Permanent Value

Week in Review 07/01/13

Bruce Doole
July 2nd, 2013

Q& A: JOHN SMET DISCUSSES THE ECONOMY AND INTEREST RATES

 
Q: After spending the better part of 2012 range-bound, rates have risen in recent weeks. Is this the beginning of a sustained rise in rates?

A: Yes, I think it is. I believe we are in the early phase of a period in which we will see a normalization of monetary policy and interest rates. Currently, we have negative real interest rates in the shorter maturities and very low real rates in longer maturities. Overall, I would not be surprised to see interest rates rise by two percentage points across intermediate and longer maturities in the next three to four years.

I’m quite bullish on the U.S. economy. Housing and autos are in solid recoveries, consumer balance sheets are in better shape, and I believe we’re going to have fewer headwinds from state and local governments as they gradually increase employment and, in some cases, expenditures. In this environment, I think we can grow gross domestic product at 2% to 2.5% for 2013 and 3% to 3.5% in subsequent years. That kind of growth will probably lead to lower budget deficits.

Q: How dependent is housing on interest rates, and if rates start to rise, could housing suffer a setback?

A: Even if mortgage rates go up by two percentage points they’ll be going up from ultra low rates to just low rates, so I don’t think that’s going to stop people from buying houses. Housing construction in this country has seen a sharp rise from very low levels, but construction could even double from here and we’d still not have too many houses built. We didn’t build many houses from 2008 to 2012, but household formation has been increasing since 2011.

Q: Do you see some level of business confidence returning in the economy? Can we expect to see increases in capital expenditures and hiring?

A: Some of the consumer confidence numbers are at multi-year highs, so the consumer has gotten more optimistic. I think you’ve seen big increases in temporary workers, and you’ve seen employment increase by 175,000 jobs in May, which is not a bad number but it’s not 300,000.
So I would characterize what we’re hearing from CFOs as cautious optimism. Moreover, when you look at manufacturing, it’s more productive, so you don’t have to hire nearly as many workers as in prior economic recoveries. I do think we’re going to see business investment go up and household investment continue to go up. It’s going to be slow, but I do think confidence is building. Another important source of growth for the economy could come from state and local governments, which have in fact been negative contributors over the last few years due to layoffs and tighter spending. But over the next couple of years we could see state and local governments start hiring people again.

Q: How much influence does the Fed have, at this point, on long term rates? Can it slow down a rapid climb if one occurs?

A: The Fed has every incentive to keep rates rising slowly to ensure the economy remains on the path of a steady recovery. It also would not want mortgage rates going up 200 basis points very quickly. The economy just isn’t strong enough to withstand that kind of rapid increase. So what tools does the central bank have? Well, the Fed can buy more securities. Policymakers can also tell the market that they’re committed to keeping rates steady. I think they have a lot of power to keep rates from going up too dramatically.

Q: Financials are the largest component of the corporate bond market. Are we past the point of crisis in the banking sector?

A: The capital base of banks has improved tremendously in the last couple of years. Profitability and capital generation by the banks has also risen substantially. The largest danger to the banks was a systemic crisis in Europe, and we came close to that in 2011. But I think we are past the crisis point. The backstops that the European Central Bank has provided have gone a long way in bringing back the confidence of investors, which is quite important.

(John Smet is a fixed-income portfolio manager based in LA. He has portfolio management responsibilities in The Bond Fund of America and Intermediate Bond Fund of America, among others.)

Source: American Funds Distributors, Inc.