Market View

Market View: Think Stocks Are Overvalued? Think Again

Mon, 20 May 2013 00:00 EDT

May 20, 2013

Here are some indications that equity valuations may not be overextended.

At this point in the equity rally, investors may be accustomed to the frequent headlines about record-high stock prices. While these reminders could curtail further interest in equities, the recent increase in prices has not had a similar effect on valuations. And by at least a couple of measures, equity valuations point to potential opportunities going forward.

For one perspective on valuations, investors could look at the relationship between stock prices and corporate profits, which have moved nearly in tandem since 2009. And with earnings for the S&P 500^® Index reaching $102.1 as of May 16, 2013, this left the index with an earnings multiple of 16.1, which is well below the average multiple of 19.6 over the prior 20 years. If there were a reversion to the mean, it would indicate that stock prices could move higher as multiples expand to that long-term average. Or, if earnings begin to stagnate, equities might not encounter the severe volatility that may be a prominent concern for many investors.

Earnings Have Supported the Market's Gains

Data are from May 1, 1993 through May 16, 2013

Source: Bloomberg.
Earnings per share (EPS) are based on market convention index earnings, calculated by summing up the equity member contributions (trailing 12-month earnings per share of the member company equity multiplied by the number of shares of the equity in the index) and dividing the sum by the index divisor.
The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy.
The historical data are for illustrative purposes only, do not represent the performance of any Lord Abbett mutual fund or any particular investment, and are not intended to predict or depict future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Investors may experience different results. Due to market volatility, the market may not perform in a similar manner in the future.
Past performance is no guarantee of future results.

Another valuation perspective was recently provided by the New York Federal Reserve, which found that the equity-risk premium—the excess return of stocks minus Treasury yields—is hovering near a record-high level, primarily due to historically low interest rates. The Fed also compared the current equity-risk premium with other periods when the premium was high, and found that the latter periods only showed a high premium through short time horizons. The current premium is high regardless of the time horizon, according to the New York Fed.

While valuations support current equity prices and the potential for further gains, the 0.1% increase in April's retail sales, while not a blistering pace, demonstrates that economic support also continues to build a case for stocks, particularly since consumer spending is responsible for more than two-thirds of economic growth. The increase in April's sales may be all the more impressive when considering that it comes as consumers have recently encountered fiscal restraint in the forms of higher taxes and reduced federal spending.

Resilient Retail Sales Indicate Sustainable Economic Growth

October 2012 through April 2013

Source: U.S. Census Bureau.
For illustrative purposes only and does not represent any specific Lord Abbett mutual fund or any particular investment.

This positive spending trend should continue "generating spending growth sufficient to propel the overall economic recovery, sluggish as it will likely remain, and stand as proof against another recessionary dip," said Milton Ezrati, Lord Abbett Partner, Senior Economist and Market Strategist. In an environment similar to the one of past years, corporate earnings may continue to advance even with only moderate economic growth. And that is the backdrop against which equity prices have risen, but not, however, to the point of overextended valuations.

IMPORTANT INFORMATION

Past performance is no guarantee of future results. All indexes are unmanaged and do not reflect reinvestment of dividends and distributions, deduction of management fees, or operating expenses. An investor cannot invest directly in an index.

No investing strategy can overcome all market volatility or guarantee future results.

Earnings per share is the portion of a company’s profit allocated to each outstanding share of common stock.

P/E ratio represents the price of a stock divided by its earnings per share.

The S&P 500^® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.

The opinions in Market View are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

Market View: TIPS and Traps

Mon, 13 May 2013 00:00 EDT

May 13, 2013

High correlations with Treasuries present a risk.

Ever since the Federal Reserve began its quantitative easing (QE) program in November 2008, investors have been worried about rising rates of inflation. The adoption of Fed-like policies in other developed economies has only heightened the concern. But with the U.S. Consumer Price Index (CPI) running at just 1.5% over the past 12 months (as of March 2013), investors’ fears have not been realized.

Funds have poured into Treasury Inflation-Protected Securities (TIPS) since QE began, causing the yield on 10-year TIPS to plummet. In 2011, those yields turned negative, and are currently -0.46% as of May 10, 2013.

Treasury and TIPS Yields Are Near All-Time Lows

(as of 5/10/2013)

Source: Bloomberg.

