January 24, 2013 | By Scott Minerd
The U.S. economy is reaching "escape velocity," powered by the monetary rocket fuel from central banks around the world. Almost every domestic economic indicator is now positive and the economic backdrop is stronger than it has been in the last seven years. We are in the healthiest financial condition since 2003. If the post-2003 experience were to be repeated, we could see an uninterrupted economic expansion for four years. Although pockets of uncertainty remain, such a favorable outlook for the economy and markets cannot to be ruled out.
Investors can expect a continuation of the themes that have dominated the environment since the recovery began: tighter credit spreads, low interest rates, improving employment, modest inflation, and sustained economic growth. Historically low interest rates and continued earnings growth will support higher equity valuations. As leveraged buy-outs come back into play, undervalued companies with large cash balances are sure to be targets. More merger and acquisition activity would lift share prices higher, furthering the expansionary trend that is already underway.
Empirical studies suggest that an increase in the Treasury yields does not necessarily lead to weaker equity performance. When yields on the 10-year note remain below 4%, the correlation between S&P 500 monthly returns and changes in 10-year yields are positive, which implies that when yields rise, equity prices move higher as well. An increase in interest rates from a low level is likely to be the result of more robust economic activity, which is positive for equity performance. When the 10-year Treasury yield climbs above 6%, the correlation inverts, with increasing yields leading to decreasing equity prices. This occurs because of the affiliated rise in the inflation premium, which is negative for input prices and earnings, putting downward pressure on equity prices. Given that the 10-year Treasury yield is currently around 1.83%, for now, any potential rise in yields should result in an increase in equity prices.
Source: Bloomberg, Guggenheim Investments. Data as of 12/31/2012.
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