Macro Strategy Review November 2013

November 2013

Forward Markets: Macro Strategy Review

Macro Factors and Their Impact on Monetary Policy,
The Economy and Financial Markets

Global Economy – Better, But Not Good

One of the investment themes gaining traction in recent months is the global synchronized growth story. Those who are bullish on equity markets for the remainder of 2013 and 2014 note that for the first time in a long time gross domestic product (GDP) growth is expected to pick up in the United States, European Union, China and even in Japan. The rising tide of economic activity is forecast to lift equity markets globally, with the primary challenge being to identify which countries are likely to perform best. Once these countries have been identified, some institutional investors will be quick to exploit newly embraced investment themes, which is why markets tend to get ahead of reality now and again. By early next year (if not sooner), we believe equity markets will have been overbid relative to the actual improvement likely to be realized in 2014. Yes, things are better, but probably won’t be as good as anticipated. Emerging economies have provided most of the sizzle to global growth, especially since the financial crisis in 2008. However, as discussed below, China, Brazil, India and Indonesia may not have the growth they have experienced over the last five years. We believe growth in developed countries will improve modestly in 2014, but will remain below their historical averages.image08

An analysis of industrial production since 2007 illuminates the bifurcation in growth experienced between emerging economies and the lack of growth in developed countries. The table titled “Industrial Production Stalling in the Developed World” shows the net change in industry production from the average monthly figures in 2007 through August 2013 for developed countries (except for Russia and Canada). Industrial production in the U.S., all the major countries in the European Union, Britain and Japan is still below the 2007 average. In contrast, the growth in emerging economies has been solid compared to the 10.4% average increase of all countries, with China, South Korea and India leading the pack.

Based on data from the International Monetary Fund, global GDP totaled $72.22 trillion in 2012. The combined total GDP for the United States, European Union, Japan and Britain was $41.35 trillion in 2012, or 57.3% of total global GDP. The combined total GDP for China, Brazil, India, South Korea and Indonesia was $14.32 trillion, or 19.8% of global GDP.

Emerging Economies

A review of the largest emerging economies suggests that China, Brazil, India and Indonesia each face challenges that may limit improvement in GDP growth in 2014 and beyond. image09

China’s GDP grew 7.7% in the first quarter and 7.5% in the second quarter, according to the National Bureau of Statistics of China. Its annual growth target for 2013 was 7.5%, which is likely to be met since growth has averaged 7.7% through September. China hasn’t failed to top its annual growth target since 1998. In addition, China’s “total social financing” liquidity measurement tool, a broad measure of credit, is up 19% through September. As we have noted in previous commentaries, Fitch Ratings estimates that bank assets have soared 126.5% in the last four years. However, economic growth from each dollar of new credit has diminished significantly since 2007. According to analysis by Bloomberg, GDP grew by $.83 for each $1.00 increase in credit in 2007. In 2012, a $1.00 increase in credit only contributed $.17 to GDP. Chinese banks are thinly capitalized with equity representing only 6.5% of total assets. In contrast, the equity capital ratio of U.S. banks is 11.5% of assets. According to research provider ChinaScope Financial, Chinese banks may have to raise $50-$100 billion though equity sales in the next two years just to maintain their current equity capital ratios. This estimate may prove low since Chinese banks have a nonperforming loan ratio of less than 1%, despite the huge increase in bank assets.

In coming years, China has indicated it wants to rebalance its economy away from image10its dependence on exports and domestic infrastructure investment and toward a domestic consumption-oriented economy. The transition will require higher wages so a larger middle class will be able to consume more goods, thus lowering China’s dependence on exports. The economic transformation could easily take 10 years and will likely result in slower growth in coming years. We think the Chinese government may lower its 2014 annual GDP target from its 2013 target of 7.5% at the conclusion of the Communist Party conclave taking place in November. If they do lower their GDP target, it may serve as a wakeup call. The days of double digit GDP may be over and the world will need to adjust to China’s gradual decelerating growth in coming years.image11

