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Bob’s View: Fed fallout

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By Bob Landaas

For most bond investors, 2013 was a disappointing year. The bond sell-off started in May, after the Federal Reserve announced its intention to taper or reduce its bond buying as early as September. Ironically, when tapering finally started, in December, bonds started to rally.

And for the new year, bonds are well on their way to recovering their losses of 2013.

The arch enemy for bond investors is inflation. In spite of stimulus spending, TARP, and three quantitative easing programs from the Fed, inflation remains barely measurable. Against this backdrop, I am optimistic about bonds for the foreseeable future. Forecasts of debasing the currency along with runaway inflation have been wide of the mark.

As I have said for years, it’s all about interest rates and earnings. And without inflation, it is hard to imagine significantly higher interest rates.

Keep in mind the role of interest rates in stock valuation, too.

In valuing stock prices, you discount the future earnings of a company by an interest rate to get to the present value of that company. If interest rates were to go up significantly, your discount rate is higher, suggesting lower values for companies. So the continuation of relatively low interest rates results in a lower discount, bringing a higher current value for stock prices.

As for earnings, corporate profits are supposed to go up 8% this year and more than 10% in each of the next two years, according to Bloomberg forecasts.

Another reaction set off by the Fed’s talk of tapering last May has not been recovering: Pressure on the emerging markets.

When interest rates started rising last summer, it put considerable burdens on the emerging markets. Emerging markets have to borrow significantly from the developed world to fund their economic expansions. Higher interest rates added to their cost of business. As a result, investors started reducing their positions in the emerging markets during the summer and the fall.

Then in January, China contributed to the emerging markets’ woes. A report suggested that China’s manufacturing sector was at its softest point in seven months.

Many of the emerging markets are dependent on exporting raw materials to China. Approximately a third of the gross domestic product of the emerging markets is dependent on their relationship with China. As growth in China slows, it inflicts additional problems on the emerging markets.

China wants to be less dependent on exports and investment and more reliant on domestic consumption, which has not caught on yet. What’s even more worrisome is that high-end luxury goods sales in China are plunging. So the people who have a lot of money in China are hunkering down and not spending their wealth.

Not to be alarmist, but the Chinese economy has been the dog wagging the tail in the global economy. Way back when, we were talking about a new normal, how China and the emerging world were going to lead the global economies. That worked out real well until last May.

Since then, the baton clearly has passed back to the developed world.

The developed world continues to gain strength while the emerging world weakens. That can’t last forever.

We will not do well without China doing well. We will not do well without the emerging world doing well.

Most recently, the military aggression in Ukraine has caused additional wariness of the emerging markets. The Russian stock market fell almost 10% on the Monday after Moscow forces entered the Crimean peninsula.

Meanwhile, we haven’t quite hit the inflection point yet for the Chinese economy. My guess is that it’s coming yet, but if I had to pick one worry right now, that’s got to be it.

So we need to pay very close continued attention to what’s going on in China. And it’s interesting that they complain about their economy weakening, and they’re still at 7% growth. We’re less than half of that in the United States.

However, most of the pros do think that the Chinese economy will start turning around. Sometime this spring, China’s manufacturing should pick up.

And then investors will move on to other worries.

Bob Landaas is president of Landaas & Company.

(initially posted March 6, 2014)

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