Yesterday the US House of Representatives passed a bipartisan budget deal—the first one we’ve had in four years—and the Senate is expected to pass it early next week. It’s been a long time coming but it looks like Washington might finally be getting out of the way. This is great news for the economy, consumer sentiment and the overall employment outlook. Unfortunately, it probably isn’t great news, at least in the near term, for investors. The markets have been keenly attuned to the Federal Reserve’s policies. As long as Washington remained dysfunctional the Fed felt the need to maintain its quantitative easing (buying Treasury and mortgage bonds in the open market) policy. The passage of this budget deal gives Washington the appearance, if only temporarily, of being functional. This action, coupled with a generally improving economic environment, should pave the way for the Fed to begin tapering down its bond buying activities early next year.
This past May, when the Fed first mentioned the idea of tapering QE, the stock market proceeded to decline 5% over the next month. The end to QE 1 and QE 2 saw declines of 10%-15% in the stock market. The market is down 2% since the announcement of the bipartisan budget deal. Considering it was up, mostly uninterrupted, 30% over the previous 12 months and 50% over the previous two years—it isn’t a stretch to suggest this market might be ready for a little breather. It wouldn’t surprise us to see a 10%-15% correction sometime in the next few months. We believe that correction will make for an attractive buying opportunity as the market enters the next phase of this bull market that began in 2009. Corporations have done an excellent job of growing their earnings in a mostly benign revenue growth environment. In this next phase of the bull market we would expect to see improving revenue growth along with continued earnings gains and price-to-earnings multiple expansion. That would be a very powerful move for stocks and could ultimately propel the S&P above 2000 (currently at 1775) in the coming year.
The near term and long term prospects for taxable bonds are probably both negative should the Fed taper its bond buying activity. The 10-year US Treasury is creeping up on 3% again (currently at 2.86%)—the peak it hit in early September. We don’t think it will stop there—yields will likely hit 3.5% and possibly even 4% in the coming year as the economy continued to improve and the fear of deflation is replaced with a fear of inflation. A 1% rise in interest rates would cause a 3%-3.5% decline in the prices of an intermediate bond portfolio. We believe even the most conservative investors may be better served investing in equity income (REITs, Infrastructure, Utilities, BDCs, etc.) and/or alternative income strategies.