Brazil was one of the countries that most benefited from the commodity boom driven by China’s almost insatiable demand for raw materials since it is a large exporter of raw materials. In recent years, China has consumed almost half of the world’s iron ore, cement, steel, coal and lead. Brazil’s economy averaged 3.6% annual growth over the past decade, and grew 7.5% in 2010 on the back of China’s growth. In terms of global GDP, Brazil is the seventh largest, just behind Britain. In an effort to close the wide gap between rich and poor, Brazil hired tens of thousands of government employees, expanded its welfare system, subsidized the costs of gasoline and electricity, and directed government banks to lend aggressively. Between 2004 and 2010, banks made auto loans without the requirement of a down payment. According to the Bank of Brazil, this led to an almost tripling in auto loans to $70 billion a year. In the four years after the 2008 financial crisis, consumer lending rose at an annual rate of 25%. As a result, more than 20% of household income in Brazil goes to service consumer debt that has an average interest rate of 37%. Hardly surprising, nonperforming loans rose to 5.6% of all loans made to individuals in 2012. Although the increase in debt-induced consumption boosted GDP growth, especially over the past four years, the dearth of government spending on new roads, trains, irrigation canals and port facilities did not keep up with the size of Brazil’s economy. This lack of spending will lead to higher transportation costs and lower Brazil’s productivity and growth over the long term.

image12Brazil’s strong growth after 2003 attracted an inflow of international capital that lifted the real – Brazil’s currency. Between October 2002 and mid-2011, the real gained approximately 60% against the dollar, which held inflation in check even as growth accelerated. This positive tailwind reversed in mid-2011, and in recent months become a significant headwind. After Federal Reserve Chairman Ben Bernanke broached the subject of tapering its quantitative easing (QE3) program on May 22, the real lost almost 20% of its value in less than three months. Since April, Brazil’s central bank has increased its SELIC rate (or overnight bank rate) five times from 7.0% to 9.5%. On August 23, Brazil’s central bank announced a $60 billion program to support the real. The decline in the real has contributed to an increase in inflation since imports are priced in dollars. In mid-October, inflation was up to 5.75%, according to the Bank of Brazil, and well above its target of 4.5%. The actions taken by Brazil’s central bank, and the Fed’s decision not to taper in mid-September, have helped the real to strengthen more than 11% versus the dollar. In 2012, Brazil ran a current account deficit of -2.4%, which means the country is still dependent on international capital inflows to fund its deficit. While the real has stabilized for now, it could face another test when the Fed moves to lower its QE3 purchases.

Brazilian GDP growth is not likely to rebound significantly in 2014 in the wake of recent rate increases and how over-indebted the average consumer is after five years of binge buying. These factors are likely to hold Brazil’s growth rate well under the 10-year average of 3.6% in 2014, and potentially in 2015 as well.

Over the past 30 years, India averaged a 6.4% increase in annual GDP, and 7.7% from 2002 through 2011, according to the World Bank. India has the tenth largest economy in the world. Over the past year, GDP growth has slowed to 4.4%. Since mid-2011, the rupee, India’s currency, has lost almost half of its value versus the dollar. Although India’s current account deficit has dipped from 5.1% in 2012 to 4.8%, it is still quite large. In July, the Reserve Bank of India tightened monetary policy by increasing its bank borrowing rate to over 10%. This has caused lending to be curtailed, which has contributed to the country’s economic slowdown. On September 20, the Reserve Bank increased its repo rate from 7.25% to 7.50%.

Over the past decade, India has relied on a limited pool of skilled labor, rather than an abundance of cheap labor to boost manufacturing exports. India specialized in call centers, software development and back office services, instead of increasing its manufacturing capacity. In 1995, manufacturers accounted for 17% of GDP, but dropped to 14% in 2013, according to the Ministry of Statistics. Over the last five years, India has built 200,000 miles of highways but no high-speed rail routes. During the same period, China built 400,000 miles of highways and 5,800 miles of high-speed rail routes. India has struggled with an ongoing energy crisis and in 2007 said it would add 78.7 gigawatts of electricity capacity to provide electricity to 400 million rural residents. India has only achieved 80% of its planned increase in electricity generation, and still suffers from outages. Since 2007, China has added 450 gigawatts of power to its grid, according to the National Bureau of Statistics of China. A gigwatt is 1 billion watts, and would provide power to 750,000 to 1,000,000 homes in the U.S.

image01Although India’s poverty has dropped from 50% to 20% over the last 30 years, the country is home to a quarter of the world’s hungry, according to the United Nations. In August, India passed legislation to guarantee cheap grain for 70% of India’s 1.2 billion people. Under the law, highly subsidized rice, wheat and other grains will be provided to low income people at a fraction of market prices. It will cover about 75% of people living in the countryside and 50% of those in cities. It will increase India’s food subsidies from $16 billion to $20 billion, making it more difficult to narrow India’s 4.8% budget deficit.