The historical data are for illustrative purposes only, do not represent the performance of any Lord Abbett mutual fund or any particular investment, and are not intended to predict or depict future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Investors may experience different results. Due to market volatility, the market may not perform in a similar manner in the future.
Past performance is no guarantee of future results. Like traditional Treasury bonds, Treasury Inflation-Protected Securities (TIPS) are issued by the U.S. Treasury and are guaranteed by the U.S. government. Although, TIPS are inflation-linked bonds that are fixed-income securities whose principal value is periodically adjusted according to the rate of inflation. In contrast, a Treasury bond’s principal value is fixed. TIPS can be volatile and decline in value over the short term. This typically happens when interest rates rise.

Market Monitor

Major equity and fixed-income benchmarks for the week ended Friday, May 10, 2013

Investors may not realize, however, the risk they are taking on when they purchase TIPS. Unlike many other forms of inflation protection, TIPS are highly correlated with Treasuries. Over the period from March 31, 1997, to March 31, 2013, for example, TIPS and Treasuries had a positive correlation of 0.64.

TIPS Are Positively Correlated with Treasuries¹

(03/31/1997 - 03/31/2013)

Source: Zephyr.
¹ Barclays U.S. Government Bond Index. ² Barclays U.S. Treasury: U.S. TIPS Index. ³ BofA Merrill Lynch U.S. Cash Pay High Yield Index. ⁴ BofA Merrill Lynch All Convertibles All Qualities Index. ⁵ MSCI EAFE Index. ⁶ S&P 500 Index. ⁷ Credit Suisse Leveraged Loan Index. ⁸ Deutsche Bank Breakeven 5-year CPI Swaps Index. CPI swap correlations calculated from the inception of the index, January 2004 through March 2013.

The historical data are for illustrative purposes only, do not represent the performance of any Lord Abbett mutual fund or any particular investment, and are not intended to predict or depict future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Investors may experience different results. Due to market volatility, the market may not perform in a similar manner in the future.
Past performance is no guarantee of future results. Bond prices move inversely to interest rates: when interest rates rise, bond prices fall, and when rates fall, bond prices rise. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. High-yield securities carry increased risks of price volatility, illiquidity, and the possibility of loss in the timely payment of interest and principal. Stock prices fluctuate, sometimes rapidly, and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Floating-rate loans are lower-rated, higher-yielding instruments, which are subject to increased risk of default and can potentially result in loss of principal. Convertible securities have both equity and fixed-income risk characteristics.

This may stem not only from their similar durations but also from the way TIPS work. Rather than adjusting the interest payments directly to keep pace with inflation, TIPS adjust the principal. This new amount is then used to calculate new interest payments. Applying the coupon rate to the adjusted principal, then, results in minimal additional income, making TIPS a less than optimal inflation hedge. In addition, this minimal adjustment to the interest payment results in little new income to invest at higher rates, and this also detracts from TIPS' appeal.

Other forms of inflation-hedging that are negatively correlated with Treasuries may offer greater protection. Historically, high-yield bonds, stocks, and convertible bonds have all had negative correlations with Treasuries. The negative relationship of floating-rate loans and CPI swaps with Treasuries is even stronger.

The strong negative correlations of floating-rate loans and CPI swaps with Treasuries stem largely from their direct ties to interest rates and the rate of inflation, according to Zane Brown, Lord Abbett Partner and Fixed Income Strategist. "The yield on floating rate loans adjusts upwardly with the rise in interest rates, while the value of CPI swaps responds directly to inflation expectations."

IMPORTANT INFORMATION

A Note about Risk: The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. The value of investments in fixed-income securities will change as interest rates fluctuate. As interest rates fall, the prices of debt securities tend to rise, and as interest rates rise, the prices of debt securities tend to fall. Investments in high-yield securities (sometimes called junk bonds) carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Income from municipal securities may be subject to the alternative minimum tax. Federal, state, and local taxes may apply. There is a risk that a bond issued as tax-exempt may be reclassified by the IRS as taxable, creating taxable rather than tax-exempt income. Bond may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. No investing strategy can overcome all market volatility or guarantee future results.

Investing in international securities generally poses greater risk than investing in domestic securities, including greater price fluctuations and higher transaction costs.

Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.

Derivatives may be riskier than other types of investments because they may be more sensitive to changes in economic or market conditions than other types of investments and could result in losses that significantly exceed the original investments.

The correlation of various indexes or securities against one another or against inflation is based upon data over a long time period. These correlations may vary substantially in the future or over shorter time periods, resulting in greater volatility.

