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Portfolio Update

More Upside to Come

By Elliott H. Gue, on Sep. 23, 2013

The Federal Open Market Committee’s September meeting confirmed our prediction that the central bank was unlikely to begin phasing out quantitative easing until at least year-end. Despite this delay, investors remain overly focused on the coming uptick in interest rates.

Some clarity is needed. The Federal Reserve isn’t aggressively tightening to combat inflation or temper growth; rather, the central bank is in the early stages of normalizing monetary policy—a process that will take at least two years.

The yield on the 10-Year Treasury note recently surged above the US core inflation rate for the first time since September 2011. When bond yields are less than inflation, real interest rates are negative; at these levels, investors are guaranteed to lose money on an inflation-adjusted basis.

Source: Bloomberg

But there’s still a long way to go before real interest rates return to normal. Between the end of 1999 and September of 2008, the yield on 10-year US Treasury notes averaged about 2.4 percent (240 basis points) above core inflation. Today, this spread stands at less than 1 percent (100 basis points).

And by any historical yardstick other than the post-2011 period, current real interest rates–and US monetary policy–remain extraordinarily accommodative and are likely to remain so for the foreseeable future.

The Great Rotation, the lead article from the debut issue of Capitalist Times Premium, explains one of the most important trends under way in global markets today: The shift in capital from defensive stocks to cyclical sectors such as industrials and information technology. This transition reflects the same improvement in US economic conditions that prompted the Federal Reserve to consider tapering. 

Moreover, with ultra-safe, fixed-income securities still offering historically low yields and investors gaining confidence in the durability of global growth, money is moving out of the bond market and into stocks. This phenomenon helps to explain the current trend of falling bond prices (rising yields) and strong equity markets.

You can track the Great Rotation out of fixed-income investments and into equities through the Investment Company Institute’s (ICI) weekly data on net new cash flows into US equity and bond funds.

Source: Bloomberg, Investment Company Institute

From the beginning of 2007 to the end of 2012, US equity funds have experienced almost $475 billion in net outflows, while bond funds have attracted net inflows of almost $1.25 trillion. During this period, investors valued the safety of bonds over equities even though they were guaranteed a low or negative real return.

But this trend has finally shifted in favor of stocks. Since the beginning of 2013, inflows into stock funds have totaled about $94 billion, while bond funds have lost about $11.6 billion in assets over the same time frame. Redemptions from bond funds have accelerated since last spring, when the Fed first broached the idea of phasing out quantitative easing.

This rotation from bonds to equities should continue to drive upside for the stock market, especially sectors that have the most leverage to a strengthening economy. Thus far, our strategy of focusing on the energy, financial, information technology and consumer-discretionary sectors has paid off: Over the past three months, our Wealth Builders Portfolio holdings have generated an average return of 9.8 percent. We expect this upside to continue; investors should regard any pullback as an opportunity to add to their positions in our favorite names.


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