Alan Greenspan, the long-time Chairman of Federal Reserve Board who just can't fade away quietly, grabbed headlines late this week calling rising Treasury rates the "canary in a coal mine". Talk about kicking a guy when he is down, given that the Treasury auctioned a ton of debt this week! Mr. Bubblemaker's observations aside, should we be concerned? Take a look at this chart, and you just might:
Holy cow! Look, the 10yr Treasury has almost doubled. Surely, the world must be coming to an end. Yet, when we take a longer-term perspective, it is quite clear that rates are returning to a somewhat normalized range from panic extremes:
We can debate the implications of this rise and what constitutes a "normal" rate for the environment we are in (which is probably an even greater source of debate!), but I will answer that this doesn't really matter. How can rates not matter? How preposterous! Well, I didn't say that RATES don't matter, I tried to say that TREASURY RATES don't matter. That is, unless they impact other borrowing rates. Take a look at the Moody's index of Long-term Corporate Bond yields, and you get a much more sanguine view of the current rise:
The bear story, being portrayed in black and white all over the place, is that our government borrowing needs are so great that there will be a buyers strike. I doubt that, but I do acknowledge that there might be some "crowding out" where traditional buyers of corporate and mortgage debt decide that the spreads above the "risk-free" Treasuries don't merit continued investment and dump them.
Why is the rate at which corporations borrow so important? As long as rates remain low and capital available to credit-worthy borrowers, companies can continue to roll over their maturing debt at perhaps even lower costs than historically (especially considering the steepness of the yield curve). A year ago, I was concerned that companies might get hit with more expensive borrowing costs.
The rate is important to the valuation of stocks as well. What should the PE be for our stock market? I would argue that it is a function of two things: Expected growth in earnings (higher PE for higher expected long-term growth) and alternative investments like Corporate bonds (higher PE for lower rates).
There is a lot of argument now about the future pace of earnings growth, which isn't surprising after the sharp moves in earnings over the past couple of years (from plunging to soaring). I am in the slow recovery camp (no double-dip), and I am cognizant about a number of potential impediments to growth though also appreciative that there is tremendous operating leverage (meaning that if there is extra top-line, it will drop to the bottom-line). But, what about the market PE? As long as rates remain well-behaved, it is too low from what I can tell.
As my clients and I have considered large-cap multinationals or other slower-growth non-cyclicals, we find that the market seems to be missing something (but maybe we are!). Let me offer a simple example of JNJ. The company is currently trading at 13X 2010 EPS, a pretty low ratio historically. Sure, it's not going to grow too rapidly most likely, but let's say that the analysts are right in their long-term projections of 6% per year. The current dividend yield is 3%, and the company, which pays out less than 50% of its earnings in dividends, has been growing that dividend at something like 11% for the past several years. I estimate that over the next five years, JNJ investors can expect that their stock will go up 35% (as long as the PE doesn't drop from 13 and earnings do compound by 6%). They will also pick up another 18% or so in dividends. Adding it all up, I think that over the next five years, an investor in JNJ can earn 9-10% compounded total returns assuming very little earnings growth and no PE expansion. This seems pretty good compared to investing in long-term corporate bonds, which are more likely to return close to the current yield of 6%. I would argue that the market PE based on current rates should be closer to 20 rather than lower than 15. I think it's that fear of the double-dip.
The point wasn't to call out JNJ (or the plethora of other large and relatively stable companies with reasonably strong balance sheets and PE ratios below 16 like KO, MCD, WAG or many others), but to illustrate how rising yields might impact our view of stocks. IF corporate rates were to shoot up, it would make us want to pay less for stocks.
This whole interest rate thing can actually be a little confusing. I have already pointed out that the Treasury rate isn't the thing to watch but rather corporate rates, which impact the earnings of companies to some degree and represent an alternative for investors. Still, I must point out that rising corporate rates may or may not be harmful to equity values. This simple diagram illustrates the point:
In an environment where rates are rising and growth is strong, the outlook for stocks can be quite favorable, especially for those companies whose growth is very strong. Maybe the market PE takes a hit from the rise in rates, but it can be offset by higher earnings expectations. This assumes rates don't choke off that growth. The scenario of rising rates and fading growth is an investor's worst nightmare. Conversely, the great Bull Market (from 1982-2000 let's say) was fueled by that rare combination of falling rates and strong growth. The current environment (i.e. the past year) has seen falling corporate bond rates and improving growth (or at least not as bad as feared). The final box - falling growth but falling rates is not one that is too likely these days given how low rates already are. So, higher rates aren't always bad for stocks. If they are accompanied by strong growth in earnings, stocks can do ok. If the economy turns out to be stronger than we expect this year, rates will indeed rise. Fortunately, it looks like we have quite a substantial buffer in place currently, as the JNJ example suggests.
My expectation is that interest rates aren't likely to be a major factor this year, so react to the headlines at your own peril. With that said, I believe that a shakeout in Treasuries here could be the catalyst that sparks the correction to which I have been alluding. If the dollar surge continues, no one wants to be left holding the bag of low-yielding Treasuries at the end of the move. My call from January remains that we see an interim peak in the late March to Mid-April time-frame (now here) at S&P 500 <1230 (we are close - within 5%). That's the game we find ourselves in. I wish I had a lot of conviction regarding how deep the correction might be or how long it lasts, but I want to see it start before I make that call.