We believe India’s lack of infrastructure investment in roads, rail lines and electricity generation will suppress productivity and future economic growth. India must also improve accessibility to its education programs for its 400 million rural residents, so future generations possess the basic skills of reading and writing. The myriad of problems confronting India suggest growth in 2014 and beyond is not likely to return to the 7.7% annual growth rate of the past decade.

image00Indonesia has averaged annual GDP growth of 6.0% over the past five years, and is the sixteenth largest economy in the world. Like Brazil, much of the growth has been driven by a strong currency and a huge increase in consumer debt. According to Moody’s, Indonesia’s compound credit loan growth rate has been 22% for the past six years. Non-mortgage consumer credit has almost tripled during the last five years. From June 2012 to May 2013, loans for apartment purchases soared 69%, so a bubble in real estate is brewing. After the May 22 Federal Reserve meeting, Indonesia’s currency lost more than 20% of its value in less than three months. Inflation has jumped from 4.3% in January to 8.4% in October. Since April, Bank Indonesia has increased interest rates from 5.75% to 7.25%. After years of running current account surpluses, Indonesia now has a deficit of -2.7%. Economic growth in Indonesia is unlikely to pick up in 2014 in the face of higher inflation, interest rates and an overleveraged consumer.

image03China, Brazil, India and Indonesia have provided a significant amount of the increase in global growth following the financial crisis in 2008. Much of the growth was fueled by an increase in consumer credit, which is likely to grow more slowly in coming years, and cause GDP growth to be slower than it has been since the 2008 financial crisis. With the exception of China and South Korea, Brazil, India, Indonesia, Turkey and Mexico are running current account deficits. When the Federal Reserve suggested it might curb its QE3 purchases in May, countries with current account deficits experienced declines of 15% to 20% in their currencies in less than three months. The Fed’s decision to postpone tapering in September brought a respite and led to a rebound in the weakest currencies. However, these countries will face another test when the Federal Reserve decides to scale back its QE3 purchases.

Investors in emerging markets will need to be nimble in coming months and should favor those emerging economies with a current account surplus until the Federal Reserve moves to taper its QE3 program.

Developed Economies

image02The eurozone may have emerged from its recession in the second quarter, but the recovery is likely to be choppy and weak. European banks are responsible for 80% of credit creation, so small- and medium-sized companies are very dependent on a functional banking system. A recent analysis by the Royal Bank of Scotland estimated that European banks need to shrink their balance sheets by $4 trillion over the next three to five years. Year-over-year lending is still negative and the study suggests lending and credit growth will remain moribund for years. The stress on a number of countries in the European Union (EU) will likely continue and require more triage and money. In 2014, Greece will require a third aid package, and Portugal’s current bailout expires in mid-2014, with another aid package likely to follow. The stress on banks may require the European Central Bank to extend its LTRO (long-term refinancing operation) loans beyond the program’s expiration in January 2015. According to Citibank, the LTRO funds 18% of the assets in Greek banks, 10% for Portuguese banks and 6% of Italian bank assets. In addition to shrinking balance sheets, banks have been improving the quality of assets by buying government bonds with some of the LTRO loans. At the end of August, sovereign debt accounted for 5.6% of eurozone bank assets, up from 4.2% at the end of 2011. Spanish banks hold 9.0% of their assets in government bonds, and Italian banks hold 10.1%. The increase in bank holdings of government bonds has helped to keep sovereign bond yields down, but there is a downside. As banks buy more government bonds, they are using less of their shrinking balance sheets for lending.

