SANTA BARBARA - Overnight, Australia unexpectedly raised their key interest rate by ¼ point to 3.25%. Commodities, which have been leading stocks, jumped on the weakness in the dollar, resulting from this rate increase. To me, this is the first shot across the bow, meaning that we will no doubt see rate increases from countries all across the globe, as the very real threat of inflation gains in intensity. There is also continuing talk of dropping the dollar as the standard for international trade, and going to a basket of currencies, or some other convention (not the dollar). Gold rallied to a new, all-time high, with commodities rallying across the board.
Here is the rub:
While a weaker dollar is somewhat positive for U.S. companies that export goods and services, making what they sell cheaper for foreign buyers, the Fed is going to have no choice but to begin an extended rate increasing cycle, which could have devastating consequences for the economy and stocks. It is true that some inflation is historically good for commodities, stocks and real estate, too much is a problem, and with rates where they are, I believe the Fed will indeed be forced to increase rates significantly from current levels. I feel we will see the Fed begin to signal higher rates before the end of this year, with actual rate increases to come in the first Q of 2010.
Implications:
First and foremost, if you are holding long-maturity bonds, I strongly suggest reducing exposures. Even corporates and tax-frees, which are trading at historically wide spreads to the treasury curve, will likely perform poorly, if we enter a sustained rate raising cycle with a reasonably large magnitude. Although spreads will likely narrow as order returns to the bond market in general, and as the economy pushes past the worst of the current recession, in my opinion, the positive impact of the contraction of spreads will not be enough to offset the huge negative of rising rates, especially on the long end of the yield curve.
My best advice for fixed income investors is to reduce exposures to long-maturities, reduce overall exposures to fixed income as a percentage of portfolio weighting, and shorten maturities for your remaining fixed income positions to five years or shorter. Cash can be redeployed in other asset classes, such as stocks, commodities and real estate, once valuations correct to more attractive levels. For the time being, I suggest holding net cash raised from reducing fixed income exposures until those valuations come in a bit.
Short-term market perspective:
We are entering 3Q earnings season, with Alcoa the first of the Dow 30 reporting tomorrow (Wednesday, October 7th). Last quarter, we had many positive earnings surprises, driven not by top-line revenue growth, but largely (almost exclusively) by cost reductions. With little remaining to cut, and unemployment at almost 10%, I do not see there being a high probability that 3Q earnings will be positive overall. Rather, I expect that just about all of the cost-cutting has already taken place, and that, due to the persistent weakness in consumer spending, we will not see top-line growth. On the contrary, I think revenues will be down across the board, except for a few isolated industries and companies, and without that cost-cutting driver, investors will re-evaluate their perspective on valuations.
Over-optimistic perceptions of a pending robust economic recovery, coupled with a lack of focus and a scramble to not get left behind by small investors, has resulted in a more than 60% rally in equities since the March lows. Without top-line revenue growth to support higher valuations (or even current valuations), I do not see a sustained positive flow of new cash supporting current market levels, much less higher levels.
Conclusions:
I still believe that stocks, as compared with all other asset classes, will be the best place for investors over the longer-term. However, in the near-term, valuations are far too expensive and cannot be sustained without a dramatic and consistent improvement in consumer spending, which we are not going to get with declining real estate prices and 10% unemployment (and rising). Investors are advised to reduce overall exposure, but to fixed income, as detailed above, and to equities. Do not get drawn into the daily media hype that suggests that the markets are going to keep rising forever. This is the clearest sign of a top and of a bubble forming. Be patient, and be prepared to step in with your cash, once valuations compel your to act. There will be plenty of opportunities to buy quality companies at better prices, once valuations become the focus of investors (they always do eventually).