With central banks manipulating asset prices like never before, equity investors who fail to anticipate the direction of the U.S. bond market in 2013 will be in for a tough year.
Chairman Bernanke's announcement of further Fed Treasury buying is only the latest measure designed to force U.S. interest rates lower. By making bond yields less attractive to investors, the Fed is hoping to divert assets into houses, equities and other investments that will create economic growth.
Strategists are divided on the potential success of the Fed's plan; in 2013, the activity in the bond markets will tell us who is right. The pessimists expect rates to rise, as investors lose faith in the Fed's ability to heal the economy. As always, there is no shortage of commentators and newsletter writers with apocalytic predictions (or hopes) that confidence in the U.S. Federal Reserve will collapse, but as we mentioned the other day, Bridgewater Associates' Ray Dalio is also endorsing a negative outlook. Currently the most widely revered hedge fund manager, Mr. Dalio is arguably the most difficult of these voices to dismiss. Not only was Mr. Dalio one of the few investors to predict the financial crisis, but unlike the perma-bears, he also called the recovery.
For Canadian equity investors it is important to note Mr. Dalio is not predicting inflation, which would signal rising economic activity and a stronger market for commodities, but a form of stagflation. In his view, rates will climb because the Fed has failed to stimulate the economy and investors demand a higher yield to compensate for the rising risks of holding U.S. assets. This scenario would be a decidedly "risk-off" environment where Canadian equities would be under intense pressure.
The bullish case for equities would see U.S. bond yields largely unchanged with the Fed's $85-billion per month bond buying spree creating enough liquidity to keep rates low. With stable or improving economic data, investor assets would begin to drift into equity markets as the Fed intends, creating a wealth effect and a virtuous cycle of further, sustainable expansion.
Now the tricky part. It is possible that the bullish scenario could also result in rising rates in the form of inflation. For resource investors this is the most positive environment imaginable – inflation signals both rising economic activity and a devaluing of currency that makes hard assets like gold and commodities more valuable.
If U.S. rates do rise, it will be extremely important for Canadian investors to understand why. Inflation-led rate increases would be a sign to buy more stocks. The more troubling scenario for equity markets, rising interest rates with a weak economic backdrop, would be initially be signalled by a sequence of U.S. Treasury auctions with weak bidding interest. This would be as strong an indication to reduce equity holdings as you're likely to get.
Scott Barlow