Although U.S. government securities are guaranteed as to payments of interest and principal, their market prices are not guaranteed and will fluctuate in response to market movements.

The Barclays U.S. Government Bond Index is a market value-weighted index composed of all publicly issued, nonconvertible, domestic debt of the U.S. government or any agency thereof, quasi-federal corporations, or corporate debt guaranteed by the U.S. government. Flower bonds and pass-through issues are excluded. Total return consists of price appreciation/depreciation plus income as a percentage of the original investment. Indexes are rebalanced monthly by market capitalization.

The Barclays U.S. Treasury: U.S. TIPS Index consists of inflation-protection securities issued by the U.S. Treasury. Securities must have at least one year to final maturity.

The BofA Merrill Lynch U.S. Cash Pay High Yield Index tracks the performance of U.S. dollar-denominated below investment-grade corporate debt, currently in a coupon paying period that is publicly issued in the U.S. domestic market.

The BofA Merrill Lynch All Convertibles, All Qualities Index contains issues that have a greater than $50 million aggregate market value. The issues are U.S. dollar-denominated, sold into the U.S. market, and publicly traded in the United States.

The MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the United States and Canada. The MSCI EAFE Index consists of the following 22 developed market country indexes: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom.

The S&P 500^® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.

The Credit Suisse Leveraged Loan Index is designed to mirror the investable universe of the U.S. dollar-denominated leveraged loan market. The CS Leveraged Loan Index is an unmanaged, trader-priced index that tracks leveraged loans. The CS Leveraged Loan Index, which includes reinvested dividends, has been taken from published sources.

The Deutsche Bank Breakeven 5-Year CPI Swaps Index is provided by Deutsche Bank AG and is based in U.S. dollars, provides intraday price frequency, and is subject to a one-day lag. It is designed to track the performance of five-year CPI swaps.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

Duration is a measure of the sensitivity of the price of a fixed-income asset to a change in interest rates and is expressed in years.

A Consumer Price Index swap references the Consumer Price Index (CPI), which is a measure for estimating inflation by referencing changes in the price levels of a standard basket of goods. Because inflation equates to a diminished value of a currency, a CPI swap may be entered into in order to manage the effect of inflation upon the value of the portfolio.

Treasury Inflation-Protected Securities (TIPS) are Treasury bonds that are designed to provide protection from inflation. The principal is adjusted upward in line with the inflation rate.

Yield is the annual interest received from a bond and is typically expressed as a percentage of the bond's market price.

Correlation is a statistic that measures the degree of association between two variables.

Market View: Attractive Dividends? Earnings Growth? A Way to Get Both

Mon, 6 May 2013 00:00 EDT

May 6, 2013

International equities provide broader opportunities for combining appealing divided yields and earnings growth.

While the low-interest rate environment has heightened investors' interest in high-dividend stocks, attaining these dividends often requires a trade-off with earnings growth. Indeed, U.S. sectors with the largest concentration of high-dividend stocks, such as the utilities sector, traditionally experience minimal rates of profit growth.

Investors seeking total return opportunities from potential dividend income and capital appreciation might observe a different composition of attractive dividend stocks when they look overseas. For instance, the percentage of international stocks that pay a dividend of at least 4% is about double the percentage of U.S. stocks paying similar dividend rates.

More International Companies Pay Higher Dividends

Percentage of MSCI ACWI stocks with dividend yield of 4% or more and market capitalization of $1.5 billion or more

Source: MSCI All Country World Index. Data as of 03/31/13.
The historical data are for illustrative purposes only, do not represent the performance of any Lord Abbett mutual fund or any particular investment, and are not intended to predict or depict future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Investors may experience different results. Due to market volatility, the market may not perform in a similar manner in the future.
Past performance is no guarantee of future results. Investing in international securities generally poses greater risk than investing in domestic securities, including greater price fluctuations and higher transaction costs. Special risks are inherent to international investing, including those related to currency fluctuations and foreign, political, and economic events.

Market Monitor

Major equity and fixed-income benchmarks for the week ended Friday, May 3, 2013

Although the representation of high-dividend stocks in U.S. and international market sectors may be similar on a percentage basis, there are simply more international companies within these sectors. Therefore, every major sector category consists of far more international companies that pay a dividend of 4% or more, including sectors that historically experience faster rates of earnings growth. For example, there are more than three times the number of international information technology stocks that pay a dividend of 4% or more when compared with U.S. stocks in the information technology sector.

