Current interest rates are at or close to all-time lows, and the general expectation is that they will increase. I agree with that, but I don’t think it will happen in 2013. For rates to increase, the following conditions have to be met:
- Because interest rates are the price of money, demand has to exceed supply.
- The Fed has to allow the markets to set interest rates.
Neither condition is likely to obtain in 2013. The Fed has purposefully expanded the money supply over the past several years. Until that supply is either exhausted or withdrawn, there will be no market pressures for increased rates. While bank lending is increasing, it is nowhere close to exhausting the additional reserves. Supply will exceed demand for the foreseeable future.
Second, the Fed is now and will be, at least through 2013, buying well more than 50 percent of all outstanding U.S. government debt. By dominating the market, the Fed has effectively removed the price discovery from the market. Until it backs off, interest rates are what the Fed says they are.
This prediction is also historically reasonable. Looking at interest rates after panics in history, the average low level of interest rates was 2 percent, very close to where we are now. Moreover, the average number of years from the panic to the lowest level of rates was more than 13 years—we are only at 8. Finally, interest rates only increased another 50 basis points from the low to the average level 20 years after the panic.
Historically and fundamentally, there is no support for a substantial increase in rates. Indeed, rates could well decline further, driven by increased demand for U.S. Treasuries, accompanied by a declining available supply. There is also a political incentive for the Fed to maintain low rates in the large accumulated U.S. debt, which will rapidly become unpayable with higher rates. Given all of these factors, I therefore expect that U.S. interest rates will remain around current levels through 2013. As a result, credit should remain a focus. Duration should also remain on the radar screen because, although interest rates should remain close to current levels in 2013, that may not be the case later.
Equity market levels depend on two primary factors: earnings and valuations. On shorter-term metrics, such as the trailing 12-month price/earnings ratio, the market appears reasonably valued. On longer-term and non-earnings-based metrics, the market appears substantially overvalued. The question, though, is whether past results are applicable in an environment with very low interest rates, substantial monetary policy support of the economy, and record-high profit margins. The answer is uncertain.
Going forward, the earnings growth rate appears likely to be moderate at best. Top-line growth will be constrained by growth in overall U.S. GDP; for companies with global exposure, it will be further limited by economic weakness elsewhere in the world. Companies have been able to grow earnings by increasing productivity over the past several years, but much of this has come from lowering labor costs through layoffs and pay constraints. Many companies appear to have hit the limit on layoffs, and the improving employment situation will make maintaining pay constraints more difficult. Recent earnings results support slow growth as the best case and suggest that stagnation or even decline is possible.
For the equity markets to meaningfully appreciate, either earnings have to grow or valuations have to increase. For earnings to grow, either revenue has to grow or profit margins have to increase. Both are challenging going into 2013.
Earnings per share, though, is more subject to improvement. Although overall earnings may be constrained, companies have the opportunity to buy back shares, lowering the shares outstanding and increasing earnings per share. Companies have been doing this increasingly for just this reason, and the pending potential tax changes to dividend rates may further support this trend. Even here, though, the relative increase may be limited in the face of slowing revenue growth and compressing margins.
Overall, given the high historical valuations on long-term normalized metrics—as opposed to the more reasonable short-term metric valuations, which are based on high but possibly peaked earnings levels and very high profit margins—it is clear that the upside potential is limited for U.S. equity markets, and there may well be substantial downside risk. Current technical factors and valuation levels give no immediate cause for concern; nevertheless, diversification among strategies and asset classes continues to be important.