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Return of the Risk-On Trade

By Elliott H. Gue on January 27, 2012

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US gross domestic product (GDP) grew only 2.8 percent in the fourth quarter, falling short of analysts’ consensus estimate of 3 percent. Despite this mild disappointment, the US economy still expanded at the fastest pace since the second quarter of 2010 and blew the early October consensus estimate out of the water.

The drivers of fourth-quarter GDP likely disappointed some investors. Check out this graph tracking the extent to which changes in private inventories have contributed to quarterly economic growth.


Source: Bureau of Economic Analysis

When companies draw down their inventories, they use products they already have in stock instead of ordering new supplies–a negative for the economy. However, when companies add to their inventories, these purchases boost GDP regardless of when these goods are sold to customers.

Companies tend to draw down their inventories aggressively during recessions to align supply with demand. In these scenarios, companies often cut their inventories too close to the bone, forcing them to rebuild stocks once the economy turns.

This pattern played out in the 2007-10 cycle: Inventory reductions weighed heavily on GDP growth in early 2009, but the subsequent wave of restocking in late 2009 and early 2010 drove the economic recovery. Inventory restocking often gives the economy a much-needed boost in the early stages of a turnaround.

As I explained in the Oct. 28, 2011 issue of Mind over Markets, Growth Accelerates, Stocks Rise, a larger-than-expected drawdown in inventories limited US economic growth during the third quarter.

Changes in private inventories also reveal a great deal about business confidence. When companies worry about future growth prospects or demand slows, they often cut their inventories to balance perceived supply and demand.

That’s exactly what happened in the third quarter, when businesses reacted to the intensifying EU sovereign-debt crisis, Standard & Poor’s downgrade of the US government’s credit rating and a soft patch for the US economy that began in May 2011.

But as I predicted in late October, a wave of inventory restocking contributed almost 2 percent to US GDP growth in the fourth quarter.

In one sense, inventory restocking is a negative for the economy; ideally, consumers would quickly snap up these items rather than allowing them to sit in warehouses. Restocking during a period of lean demand prompts companies to eventually slash prices in an effort to move inventory or simply to keep less inventory on hand.

My take on this aspect of fourth-quarter GDP is far more sanguine: This round of inventory restocking reflects the business community’s renewed confidence. Management commentary during a number of widely watched conference calls backs up this claim. Consider Ron Slaymaker, Texas Instruments’ (NSDQ: TXN) vice president of investor relations, bullish take on business conditions during the semiconductor manufacturer’s conference call to discuss fourth-quarter earnings:

So let me start with the market environment. As you can see, the fourth quarter revenue of $3.42 billion was significantly stronger than the reduced outlook we had provided during the mid-quarter update. Higher-than-expected revenue came in all our major product lines. We believe this strength relative to our outlook is consistent with a historical bottoming pattern in the industry. The slowdown that began in the third quarter continued in the fourth, during which customers and distributors were significantly reducing inventory. In December, with low levels of customer inventory and short TI [Texas Instruments] product lead times, we experienced significant strength compared to what our backlog indicated at the start of the month.

Our belief based on historical trends is that the semiconductor market bottomed in fourth quarter 2011 or else will bottom in first quarter 2012.

Slaymaker’s comments stand out for two reasons.

Since mid-2011, Texas Instruments’ management team had grown increasingly discouraged about the operating environment, which suggests that this newfound optimism isn’t a case of whistling past the graveyard.

Moreover, management had lowered its estimate of fourth-quarter revenue and earnings during the firm’s mid-quarter update on Dec. 8, 2011, and indicated that demand had weakened across the majority of its product categories and geographic markets. A significant improvement occurred during the month and a half that transpired between Texas Instruments’ mid-quarter conference call and the firm’s fourth-quarter earnings release.

Slaymaker cites the restocking trend evident in fourth-quarter GDP numbers, indicating that customers had allowed their inventories to dwindle early in quarter because of macroeconomic concerns. The vice president of investor relations also suggests that an improved outlook prompted customers to rebuild their inventories and emphasizes that this positive momentum has continued into January 2012.

But our outlook hasn’t changed: The US economy continues its lumpy, subpar recovery from the financial crisis and Great Recession. This latest acceleration in GDP growth mimics the pattern of 2010, when the economy accelerated in the fourth quarter after stumbling in the summer.

The market has reacted violently to these economic fluctuations, with traders adding risky assets aggressively when conditions improve and piling into the safety of US Treasury bonds when the going gets tough. This pattern is unlikely to change in 2012.