International Markets Offer More Total Return Opportunities

Number of stocks by sector with dividend yield of 4% or more and market capitalization of $1.5 billion or more

From the perspective of potential capital appreciation, "earnings among the universe of international equities with above-average dividend yields and below-average valuations have been resilient," said Vincent McBride, Lord Abbett Partner & Director of International Equity. "As a result, the dividends and dividend growth rates among this universe have been resilient as well."

IMPORTANT INFORMATION

Past performance is no guarantee of future results. Current performance may be higher or lower than the performance data quoted. All indexes are unmanaged and do not reflect reinvestment of dividends and distributions, deduction of management fees, or operating expenses. An investor cannot invest directly in an index.

Foreign securities generally pose greater risk than domestic securities, including greater price fluctuations and higher transaction costs. Foreign investments also may be affected by changes in currency rates or currency controls. With respect to certain foreign countries, there is a possibility of nationalization, expropriation, or confiscatory taxation, imposition of withholding or other taxes, and political or social instability that could affect investments in those countries. The securities markets of emerging countries tend to be less liquid, to be especially subject to greater price volatility, to have a smaller market capitalization, and to have less government regulation, and may not be subject to as extensive and frequent accounting, financial, and other reporting requirements as securities issued in more developed countries. Further, investing in the securities of issuers located in certain emerging countries may present a greater risk of loss resulting from problems in security registration and custody or substantial economic or political disruptions. Foreign currency exchange rates may fluctuate significantly over short periods of time. They generally are determined by supply and demand in the foreign exchange markets and relative merits of investments in different countries, actual or perceived changes in interest rates, and other complex factors. Currency exchange rates also can be affected unpredictably by intervention (or the failure to intervene) by U.S. or foreign governments or central banks, or by currency controls or political developments.

While municipal bonds are backed by municipalities, U.S. government securities, such as U.S. Treasury bills, are considered less risky since they are backed by the U.S. government. High-yielding, non-investment-grade bonds (junk bonds) involve higher risk than investment-grade bonds. Adverse conditions may affect the issuer’s ability to pay interest and principal on these securities.

Although U.S. government securities are guaranteed as to payments of interest and principal, their market prices are not guaranteed and will fluctuate in response to market movements.

Dividends are not guaranteed and may be increased, decreased, or suspended altogether at the discretion of the issuing company.

Dividend yield is a ratio that reflects how much a company pays in equity dividends relative to the price of its stock.

The MSCI ACWI Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The MSCI ACWI consists of 45 country indexes comprising 24 developed and 21 emerging market country indexes. The developed market country indexes included are: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom and the United States. The emerging market country indexes included are: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

Market View: Munis—Watch This Yield Sign

Mon, 29 Apr 2013 00:00 EDT

April 29, 2013

The rising ratio of muni yields to Treasury yields indicates that tax-exempt bonds could outperform if Treasuries encounter volatility.

The yields on municipal bonds traditionally have been below those on comparable Treasury securities because of investors' willingness to accept lower yields in exchange for munis' exemption from federal income taxes.

But the financial crisis distorted many historical relationships, including the traditional ratio of muni yields to Treasuries, and that distortion has become more prominent over the past several years. After briefly dropping below 100% in early 2013, the ratio of 10-year municipal bond yields to 10-year Treasury yields recently climbed above 110% as of April 23, 2013, according to Bloomberg.

The prominence of this new relationship could have a couple of ramifications for investors. The first is that, as most fixed-income yields continue to compress toward Treasury rates, investors might obtain the benefit of munis' tax exemption for relatively little cost—or potentially no cost—in yield.

Muni Yield Ratios Have Headed Higher Recently

Based on 10-year 'AAA'* municipal bond yields divided by 10-year Treasury yields,
04/01/2009-04/23/2013

Source: Bloomberg.
Income from municipal bonds may be subject to the alternative minimum tax. Federal, state, and local taxes may apply. There is a risk that a bond issued as tax-exempt may be reclassified by the IRS as taxable, creating taxable rather than tax-free income. Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes. Past performance is no guarantee of future results.
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
*As rated by Standard & Poor's, Moody's, and/or Fitch. **10-Year AAA Muni yield divided by 10-Year Treasury yield.
The 10-Year Treasury Yield is represented by the Bloomberg Generic United States 10 Year Government Note (GT10) Index, which tracks the price and yield of United States government debt with a maturity of 10 years.
The 10-Year AAA Municipal Bond is represented by the Bloomberg Fair Value Municipal General Obligation AAA 10-Year Index, which tracks the price and yield of all general obligation municipal debt securities with a maturity of 10 years. For illustrative purposes only and does not represent any specific Lord Abbett mutual fund or any particular investment.

