July 2006: Inflation, Interest Rates and Equity Valuations
As always, the global financial markets appear to be at a critical inflection point. Spurred by rising energy costs, inflation (and worsening inflationary expectations) is (are) becoming a cause for concern in the minds of investors. Around the world, most central bankers, and certainly our Federal Reserve Bank (FED) regulators, are attempting to control inflation by manipulating short-term interest rates and the supply of money in circulation. In most market-driven economies, accelerating levels of inflation bring on rising interest rates, because lenders wish to protect the purchasing power of their capital and central bankers attempt to slow down economic activity and deter marginal borrowing (i.e., dampen the demand for credit growth). In theory, economists and investors agree this is the way the world works, but when national interests, geopolitical considerations and religious beliefs intrude, the model is often driven by investor behavioral factors unrelated to classroom economics and investment fundamentals. Further, since this is an equation of so many independent variables, what worked in the past as a remedy tends to be irrelevant during any thought-to-be similar set of current circumstances.
Since the collapse of the internet bubble in the spring of 2000, the emotional hit of 9/11 and the emergence of the now ever-present terrorist threat, investment markets around the world have undergone extraordinary valuation readjustments. During this period, central bank administered short-term interest rates around the world were pushed down to 50 year historic lows (in Japan a borrower still pays no interest on loans taken out today) and corporate profits grew at unprecedented rates. As company earnings grew, the floor under stock prices moved up while earnings valuation spreads retreated to more “normal” relationships. That is to say, the price investors seem willing to pay for a given dollar of corporate earnings per share (P/E ratio) has declined since 1999 from 30-35X (for the S&P 500 Index) to roughly 14X prospective 2007 earnings per share presently. Seen another way, corporate earnings have roughly doubled since 1999, while stock prices did nothing more than tread water, causing P/E ratios to be cut in half.
One interpretation of this would be that stock prices have marked time while reducing the risk in owning U.S. equities to below conventional levels. If one adds to this reasoning the fact that due to more conservative accounting rules introduced recently, and the impact of high profile corporate scandals, the quality of a given dollar of U.S. corporate earnings has improved considerably during the last four or five years. It could be argued that present low equity valuations provide a comfortable cushion against the risk of weak markets in the near term. Investors may subliminally have been incorporating this improving “profit purity” into their risk assessment screens these past few years. Counter to this is the probability that rising inflation expectations (the CPI in the Boston area was last reported to be moving up at a rate of 4.6% for the trailing twelve months) tend to compress stock earnings multiples. Even so, on balance domestic equity valuations today appear reasonable, and despite the prevailing negative sentiment, stocks seem to offer the prospect of further modest improvement in price. Elsewhere outside the U.S., with the possible exception of special situations like India, worldwide equity markets appear positioned to reflect solid GDP growth well into 2007.
Bernanke’s First 100 Days
However, Chairman Bernanke at our FED, who seems intent on moderating inflationary expectations, is still faced with a formidable task. He and his other seven Governors must carefully wean investors, homebuilders and buyers, and hedge fund managers, from the comfort of 50 year low interest rates. They must also reign in the tsunami of central bank-provided liquidity pumped into the world’s banking system these past six or seven years, while not damaging the global economy’s growth prospects. They may pursue this course for no other reason than to establish his (their) credentials as an inflation hawk. Another quarter point increase in the FED’s mandated overnight short-term interest rate appears probable in August. A preemptive step of this nature is preferred to taking required corrective moves of greater magnitude later. A little pain today will probably be good for the longer term health of the economy.
Will Dividends Assume Greater Importance in Stock Valuations?
Since the 1960’s, for U.S. investors the dividend portion of equity market total return has diminished from 42% to 15% (see accompanying table).
One of the consequences of our equity fund portfolio shift over the last year from small company overweight to larger companies has been the addition of a higher dividend paying component to our resulting combined asset class mix. In 1999, the top tier by company size of the S&P 500 Index was selling at 34X projected earnings; today the largest S&P 500 companies screened by size, prospective earnings growth and future dividend payout expectations are valued at approximately 13X 2007 earnings. Those companies now comprise roughly 75% of our domestic large company portfolio fund selections. If dividend and capital gains tax rates remain at 15% (federal), more corporations will begin to treat such payouts as part of a disciplined sharing of corporate earnings with shareholders. This, in turn, will add another solid plank to investor confidence, enhancing the improving “profit purity” perception referred to earlier. As we so often have said in the past letters, the one irrefutable characterization which has stood the test of time in investment lore is that all investment phenomena, statistics and trends tend to revert to the mean. Going forward, it appears to us that dividends, as a proportion of account total return, promise to regain increased importance.
Globalization Step 3 (or is Step 4, 5 or 6?)