The current rally should continue for at least a few months, supported by three trends.

1. Improvements in EU Credit Markets

The launch of the European Central Bank’s (ECB) Long-Term Refinancing Operation, which provided three-year loans to banks at ultra-low interest rates, relieved investors’ fears (at least for the time being) that a liquidity crunch would force a major financial institution to default on its obligations. Participation in the LTRO has surpassed many analysts’ expectations, with the ECB doling out EUR489 billion to 523 bidders.

This injection of capital also allows banks to earn an attractive carry by buying the sovereign debt of the EU’s fiscally weak member states–a trade that also lower these nations’ borrowing costs. For example, at the end of 2011, yields on shorter-term debt issued by the Italian government fell sharply. More recently, yields on Italy’s 10-year sovereign bonds have declined to less than 5.9 percent.

Key credit market indicators have also improved. The US TED spread, which measures stress in the interbank lending market and is an important component in many short-term economic models, in early January fell to 50 basis points from almost 60 basis points.

Credit market conditions have fluctuated over the past few years, depending on the level of panic about the EU sovereign-debt crisis; it’s only a matter of time before concerns about Europe drive the tape once again in 2012. That being said, it pays to stick with the trend: for now, that means adding equities.

2. Strong US Economic Data

Although some US economic data points have come in below expectations, the majority of recent releases have been encouraging.

The Citigroup Economic Surprise Index remains at 65.40, an elevated reading by any historical yardstick. As economists revise their expectations, economic data will have a higher bar to clear to exceed expectations. Nevertheless, the index is a long way from a negative reading, which would indicate that data consistently fell short of analysts’ expectations.

Still, investors should remain vigilant as the summer approaches; the economy and stock market are likely to hit another soft patch, particularly with the 2012 presidential election on the horizon.

3. China’s Economic Growth: Not Too Fast, Not Too Slow

Beijing appears to have engineered a soft landing for China’s economy. Toward the end of 2011, some economists worried that higher interest rates and reserve requirements for banks would tip the economy into recession. The effects of a downturn in China–a key driver of the global economy–would ripple throughout equity markets.

But China’s GDP expanded by 8.9 percent in the fourth quarter, a growth rate that should quell fears that the economy is decelerating without prompting monetary authorities to hike interest rates.

Meanwhile, China’s Purchasing Managers Index (PMI) for manufacturing came in at 50.3, exceeding the consensus estimate of 49. This reading suggests that manufacturing in China continues to expand and that economic growth will probably bottom early in the New Year.

The Verdict

Until these three tailwinds abate, investors should give the bulls the benefit of the doubt and regard any correction in the stock market as an opportunity to buy.

In past years, the market has pulled back slightly in late January and early February. At these levels, the S&P 500 appears overbought; a pullback to between 1,250 and 1,275 could be in the cards. But such a correction will likely prove short-lived, and the S&P 500 should eclipse its 2011 high in the next few months.

In these uncertain times, all investors–not just those who consider themselves income investors–should hold significant exposure to stocks offering high yields, especially in light of the Federal Open Market Committee’s Jan. 25 policy statement:

To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee expects to maintain a highly accommodative stance for monetary policy. In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.

The Committee also decided to continue its program to extend the average maturity of its holdings of securities as announced in September. The Committee is maintaining its existing policies of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate to promote a stronger economic recovery in a context of price stability.

The Federal Reserve plans to keep interest rates near zero for the next three years–18 months longer than it indicated in its Dec. 13, 2011, policy statement. The second paragraph of this excerpt suggests that the Fed plans to continue selling its shorter-dated bond holdings and buying long-term debt to drive down long-term interest rates. And the door is wide open to additional quantitative easing, or direct bond purchases that drive down rates and flood the market with liquidity.

What this means for investors is simple: Don’t expect to earn any real return by holding money in savings accounts or by buying US government bonds and high-grade corporate debt. All these investments will likely lose you money on an inflation-adjusted basis for the foreseeable future.

The Fed’s actions should push savers into stocks and other investments that offer enticing yields; inflows to these assets should continue apace. Two of my favorite plays on this trend: energy-focused master limited partnerships (MLP) and US-listed oil and gas royalty trusts.

For more on MLPs, check out The Case for MLPs: Investor Psychology and Demographics, an article penned by my colleague, Peter Staas. I also discussed SandRidge Mississippian Trust II (NYSE: SDR), a US oil and gas trust that will go public in April, in Energy Investing: Eagerly Awaiting the IPO of SandRidge Mississippian Trust II.

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