A second ramification relates to potential market performance if the yield relationship between munis and Treasuries were to revert to its historical average. This reversion could occur with an increase in Treasury yields—which is one of the most pressing concerns for fixed-income investors in the current environment—while municipal yields might increase to a lesser extent, or even remain stable.

Market Monitor

Major equity and fixed-income benchmarks for the week ended Friday, April 26, 2013

One reflection of this potential stability compared to Treasuries has been a standard deviation on the 10-year segment of the municipal market that was 309 basis points lower than that of the 10-year Treasury securities over the past 10 years ended March 31, 2013 according to Morningstar.

Meanwhile, there are some technical aspects within the muni market that may continue to lend support. Specifically, most of the newly issued securities in the market are related to refinancing transactions, where one bond essentially replaces another. Thus, the supply entering the market is not likely to overwhelm investor demand for tax-exempt debt.

Most Newly Issued Securities Have Been Tied to Refinancing Transactions

Data as of 02/28/2013

Source: Securities Industry and Financial Markets Association and Thomson Reuters.
Excludes maturities of 13 months or less. Data are available on a month lag.

The increased frequency of refinancing transactions, however, does raise obstacles for individual investors. "The large volume of refinancing-related issuance underscores the risk that individual investors are facing when their bonds are being called away, thus leaving them with the challenging task of reinvesting the returned principal in the current low-rate environment," said Dan Solender, Lord Abbett Partner & Director of Municipal Bonds. Therefore, investors might take advantage of the recent increase in municipal yield ratios through an active strategy that can manage refinancing risk on an ongoing basis.

IMPORTANT INFORMATION

Although U.S. government securities are guaranteed as to payments of interest and principal, their market prices are not guaranteed and will fluctuate in response to market movements.

A basis point is one one-hundredth of a percentage point.

Standard deviation is a measure of dispersion. It indicates the amount by which a set of values differs from the average.

The credit quality ratings of the securities in a portfolio are assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor's, Moody's, or Fitch, as an indication of an issuer's creditworthiness. Ratings range from 'AAA' (highest) to 'D' (lowest). Bonds rated 'BBB' or above are considered investment grade. Credit ratings 'BB' and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer’s ability to pay interest and principal on these securities. Credit quality distributions breakdown is not an S&P credit rating or an opinion of Standard & Poor's as to the creditworthiness of the portfolio.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

Quarterly Roundtable—The Cyprus Surprise

Tue, 23 Apr 2013 08:00 EDT

As the third-smallest economy in the European Union, Cyprus is easy to overlook. But the agreement to bail out the country’s banks may mark a big change in the way future rescues are handled. The agreement is the first since the eurozone debt crisis began in 2009 that imposes losses on uninsured depositors. Until the Cyprus bailout, government officials had taken great pains to avoid penalizing depositors. Even in the United States, at the height of the subprime meltdown (2008–09), officials went to extra lengths to avoid such losses, raising federally insured amounts, from $100,000 to $250,000, and even temporarily protecting deposits, such as those in money market funds, which were not previously insured—all in an effort to stem any possible run on financial institutions.

Should uninsured depositors everywhere now be worried, or is a Cyprus-type bailout a one-time event? Is there any risk of contagion to the U.S. market? All across Europe, economies are struggling, posing a threat to efforts at reform. What, then, is the outlook for continued progress?

Addressing these and other questions in this quarter’s roundtable discussion are Lord Abbett Partners Milton Ezrati, Senior Economist and Market Strategist; Zane Brown, Fixed Income Strategist; and David Linsen, Director of Domestic Equity Research.

Q: How consequential is the Cyprus situation and the form of the bank bailout?
Zane Brown: I imagine there have been some runs on deposits in Spain and Italy, but the reaction in Europe, including the periphery, as well as in the United States, has been surprisingly modest. We have seen very little increase in Spanish or Italian bond yields, which is where you would expect to see reaction surface.

