Sunny Economic Skies, But Fed to Remain Hawkish

by: J.D. Steinhilber

In addition to a supportive economic backdrop, record levels of cash acquisition and stock buyback activity continue to provide a very bullish liquidity dynamic and a favorable tailwind for the stock market. 2006’s total cash acquisitions of $469 billion is the highest annual amount ever, coming in 67% above the previous record: 2005’s $281 billion.

Net of new equity public offerings of $143 billion, cash acquisitions shrank the U.S. equity supply base by a record $326 billion for the full year 2006. Stock buyback activity also rose to a new record in 2006, totaling over $400 billion.

This amount is two times the level of cash dividends paid by U.S. companies in 2006 and is three times the dollar volume of shares repurchased just three years ago. Stock repurchases by public corporations are partially offset by new equity created from option-based incentive programs, but buybacks are also contributing significantly to the shrinkage of equity supply.

In combination with cash-for-stock acquisitions, stock buybacks provide a powerful supply/demand driver for stock prices due to their shrinkage of the “float” of U.S. stocks, which have an aggregate market capitalization of approximately $16 trillion.

Bond prices have had to adjust to a brighter economic outlook and the reality that the Fed is not going to be easing anytime soon. Since the beginning of December, the 10-year Treasury yield has backed up from 4.43% to 4.76%. However, long-term interest rates remain well below their summer highs, when the 10-year peaked at 5.25%, so unless rates rise substantially from here, the recent sell-off in the bond market is not expected to impede progress in the equity market. We continue to see little value in longer-term Treasuries at current yield levels, and with markets pushing out the timetable for a possible Fed easing, money markets and short-term high-grade bonds continue to look like the most attractive place to be in the fixed income markets.

No Sign of Fed Easing

Money markets outperformed 10-year Treasuries in 2006, and we expect that to again be the case in 2007. There is absolutely no reason for the Fed to signal a move towards an easier policy stance at this juncture. It would be damaging to the Fed’s credibility to ease monetary policy while core inflation remains above the Fed’s target range and with financial markets already highly stimulated. Just by going on hold last August, the Fed prompted a significant rally in the financial markets, which has had the effect of loosening financial conditions.

In our view, it would be a policy mistake for the Fed to throw more fuel on that fire. By remaining hawkish on inflation, the Fed has kept inflation expectations in check and supported prices at the long end of the yield curve, which has contributed to an orderly correction in the housing market. With the employment market tight and little evidence that weakness in housing and manufacturing is spreading more broadly in the economy, there should be minimal political pressure on the Fed in the near term to ease monetary policy.

A Fed preparing to ease is not a precondition/requirement for stocks to continue to perform well. A healthy stock market can continue if the Fed simply stays on hold provided the economy remains on track for a soft landing, which has to be viewed as the baseline assumption.