there is unlikely to be a safe harbor from the fallout, other than cash itself…avoiding losses as real discount rates rise requires sitting on cash, and we know cash offers no return today.” The secular low in bond yields has yet to be recorded. Always provocative, if not also prophetic with “out of the box” thinking, Hoisington Investment Management says “The secular low in bond yields has yet to be recorded,” who also notes their position is a minority view. Despite the recent increase in rates, Hoisington expects lower yields in the coming quarters. Their reasoning is that yields are primarily and most fundamentally determined by attitudes toward current and future inflation. “From that perspective, the outlook for long term Treasury yields to fall is most favorable in light of: a) diminished inflation pressures; b) slowing GDP growth; c) weakening consumer fundamentals; and d) anti-growth monetary policies. Sustained higher inflation is, and has always been, a prerequisite for sustained increases in long-term interest rates…presently the inflation picture is most favorable to bond yields…sustained higher inflation is not currently evident, and the forces that create inflation are absent…thus, a period of sustained higher long term rates is improbable.” The case for investing in Emerging Markets is still intact. Equity markets may be rallying again, but as far as US retail investors are concerned it is almost purely a domestic affair. By thinking that way, however, they may be missing an opportunity, especially over the long-term. While emerging markets economies have slowed, they are still likely to expand at a much faster rate than developed countries. Emerging markets trade at a discount of approximately 30 percent to developed markets. These countries continue to liberalize their economies, and in certain respects look better than the developed world. Most are models of fiscal rectitude with sovereign debt-to-GDP ratios well below 50 percent, compared with more than 100 percent in the US and more than 200 percent in Japan. Click here to read (tiered registration required) And in case you missed it, click here to read last week’s blog post on Chairman Bernanke’s testimony to Congress, including a discussion of the plunging Federal budget deficit and what it means. We hope you enjoy reading these articles along with us and that you find them informative. Please forward this to your friends and family. J. Mark Nickell & Co. Disclosure – The articles mentioned in This Week with J. Mark Nickell & Co. are for information and educational purposes only. They represent a sample of the numerous articles that the firm reads each week to stay current on financial and economic topics. The articles are linked to websites separate from the J. Mark Nickell & Co. website. The opinions expressed in these articles are the opinions of the author and not J. Mark Nickell & Co. This is not an offer to buy or sell any security. J. Mark Nickell & Co. is under no obligation to update any of the information in these articles. We cannot attest to the accuracy of the data in the articles.