David Linsen: I think the resolution has produced very little reaction because it was sold effectively as a unique event. And the markets showed confidence in the statement to that effect by the Eurogroup of finance ministers.¹ So there was little reaction because investors and depositors elsewhere in Europe were convinced that deposits in peripheral Europe are safe.

Brown: It was helpful that [European Central Bank president] Mario Draghi also reassured people that the Cyprus crisis is a unique situation. That statement became necessary after Jeroen Dijsselbloem, president of the Eurogroup of finance ministers, appeared to call the Cyprus solution a template for future bailouts.

Milton Ezrati: The real drawback to the eurozone’s approach to these situations is that every time there is a crisis, they reinvent the wheel. So, when the crisis flares up, no one knows what the rules are. Nobody knows who will be required to take losses: depositors, investors, or taxpayers. Insured depositors initially were told that they would have to contribute to the bailout—and only after they protested were their deposits protected.

The statement by Draghi last summer—that he would do “whatever it takes” to keep the eurozone together—has helped credit markets remain calm throughout this period. But if every crisis resolution follows different rules, then no one knows who will pay for future bailouts.

Brown: The Cyprus situation has focused attention on the importance of the capital structure of banks and on the priority that parties have in the case of a bankruptcy. And the solution, which was consistent with the principles of bankruptcy law, protected insured depositors, wiped out equity holders, and gave bondholders some equity. Uninsured depositors took a big hit, but also received some equity.

Ezrati: In effect, it was a bankruptcy. It was the closest thing the eurozone has had to a proper bankruptcy since the bailouts began. And as in a bankruptcy, the uninsured depositors were given priority even over holders of senior debt, so they were first in line to receive stock. To some extent, the Cyprus solution is a template for the future—it’s the “bankruptcy template.”

Brown: That’s right. I think the capital structure of other European banks is sufficient to protect uninsured depositors from losses. In other words, shareholders would get hit first, debt holders would be next, and only then would uninsured depositors take losses.

In Spain, some uninsured depositors converted their deposits into what are called preferentes, or preferred debt. Now they’re taking losses on that debt because there are several Spanish banks in financial trouble.

So, as in Cyprus, the situation in Spain is being handled in line with bankruptcy principles, but uninsured deposits will probably be safe because it is unlikely that the banks’ losses would be large enough to burn through all the equity and debt, as in Cyprus. These Spanish banks aren’t as weak as those in Cyprus.

Linsen: Unlike 2012, Spanish banks have not seen significant capital outflows and sovereign yields have continued to decline. If depositors were worried that they would have to help bail out the banks, there would be significant deposit outflows. But that isn’t happening. So depositors in Spain appear to view that risk as less than the risk faced by depositors in Cyprus.

Q: Is there any risk of a contagion to the U.S. market?
Ezrati: If there is any risk to the U.S. market, it is the European bank debt held by our financial institutions. If there is a financial link from Cyprus to the U.S. system, that’s it.

Brown: But U.S. financial institutions began to be wary of exposure to European banks as far back as 2009. Back then, money market funds, for example, had a lot of exposure to French banks. Since then, U.S. investors have been very careful about that exposure. So I’m not sure that is a serious issue.

Linsen: Our bank analyst Greg Wachsman has done an analysis of this, and he found that relative to U.S. bank capital ratios,² the exposure to the debt of the financially troubled countries of Europe is very small, and this comes at a time when those capital ratios have never been better. Of the largest U.S. banks, only five have significant exposure to Greece, Italy, Ireland, Portugal, and Spain. Combined, that net exposure is approximately $50 billion. But, assuming their hedges work, even if the exposure were written down to zero, then on average 10% of their Tier 1 common equity³ is at risk. Greg also pointed out that not all of the exposure is to banks and sovereigns; a significant percentage is to corporates. [See Table 1.]

Table 1. Exposure of U.S. Banks to Risky European Debt Is Manageable

Source: Company financial statements and Lord Abbett. Data as of December 31, 2012.
Gross exposure is the amount of debt from financially troubled countries of Europe held by the bank, excluding the effects of hedges. The countries include Greece, Italy, Spain, Portugal, and Ireland.
Hedges are securities held by the bank to offset the risk represented by the debt securities. Net exposure is the gross exposure minus hedges.
Sovereign debt is debt issued by a government. Other debt includes debt issued by corporations and other nongovernmental entities.
Source: Citi Research.