Labor laws in many EU countries make it very difficult for companies to lay off workers. These laws may provide a buffer during a short recession, but it makes companies reluctant to hire, which mutes any recovery. During a prolonged period of economic stagnation, revenues fall and losses mount if companies are unable to lower labor costs to match their weaker revenue. Labor inflexibility has proven especially troublesome for European automakers, which are experiencing the lowest vehicle sales volume in 20 years. A recent study by consulting firm AlixPartners found that more than half the auto factories in Europe, most of which are located in Italy, France and Spain, are functioning at less than 75% of capacity and operating at a loss. Because of the labor laws it is extremely difficult and expensive to lay off workers and close unprofitable plants. Automakers in Europe are losing billions in revenue each year by holding on to workers and factories they no longer need.

Germany represents 30% of eurozone GDP and is the engine of growth. According to the Federal Statistics Office of Germany, total spending on machinery and equipment rose 0.9% in the second quarter, after six consecutive quarters of decline. A recent survey by the Wall Street Journal suggests that investment spending, which has dropped to historic lows as a percent of GDP, is not likely to pick up significantly in Germany. Lack of expected sales growth in Germany and Europe is leading most of the 19 blue-chip corporations surveyed to invest more in emerging economies and the U.S. than in Germany or Europe. Just 15% of respondents said they would invest in Germany, only 5% in Europe, 11% in the U.S. and 43% in emerging markets, with 26% providing no guidance. If companies like BMW, Siemens, Adidas and Henkel are looking outside of Germany and Europe for growth, eurozone GDP may struggle to exceed 1% in 2014.

image04Earlier this year Japan’s national debt topped 1 quadrillion yen, or more than $10 trillion dollars. Numerically, 1 quadrillion is 1,000,000,000,000,000. Japan’s debt is almost as much as the combined GDP of Germany, France, Britain and Brazil. In what we have described as the ultimate economic “Hail Mary” pass, Japanese Prime Minister Shinzō Abe has authorized the doubling of Japan’s money supply in the next two years, and the decline of more than 20% in the value of the yen versus the dollar and the euro since last November. The cheaper yen has lifted exports, contributing to a 4.1% gain in first quarter GDP, and a 3.8% increase in the second quarter. In July, exports surged 12.2% from a year earlier, up from a gain of 7.4% in June, so the export boom seems to be continuing into the third quarter. Capital spending rose 1.3% in the second quarter, which was the first increase since the fourth quarter of 2011.

Japan is on a roll, but to keep the ball rolling, Prime Minister Abe must address the amount of government debt and the inflexibility of Japan’s labor laws. Much like many countries in Europe, Japan’s culture of lifetime employment makes it very difficult to dismiss workers. It may seem counterintuitive, but making it easier to lay off workers also makes employers more willing to hire even when the economic outlook is uncertain. Current law forces many Japanese companies to keep investing in unprofitable business lines, which undermines the efficient allocation of capital. In the long run, laws intended to protect workers in Japan and Europe have unintended consequences of causing more harm to workers and hurting economic growth. Prime Minister Abe has yet to detail how this impediment to growth will be modified. Without significant labor market changes, the long-term success of “Abenomics” may be undermined.

To address Japan’s mountain of debt, Japan is planning to raise its sales tax in April 2014 from 5% to 8%. It is estimated the sales tax increase will raise $88 billion in the first year, or almost 1.5% of GDP. As another example of unintended consequences, demand will likely be pulled forward into the first quarter, as consumers rush to buy before April in order to save 3% on their purchases. We believe first quarter GDP will be lifted by the surge in consumer demand, only to weaken significantly in the second quarter. This will be the first real test of the durability of Abenomics. Longer term we remain skeptical. Japan must generate enough economic growth to overcome its mountain of debt and the fact that its population is shrinking about 1% per year, which is a huge headwind to economic growth.

