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From the experts - US

Hersch Cohen

After the honeymoon

Hersh Cohen, co-chief investment officer at Legg Mason company Clearbridge Investments, asks whether the US interest rate ‘honeymoon’ is over and, if so, to what degree does that matter?

For the past few months, many investors have fretted about a potential rise in US interest rates. Similar concerns have been apparent in each of the past few years, but persistent economic weakness caused those fears to dissipate. Despite a negative first-quarter GDP report, some signs of improvement in the US economy have been interpreted as a signal to the Federal Reserve to move on rates.

Home sales, both existing and new, have begun to pick up – though at levels still well below those of pre-crisis. Jobs have improved slightly and there is a bit of hope that wages will begin to rise. The stagnation of incomes has been a primary factor in the economic malaise and has caused the Fed to be very cautious on rates.

"There is a growing sentiment that ultra-low interest rates have become counterproductive."

Further, there is a growing sentiment that ultra-low interest rates have become counterproductive. Savers, upset by virtually no returns on safe instruments, have been spending less because they feel the need to have even more reserves. That is impacting retail sales.

Equally disturbing to some is the huge amount of merger and acquisition activity, abetted by the very low cost of borrowing to fund it. While positive for stocks on a short-term basis, the fear is that debt levels will become onerous down the road. Arguments abound as to whether the Fed has helped create asset bubbles. Clearly, many facets of the financial world are distorted, if not outright manic.

So we would say the honeymoon with ultra-low rates is likely to begin to wear off over the next year. If no further setbacks to the economy occur, the Fed will indeed begin to raise short-term rates – but the process will likely be extremely gradual.

Normally, we would expect markets to have adjusted in advance of such moves. However, these are far from normal times and therefore it becomes difficult to predict how investors or speculators will react when there actually is some Fed action. In our opinion, the most likely scenario is that any rise will be very small and therefore not overly disruptive.

The stockmarket is generally conforming to our forecast from January. We projected a subdued market with modest gains at best, as the market needed a pause to allow earnings to catch up with stock prices that had made strong advances in prior years.

Watching the internal workings of the market, things are more complicated. Any minor disappointment on revenues or earnings, even if driven by currencies, has been greeted with immediate outsized declines. Fear of rising rates has led to declines in many dividend-growers, such as utilities. Industrial stocks have stumbled as the economy lacks lift-off. Market gains have become increasingly narrow, making stock selection more important but also more frustrating, as moves both up and down become exaggerated.

By definition, the healthiest markets are those when most stocks and groups are in rising trends. Even disappointing earnings can be overcome by a rising tide and individual stocks can reach their potential. More problematic is what we see this year. Many stocks, despite decent or good results, have stalled or rolled over after multi-year up-moves. This suggests a tired market in need of patience from investors.

For proof, we need look no further than to companies that are, in our opinion, executing well in their operations and growing their dividends. Some continue to be treated favourably by investors, while others are either languishing or declining.

Stock prices, unlike underlying companies, are subject to supply and demand by investors. In companies we favour, quantitative metrics such as cashflow and dividends are tangible – and, we believe, sustainable. Against this backdrop our approach to the market remains unchanged.

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