Q: Europe is in recession, and Italy has had difficulty forming a government since the election. How will this affect Europe’s reform efforts?
Ezrati: Europe’s reform effort hinges on Italy. Pier Luigi Bersani—whose party won the elections in February, but who lacks the majority needed to govern—has so far been unable to form a government. If he is unable to do so, then there will have to be another election.

If Bersani can form a government, or if there is another election and Bersani ends up in stronger position, then Italy will be back on the path of reform. Italy has been committed to reform and has been a leader in reform efforts. But if the country continues to fail in forming a government, then the rest of Europe could begin to doubt that commitment. The danger then will be whether that will influence the German election in September. German voters might start to ask themselves, “Why are we going along with reform when the people who need it aren’t committed to it?” That, to me, is the potentially disruptive development.

Italy was following the German model: apply austerity to the government and apply pro-market reforms to the economy so that fiscal stimulus is not necessary. This worked for Germany 10 years ago, and it is what the outgoing Italian prime minister Mario Monti had implemented. And Bersani said he would continue it. But I don’t know if it will work for Italy because Europe is weaker now, and the model combines immediate costs with gains that won’t occur except over the long term.

Brown: The euro, which is weakening, could help, however. It could boost exports for Germany and other major European exporters, and help the other countries become more competitive. As for the austerity, the worst is behind them, so any additional measures will probably be incremental. Reforms elsewhere in Europe are having some effect. In Spain, for example, deficits as a percentage of GDP [gross domestic product]⁴ have declined, from around 8–10% to around 6.7%, just short of the target of 6.3%. So that’s progress.⁵

Q: How will the U.S. economy likely to perform for the remainder of 2013?
Linsen: Last quarter, this group expected the economy to be soft in the first half; but first-quarter GDP is likely to surprise to the upside, given the strength in economic indicators in January and February. But, recently, some of the economic data have softened, and we may be about to see the annual spring soft patch that we’ve seen in the last few years.

Ezrati: The surprise in the first quarter was that the consumer was not affected by the rise in the payroll tax and the rise in oil prices. January and February were particularly strong. Consumer spending is very strong. Housing is strong. Auto sales have also been strong. Inventory replenishing may also contribute to a strong first-quarter GDP number, because in the fourth quarter of 2012, there was some inventory drawdown, which contributed to weaker growth.

Brown: Many people are suggesting that real GDP growth could reach 3% quarter-over-quarter in the first three months on an annualized basis. Consumer spending has been so strong partly because of housing and the wealth effect. And I think the Federal Reserve deserves some credit for keeping mortgage rates so low. That enables people to buy houses and, more important, to refinance existing mortgages, which frees up consumers to spend more. Three-quarters of mortgages today are refinancings.⁶

Ezrati: To give you an idea how much better off consumers are, the Fed says that just a few years ago the average American household dedicated 14% of its disposable income to debt servicing of all kinds. That’s now down below 10.5%, which is a 30-year low. That’s because of refinancings and cutting back on debt. Foreclosures are also included, but refinancing accounts for most of the drop. [See chart 1.]

Chart 1. Households Have Reduced Their Debt

Source: Federal Reserve Bank of St. Louis. Data as of October 2012.

And, according to the Fed, one-third of mortgages in the country have an interest rate above 5%. So there are many more potential refinancings out there, and there is room for this strength in consumer spending to continue.

Linsen: As strong as the first quarter was, the cold spring weather may have postponed some seasonal spending. When spring is colder than normal, consumers delay seasonal purchases. So that could positively affect consumer spending in the second quarter.

Ezrati: We could also see the slowdown that is implicit in the purchasing managers index⁷ from the ISM [Institute for Supply Management], which declined in March. The index is still above 50%, which indicates expansion, but it has declined, and that points to slower economic growth. So we will probably again see people expressing fears about a double-dip recession.

Brown: It also remains to be seen what the real impact of sequestration will be. Clearly, we haven’t yet seen any impact so far, but the job furloughs haven’t taken place yet. So I think sequestration could slow the economy in the second quarter.

Ezrati: Housing could eventually slow down this year, too. By my calculations, construction is outpacing sales now, which suggests construction may slow in the second half. That doesn’t mean it will decline in the second half, but it could moderate. If sales remain slow, then all the knock-on effects—purchases of furniture, remodeling, etc.—could also slow.