GDP growth in the United States hovered around 2% in 2011, 2012 and 2013 even though housing and vehicle sales improved significantly. As we discussed in detail in our July commentary, gains in housing and vehicle sales are poised to moderate in the second half of 2013. Although these sales will add to GDP, they are unlikely to contribute more to GDP in coming quarters. Job and income growth are not likely to accelerate much, so a marked pickup in consumer spending seems a stretch. Back-to-school sales were punk, and are often a precursor of holiday sales. There are many adjectives to describe Washington D.C., but in our opinion, competent isn’t among them. According to a recent Gallup poll, the approval rating for Congress is the lowest ever, but in the 2014 election, it is likely more than 85% of the incumbents will be re-elected, due to the gerrymandering of districts by both parties. When all the pieces are put together, it’s hard to see how growth is going to pick up to 3% or better in 2014 as forecast by the Federal Reserve and many private economists.

The Clues to a Future Crisis Are Usually Hiding in Plain Sight

In coming months we’re going to highlight a number of crises that may emerge in coming years. If and when they make the evening news, the reaction will be one of surprise even though the clues to each crisis were likely hiding in plain sight well before the event. Inspiration for this series comes from the housing crisis, which led to the 2008 financial crisis. Although most investors were surprised by the housing crisis, the clues to the potential problem were hiding in plain sight in 2006 and 2007. For instance, according to the National Association of Realtors, the ratio of median home prices to median income held near 3.2-to-1 between 1965 and 2000, as mortgage lenders restricted mortgage payments to one-third of a homebuyer’s income. Low interest rates and lending standards for liar’s loans pushed homes prices higher so that the ratio of median home prices to median income rose to 4.6-to-1 by 2006. A simple regression-toward-the-mean analysis suggested that median home prices had the potential to fall 30% (4.6 times median income down to 3.2 times median income). The risk models used by Moody’s, Standard & Poor’s and Fitch Ratings assumed home prices would not decline because they hadn’t since the Depression. This valuable information was widely available long before housing prices began to fall in 2007 and the financial crisis made headlines in 2008. Despite this simple analysis, most investors were caught off guard.

Similar to the housing crisis, there is a problem with our nation’s infrastructure. According to the Federal Highway Administration (FHWA), there are 607,000 bridges in the United States. Bridges are an important part of our transportation system, since they make it possible to travel in a straight line, rather than circumventing rivers, canyons and other natural obstructions. Bridges help lower the cost of shipping goods anywhere in the country, and save valuable time for millions of commuters every day. Many bridges were built as a result of the Federal Aid Highway Act of 1956, which established the Interstate Highway System. As of 2010, its network of roads comprised a total of 47,182 miles, making it the world’s second longest system after China. The initial cost estimate for the system was $25 billion over 12 years. It actually wasn’t finished for 35 years and at a cost of $114 billion (or $425 billion in 2006 dollars, adjusted for inflation). Many of the bridges built as part of the Interstate Highway System are now 30, 40 and 50 years old. When they were built, the engineers didn’t know that decades later the bridges would be supporting much larger and heavier trucks. This has caused a much higher level of wear and tear and many bridges have degraded. Since 1989 there have been more than 600 bridge failures in the United States.

The money needed to maintain our roads and bridges comes from the federal government via gasoline taxes of $.183 per gallon of unleaded fuel and $.244 for diesel fuel. In 2010 these taxes totaled $28 billion, according to the Congressional Research Service. Roughly 60% of this revenue is spent on new roads and bridges, with the balance spent through congressional earmarks (read pork-barrel projects). This tax has not been raised since 1993, and has lost about 35% of its purchasing power if it were adjusted for inflation. According to the University of Michigan Transportation Research Institute, the average fuel economy on the window stickers of cars and trucks sold in August was 24.9 miles per gallon. That was up 23.8% from October 2007 when it was 20.1 miles per gallon. Increased fuel economy is a good thing for our country and environment, but it means less fuel tax revenue is generated for road and bridge repairs. The FHWA estimates that the national annual cost of bridge and road repair is $20.5 billion. The longer Congress fails to address this problem the more likely it is that the costs are going to rise since it is more expensive to replace or rebuild a bridge than repair it. Interestingly, over the last decade Congress authorized $89 billion on road and bridge construction in Afghanistan and $69 billion in Iraq.