It seems that with every succeeding letter in this series a new development surfaces in the inexorable move toward global economic integration. In the news today, but not much discussed below the policy wonk level, is the World Trade Organization’s next set of tariff reduction talks. The “Doha Round,” due to be held later this fall, could yield improved international trading conditions beneficial to all nations. At the moment, however, preliminary discussions are stalled on the issue of farm subsidies. Meanwhile, unfettered capital markets facilitate the movement of investor funds throughout the world, luckily a mechanism with which politicians seem reluctant to tamper. Another significant step toward economic integration initiated this past month has been the New York Stock Exchange’s bid to create a global securities marketplace by offering to acquire the operator of five European stock and futures exchanges. Finance and investment markets have long been international operations, but until now owned only locally. Further, the impact of Sarbanes-Oxley has been to send out of the U.S. to overseas, many new issue offerings and stock listings; a consequence Congress failed to acknowledge as a possible outcome of this “we must be seen to be doing something about Enron” remedial legislation. If the NYSE bid results in its proposed consolidation (the European Community is opposing it on grounds of national interest) then New York, Paris and Germany will become another nexus of the evolving global 24/7 market, competing on solid ground with the London and Tokyo markets. For years America’s capital markets have been the envy of the world, but not so much recently. This proposed NYSE merger with its European counterparts would seem a sensible next step on the surface at least. “Follow the money” still strikes us as useful counsel in this instance.
Future Rates of Return Expectations, Evolving Equity Market Volatility Patterns, Converging Correlation Relationships Amongst Asset Classes
Assessing the probabilities for future asset class behavior and returns has, of course, always been hazardous. With the world awash in liquidity, hedge funds every nanosecond applying computerized investment models designed to spot price anomalies before others do, and 24/7 markets instantaneously discounting information available to all via the internet, asset class and securities valuations have tended to converge as investors around the world attempt to arbitrage perceived opportunities. Today, a “diversified” portfolio is seen as the best way to evade the usually unproductive consequences of actively moving from one asset class to another, attempting to time the markets. Valuations amongst asset classes have tended to become more homogenized and highly liquid investors and corporations are diverting more funds to riskier, less liquid deals. On our east and west coasts, overly optimistic returns projected for commercial real estate stand out as an example of this willingness to trade liquidity to achieve hoped-for incremental return.
Along with changing investment cash flow patterns, the unexpected seems to have occurred; global equity markets have become less, not more, volatile. According to studies undertaken by Warner Henderson at Aequitas Investment Management, since the summer of 2002 price volatility in U.S. equity markets has diminished to 75% of historic patterns. Most pundits today have been predicting a return to historic volatility levels. If price/earnings ratios remain steady, this normalization may not materialize; we are not betting on expanding P/E’s. Thus, future equity returns will be more closely tied to corporate earnings growth (i.e., a reversion to fundamental investment concepts).
A new element which needs to be added to today’s diversified portfolio strategic asset allocation mix is a global currency overlay. With seventeen successive short interest rate increases in the U.S. these past few years the FED has in effect postponed the dollar’s inevitable downward adjustment against the currencies of our major trading partners. The massive petro-dollar recycling underway, as well as the continued build up of our Treasury debt in the hands of both mid-east and Asian investors and central banks, arguably will trigger future dollar weakness. Although perhaps sounding unpatriotic, betting against the U.S. dollar, exposing a portion of our portfolios to unhedged currency risk, seems prudent in today’s environment. As you are aware, your diversified portfolio structure generally includes approximately 30% of equities in international, non-dollar-denominated securities. These positions are entirely unhedged presently. If dollar weakness develops, a meaningful benefit could be reflected in the net asset value of your international fund holdings.
Move to 30 Federal Street A Great Success
Relocation to our new offices on the 7th floor of 30 Federal Street was accomplished a few weeks ago with very little disruption. We hope you will stop by and spend some time with us. We still have a few pictures to hang, but by the fall, after the summer vacation season, we will hope to welcome you to an office-opening reception.
In the interim, if you are coming into Boston for a meeting, please consult our website (www.tfcfinancial.com) where under the “About The Firm” section you will find directions and a detailed map of our new location. Also, we hope you received an announcement of our change of address and new telephone system direct-dial numbers. On the chance you did not, a copy is enclosed.
Privacy Policy Notice Under the Gramm-Leach-Bliley Act
A copy of our Privacy Policy also accompanies this letter. As you know, all of our client records are kept in strictest confidence. Most of our files are digitized (i.e., scanned to our central computer network, available only to TFC users with appropriate passwords). Critical documents are digitized and then stored at a secure off-site facility. All e-mails are archived on a central database outside our offices, again available to only those with appropriate security clearance. Our entire network, its programs, files and documents are backed-up daily to a system off-site so that recovery in case of office disaster can be accomplished with minimal disruption.
Revised Form ADV Part II Available
A change in location and certain recently added SEC regulations have led us to revise our ADV filing with the SEC. Should you wish a copy, please let us know and a copy will be sent or we can supply a web address at which the ADV in its entirety can be viewed on the screen.
One of the policy issues the SEC has been attempting to clarify in recent months is how investment managers utilize client account securities trading commissions, so- called “soft dollars,” for purchasing research and other brokerage-supplied services. The presumption is that such expenses are generally to be considered the manager’s costs of doing business. Suffice it to say that TFC pays for its research not out of client commissions charged by the account custodian, but rather as an expense on our profit and loss statement. We have negotiated a client’s commission schedule with Charles Schwab to the bare-minimum, so no such “soft dollars” remain.
As always, we welcome your questions, comments, and suggestions.
Sincerely,
James L. Joslin
Chairman, CEO