Also, consumers have been outspending their income for a while now. Their income has been growing by about 0.3% per month, and the spending has been growing by over 1% per month since late in the fourth quarter of 2012. So that suggests that unless they’re off to the races again—and I don’t think they have enough confidence in the economy for that—then they’re going to start slowing down to a pace that matches the growth in their income.⁸

Q: The stock market is up sharply this year. How is it likely to do for the rest of the year?
Brown: Corporate profit margins are unlikely to rise, since they are already very high, and a relatively strong dollar won’t help profits earned overseas. Also, we don’t expect economic growth to be very robust, so significant top-line growth is also unlikely. This all means that if the market rises from here, it is unlikely to be because of substantially higher earnings.

Any rise would most likely come from higher valuations. The S&P 500^® Index⁹ was up about 10% in the first quarter of 2013. If investors believe that next year will be better than this year, then valuation multiples could rise. If the price-earnings ratio¹⁰ on the S&P 500 is around 13.5 now, and it rises to just 14.5, then by the end of the year we could easily see a mid-teens return, around what we saw on the S&P 500 last year.

Linsen: The market leaders so far have been defensive sectors—health care, utilities, and consumer staples. But U.S. growth has accelerated, so, in your opinion, is the leadership of defensive stocks due to investors returning to equities, but primarily to sectors that are historically less risky, or is it a sign that investors are concerned about growth from Europe and China and have turned defensive?

Brown: I think it’s the former. I think people are looking for dividends. I think they are focusing on an easy way to get into the market, and they don’t want to take a great deal of risk. But they appear to be willing to take on more risk than last year. Last year, money flowed into slightly more risky fixed-income securities, and this year I think we’re seeing investors move into equities.

But more money is going into actively managed funds, not just index funds and ETFs [exchange-traded funds]. This suggests that people are making a conscious decision to have somebody manage their money in a way that targets particular parts of the market.

Linsen: I’ll raise a third possibility: Could it also be that given a likely upside surprise in first-quarter GDP, as well as better-than-expected jobs growth, that the market is anticipating Fed tightening?

Ezrati: I don’t think investors are anticipating that yet. I think the Fed’s tightening is too far out for the market to be anticipating it at this point.

Let me reinforce what Zane said about the first alternative. When I talk to the financial advisors when I’m on the road, they tell me that it’s difficult to talk their clients into an equity fund because people are still too frightened. But their clients are willing to listen to stories about individual stocks, and the stories that are most appealing are those related to income investing. I think this suggests that people are willing to invest in stocks, if those stocks are defensive.

Brown: The “great rotation” out of bonds that many people have talked about, however, is not happening. People are not selling their fixed-income funds, but they are selling their money market funds. And the money that has gone into equity funds in the first 10 weeks of this year has averaged about $5–6 billion per week. About the same amount has gone into fixed income.¹¹ So there hasn’t been a big slowdown in fixed income, but there has been a big jump in equities. Why are investors moving into equities? They may believe that risks such as those in Europe are less now.

Ezrati: I think it’s that they are not getting paid much to buy fixed income.

Linsen: If the strong growth that is anticipated in the first quarter continues through the rest of the year, the market will begin to anticipate Fed tightening, and that would call for a different investor playbook. But if the economy continues to muddle along, then investors may continue to seek dividend yields¹² for an extended period.

Brown: On the fixed-income side, investors may want to consider staying away from longer-term securities and top tiers of investment grade. Because, as David suggested, at some point the Fed is going to unwind QE [quantitative easing]. When the Fed starts to signal that it is going to start to do that, the market will likely move away from anything longer than 10 years, and yields will rise sharply. In March, when there was a rumor that some on the FOMC [Federal Open Market Committee] wanted to end QE before the end of the year, the yield on the 10-year Treasury went from 1.85% to 2.05% in two days. So there is that cloud hanging over the long end of the higher quality tiers of the fixed-income market.¹³

But the Fed doesn’t want the yield on the 10-year Treasury to get to 2.5% because mortgage rates would then rise to 4.5%, and that would harm the housing recovery. So the unwinding of QE is likely to happen slowly, and it will hang over the market for a long time. So investors may want to consider lower maturities and floating-rate loans, high-yield bonds, the lower tier of investment grade, or short duration.

When the Fed does begin to tighten, the effect is likely to be different than in previous tightening cycles. In the past, the Fed would raise short-term rates, and that would begin to flatten the yield curve. When the Fed begins to tighten this time, the opposite could happen. Because of QE, which has targeted long-term rates, the long end of the yield curve could rise, which could mean a steepening of the curve. So that would create different opportunities from those we have seen historically.