The External-Event Factor

{Q} Have you noticed any increased reactions to bond prices?

{A} Two things struck me as very interesting about that. One is that it didn’t come as a surprise to us. We have been expecting bond yields to move back up to between 5 percent and 5.25 percent for some time. That’s been our forecast for 6 to 12 months now. We were underweighted in bonds, and we were defensively positioned in the exposure we did have.

Wall Street took a very different view: The economy is soft, it’s going to remain soft, and the Fed is going to have to lower interest rates to offset it. What’s happened in the last two months is that it has become increasingly clear that the Fed has no intention of lowering interest rates.

 

{Q} What effect does that have on stocks?

{A} Now, people are thinking that if yields are a little bit higher, then maybe the advance in equity prices has to slow down a little bit. While we don’t think this increase in yields is going to go on uninterrupted, all of a sudden it’s raising questions about whether rates will get too high to allow the leveraging activity we’ve seen to continue to be profitable. Bond yields are very important because they make the cost of operating in the economy either cheaper or more expensive.

 

{Q} Where are the inflection points?

{A} I’ll go right back to interest rates. In my mind, that’s the most pressing issue that the markets will confront in the next 12 months. We have very little excess capacity in the United States and globally, whether you’re talking about labor markets or productive capacity in the manufacturing sector. We’re already seeing central banks around the world raising rates to offset what they perceive to be, perhaps, an inflationary threat.

{Q} Some private-equity deals are getting done at high valuations. Do you see that as an issue for the equity markets?

{A} I do, for a couple of reasons. There is no doubt that private equity has been one of the underpinnings of this market. A lot of individual companies have been taken private and it has boosted performance by making them more efficient in the process. That has also reduced the supply of equities. What concerns me about private equity is that it seems there is so much money yet to be put to work, and some deals that are getting done are a little sloppy.

 

{Q} In the past four or five years, we’ve seen a steady contraction in earnings multiples—particularly in large-cap stocks. Do you feel like this contraction makes this market a little stronger?

{A} I am concerned about the slowdown in earnings growth. I know we had a decent first quarter, but it was still consistent with the decelerating growth pattern year over year, and we expect this is going to continue. But having said that, it’s one of the reasons we happen to be attracted to large-cap stocks, and in particular mega-cap stocks. Their expected earnings growth this year is the best within the Standard & Poor’s 500. Plus, their valuations are cheaper than the rest of the market.

 

{Q} Here’s a question that’s a bit of a paradox: What unknown factor worries you the most?

{A} The unknown [factor] of how much leverage is truly in the global financial system as evidenced by all of these derivative instruments. How will the global financial system handle that if it all unwinds? There’s been such a proliferation of leverage in derivative securities that I don’t think anybody’s quite sure how it’s all going to react when there’s a time of financial stress.