According to the American Society of Civil Engineers, inadequate surface transportation is projected to cost U.S. businesses $430 billion in operating expenses by 2020 and cause $1.7 trillion in lost sales opportunities. In Pennsylvania, 24% of bridges are structurally deficient. In an effort to reduce wear on bridges, the Pennsylvania Department of Transportation lowered weight limits to extend the life of 1,000 bridges. Trucks transport the bulk of goods in the United States, and the weight limit reduction will force some truckers to change driving routes to avoid the 1,000 bridges no longer available. The decreased number of available bridges could add 100 miles to a 600-mile trip between Pittsburg and Boston, increasing the cost of a shipment from $1,000 to $1,100, or by 10%.

According to the Federal Highway Administration, there are 67,300 bridges in the U.S. that are deemed “structurally deficient” or “fracture critical.” While not inherently unsafe, structurally deficient bridges require significant maintenance, rehabilitation or replacement. About 18,000 bridges are considered to be fracture critical, which means if a portion of the tension steel cable supporting a bridge breaks there is no redundancy to prevent a portion of the entire bridge from collapsing. In 2007, a bridge over the Mississippi River that is part of I-35 highway in Minnesota collapsed, killing 13 car passengers. There are 7,980 bridges that are both structurally deficient and fracture critical across the country. To find out what bridges may be deficient, go to, and follow the instructions near the bottom of the page. Every day thousands of trucks and millions of drivers and their passengers use these bridges. As time passes there will likely be more bridge failures. The clues to this coming crisis are hiding in plain sight.


image05In last month’s commentary we noted that our proprietary Major Trend Indicator, the NYSE Advance-Decline Line (NYSE A/D Line) and the 21-day average of 52-week new highs less new lows had gradually weakened since May and suggested the market was vulnerable to the largest correction so far in 2013. We noted that 1,645 on the S&P 500 Index was a key level, and if broken, could lead to a decline to 1,550-1,575. On October 9, the S&P 500 dipped to 1,646 before reversing. The temporary resolution of the debt ceiling and nomination of Janet Yellen as the next chair of the Federal Reserve breathed new life into the market. As of October 25, the Major Trend Indicator has pushed above 3.2, the NYSE A/D Line has made a new high, and the 21-day average of new highs less new lows is above its August high, but still well below the May peak (187 versus 365). In addition, the S&P 500 continues to make higher highs and higher lows, which is the definition of an uptrend. A decline below 1,627-1,646 would turn the intermediate trend negative.

image06Since September 2011, S&P 500 earnings have risen by 15.4%, while the S&P 500 has gained 48.6%. The biggest lift hasn’t come from an increase in earnings, but the willingness of investors to pay more for each $1 increase in earnings. Compared to other investment opportunities, stocks look more attractive since the Fed is expected to maintain QE3 potentially into 2014, global growth is improving and investors have no obvious reason to sell stocks. The lack of selling pressure combined with more than $100 billion in corporate stock buybacks every quarter has clearly aided the upward drift in market averages. While these trends can continue, investors should keep their eyes open and understand that the investment reward versus the risk being taken is becoming more imbalanced.

The Q Ratio was developed by Nobel Laureate James Tobin as a method to estimate the market’s fair value. The Q Ratio is the total price of the market divided by the replacement cost of all its companies. The chart titled “Q Ratio Since 1900” was updated through June 30 by Doug Short at Since the S&P 500 has risen 9.2% since June 30, (from 1,606 to 1,754 as this is being written), the Q Ratio has climbed from 0.98 on June 30 to near 1.07 on October 25. The chart illustrates that the Q Ratio is near one of the most expensive levels of the past 113 years. The Q Ratio peaked at 1.08 in 1906, 1.06 in 1929, 1.08 in 1937 and 0.98 in 1968. With the exception of the tech dot-com bubble in 1999-2000, the market is near one of the most expensive levels of the past 113 years. A similar valuation assessment is revealed from Nobel Laureate Robert Shiller’s cyclically adjusted price-earnings ratio, also known as CAPE. The 142-year average is 16.5, and as of October 25 it measures 24.65, and is almost 50% above its long-term average. The only instances when it was more expensive were in 1929 and 1999-2000.

