US economy, interest rates and the equity market

Global sharemarkets were skittish in May as a result of concerns that the US Federal Reserve (“US Fed”) may begin plans to remove the quantitative easing measures in place designed to stimulate the US economy.

With medium term targets for unemployment of 6.5% and inflation of  2%, the US Fed is clearly seeking to stimulate growth in the economy;  through the continuation of a near zero funding rate (0%-0.25%) and

Federal Open Market Committee purchases of about $45 billion per month in Treasury securities and $40 billion per month in mortgage backed securities. These measures appear to be having the desired effect, with March quarter GDP ticking up to an annualised growth rate of 2.4%, whilst inflation remains well under target at 1.1%. Unemployment remains high, but has fallen to 7.6% (at the end of March).

Consumer confidence has also risen to its highest level since 2007, and in the corporate sector, balance sheets have been progressively repaired as a result of the cheap financing rates. This ongoing improvement in the US economy and stronger balance sheets has also translated in an improvement in listed company earnings per share (“eps”). In fact, the eps of listed businesses in the US now exceed 2007 levels.

Trailing EPS Since 2007 Peak

Source: Citi Research, Trailing EPS Since 2007 Peak, May 2013

In the psyche of markets however, the corollary of an improving US economy is the question of likely changes to quantitative easing and monetary policy. Bond markets have already started to react, with 10 year US government bond yields rising 46 basis points in May.

Interestingly, Australian 10 year bond yields rose 26 basis points over  the same period, highlighting the high level of correlation between the  markets (further illustrated in the following chart), and suggesting any

Further changes in US Fed stimulus and yields will directly influence bond yields in Australia.

Comparing Australian and US rates

 

Source: Macquarie Research, May 2013

It is clear that once the US Fed becomes comfortable with the rate and extent of the economic recovery it will begin to unwind is stimulatory monetary and quantitative easing measures (whilst taking care not to derail the recovery). As they plan to ‘communicate their intentions’ we expect bond markets to also unwind - as has already begun.

Noted US economist and Professor of Economic and International Affairs at Princeton University, Paul Krugman, recently offered an interesting summary of the possible scenarios for US bonds, stocks and the US Dollar as a result of US Fed, as per the following:

Source: “Rate Stories”, Krugman, May 2013

We are firmly in the ‘stronger recovery’ camp, and thus expect continued US equity market growth (supported by improving corporate profits) and a strengthening US dollar. As such, Australian stocks with US derived (and/or US priced) earnings remain a continued portfolio theme

Indices:

The Australian All Ordinaries Index has moved up increasing +1.3% since closing last Friday to 01:10 pm today.

                                                                                                                                  

The rest of the world as measured by the MSCI index increased +3.3% in A$ from closing last Friday to end of trade Thursday.

Have a great weekend,

The team at IPS