Global QE and Investment Assets

May 16th, 2013
in contributors

Investing Daily Article of the Week

by Philip Springer

This article was first published by Investing Daily (May 10, 2013)

Over the last 50 years, the yield on 10-year US Treasury issues has averaged 6.7 percent.

During that same period, the average price-to-earnings (P/E) ratio of the Standard & Poor’s 500 has been 15.

Today, with the 10-year Treasury paying only 1.9 percent and official inflation at under 2 percent, the S&P 500 is trading at around its 50-year P/E average.

Follow up:

Investors typically underestimate the dramatically positive impact that low inflation and rock-bottom interest rates have on various asset classes, as Warren Buffett said this week.

It’s fair to say that we’re in an investment environment that’s been distorted by global quantitative easing. Without an historical precedent, it can be difficult to make “rational” investment decisions.

However, the numbers tell us that stocks generally have been less affected by aggressive monetary easing than bonds or cash, where yields have collapsed. (Not always; see below.) Bond yields fall when prices rise.

This week, for example, yields on junk bonds hit a new all-time low. The Barclays US Corporate High Yield index fell below 5 percent for the first time ever. This benchmark index tracks debt, rated below investment grade, that’s issued by weaker US companies.

The index yield has tumbled more than a percentage point this year amid continuing strong demand for income-producing securities. The yield hit 22 percent at the depth of the financial crisis in late 2008.

The spread between junk-bond yields and those of Treasury issues of comparable maturities also has plunged, to 4.05 percentage points. This is a post-crisis low but still well above the nutty historic bottom of 2.3 points that occurred in May 2007, before the crisis hit.

Amazingly, investor demand for junk has far outstripped even record new issuance of high-yield bonds in 2012 and now again this year. Not only are investors starved for income. They also evidently believe that the risk of corporate bond defaults has shriveled as the economic recovery continues.

While the default rate on junk bonds has risen slightly to 3.1 percent from 3 percent a year ago, it’s still well below the 14.6 percent peak in November 2009.

It’s a virtuous circle: The flood of investor money into high-yield bonds has enabled less financially strong companies to raise money at unusually low interest rates, in many cases replacing higher-cost debt and therefore strengthening their balance sheets.

Junk bonds (perhaps the term “high yield” should no longer apply) offer two key advantages over Treasury issues at this stage of the game. The first, of course, is the significantly better yield.

Second, as market rates move higher, whenever that may be, junk bonds tend to suffer less than plain-vanilla Treasury issues. Corporate issuers benefit from a stronger economy and/or higher inflation, both of which provide some pricing power.

Meanwhile, roughly half the stocks in the S&P 500 still pay a higher current yield than the 10-year Treasury’s 1.9 percent. Stocks offer better total-return (growth and income) potential than bonds because companies can grow their earnings, raise their dividends and buy back stock.

But that doesn’t mean you should cash in all of your low-yield government bonds or funds to buy junk and stocks.

For one thing, the unprecedented quantitative easing involves central-bank purchases of government bonds, which means the bond markets have strong support. For another, bonds have been and will continue to provide a hedge against economic weakness.

The historically aggressive monetary easing evidently hasn’t ended yet, much less started to reverse itself. This week alone, South Korea’s central bank made a surprise interest-rate cut. India and Australia also lowered rates.

Then there’s Japan. Its central-bank moves, which are in a class by themselves, may be starting to pay off.

The Japanese yen has weakened dramatically, and this week it hit 100 to the dollar for the first time in four years.

Once upon a time, a weak currency was considered a negative. But now every government seems to want to depreciate its currency to make exports more competitive in the global marketplace.

Yet nobody actually admits that a weak currency is a goal. This week, Japan’s “economic revitalization minister” explained the yen’s decline by saying,

It’s the dollar that’s in demand because economic recovery in America is gathering steam.

The most immediate effect of the weaker yen has been the increase in profits of major exporters. This week, Toyota Motor (NYSE: TM) said that its net income for the last 12 months had jumped threefold. Even long-beleaguered Sony (NYSE: SNE) produced an annual profit for the first time in five years.

The declining yen is also paying off for tourism. The number of foreign visitors to Japan in March, even before the yen’s latest tumble, was up 26 percent from March 2012, to 857,000. This is the highest for that month since at least 1964, when the Japan National Tourism Organization started tracking that number.

While a weaker currency is good for exports and tourism, though, it makes imported products more expensive. In Japan’s case, the latter notably include energy and food.

Japan’s policymakers seek to rekindle not only the long-depressed economy but also get inflation up to 2 percent. The Bank of Japan’s efforts are likely to keep downward pressure on the yen for awhile in addition to boosting the Japanese stock market.

Japan’s benchmark Nikkei average has soared 64 percent in less than six months, including 15 percent in the five weeks since the Bank of Japan announced its new monetary-easing program. Offhand, I can’t recall another major economy’s stock market doing so well in such a short period of time.

Despite global governments’ race to the bottom for their currencies, gold continues to suffer. The most actively traded contract, for June delivery, was recently down almost $40 to $1,429 per ounce.

Gold was supposed to serve as the ultimate store of value in a world of declining paper-money values. That’s not happening now.

A key reason is the newfound strength of the US dollar. All other factors being equal, a rising greenback tends to dampen the prices of commodities, which are priced primarily in dollars in global markets.

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