Investor sentiment has become more bullish with the resolution of the debt ceiling, appointment of Janet Yellen, embracement of the synchronized global growth story and new all time highs in the S&P 500. However, markets don’t go down because there is too much bullishness or overvaluation. Markets decline when investors are confronted with new information that doesn’t align with their positive outlook, thus providing them a reason to sell. Until a reason to sell appears, the market can continue to grind higher, with a possibility that a “melt up” occurs prior to a top. The higher the market climbs in coming months, the more vulnerable it could be to a significant decline once a reason to sell materializes. As discussed, investor’s expectations for global growth seem too optimistic as statistics indicate that a number of countries will face hurdles in 2014. In this environment, technical analysis can be helpful. At some point, the S&P 500 will fall below a prior low, which will provide investors the first warning that trouble may be brewing. For now, the level to watch is 1627-1646.


image07From a low of 1.39% in July 2012, the 10-year Treasury rose to 3.0% in early September 2013, an increase of 161 basis points. A 50% retracement would allow the yield to drop to 2.2%, which may be possible since the Fed may not curtail QE3 until early 2014 and the economy is unlikely to strengthen much before year-end. If the yield does dip to 2.2% or so, a 161 basis point increase would suggest the 10-year yield could make a run at 3.75-4.00%. Coincidently, this range is where the 10-year yield topped in 2009, 2010 and 2011. When the Fed does eventually reduce its QE purchases, the bond market will seek to establish a new equilibrium point. It should be noted that a majority of corporate pension funds use a discount rate of 4.0%. Should the 10-year Treasury yield approach 4.0%, corporate pension funds could be natural buyers at that level.

Jim Welsh, David Martin, Jim O’Donnell
Macro Strategy Team

Definition of Terms

10-Year Treasury is a debt obligation issued by the U.S. Treasury that has a term of more than one year, but not more than 10 years.

Abenomics refers to the economic policies advocated by Shinzō Abe, the current Prime Minister of Japan.

Basis point is a unit that is equal to 1/100th of 1% and is used to denote the change in a financial instrument.

Blue chip refers to a nationally-recognized, well-established and financially-sound company.

Gross domestic product (GDP) is the total market value of all final goods and services produced in a country in a given year.

Liar loans are a category of mortgages known as low-documentation or no-documentation mortgages that have been abused to the point where the loans are sometimes referred to as liar loans.

Long-term refinancing operation (LTRO) refers to the European Central Bank’s refinancing program which lends money at a very low interest rate to eurozone banks.  

NYSE Advance/Decline Line (A/D Line) is a technical indicator that plots changes in the value of the advance-decline index over a certain time period.

Price-to-earnings (P/E) ratio of a stock is a measure of the price paid for a share relative to the annual income or profit earned by the firm per share. A higher P/E ratio means that investors are paying more for each unit of income.

Q Ratio is a ratio devised by Nobel Laureate James Tobin which suggests that the combined market value of all the companies on the stock market should be about equal to their replacement costs.

Quantitative easing (QE) refers to a form of monetary policy used to stimulate an economy where interest rates are either at, or close to, zero.

Repo rate is the rate at which the central bank of a country lends money to commercial banks in the event of any shortfall of funds. The repo rate is used by monetary authorities to control inflation.

S&P 500 Index is an unmanaged index of 500 common stocks chosen to reflect the industries in the U.S. economy.

Total social financing (TSF) is a liquidity measurement tool invented by China in 2011 that serves as an indicator of monetary policy.

Valuation is the process of determining the value of an asset or company based on earnings and the market value of assets.


Investing involves risk, including possible loss of principal. The value of any financial instruments or markets mentioned herein can fall as well as rise. Past performance does not guarantee future results.

This material is distributed for informational purposes only and should not be considered as investment advice, a recommendation of any particular security, strategy or investment product, or as an offer or solicitation with respect to the purchase or sale of any investment. Statistics, prices, estimates, forward-looking statements, and other information contained herein have been obtained from sources believed to be reliable, but no guarantee is given as to their accuracy or completeness. All expressions of opinion are subject to change without notice.

Jim Welsh is a registered representative of ALPS Distributors, Inc.

Forward Funds are distributed by Forward Securities, LLC.

©2013 Forward Management, LLC. All rights reserved.


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