Bridgewater Daily Observations
October 16, 2013
Equity Investors Are Discounting Continued Growth and Expanding Liquidity
As you know, we view the pricing of assets as reflecting discounted economic scenarios, with their returns driven by how these discounted scenarios are changing. Within the equity market, there is significant variation in the nature of the cash flows across companies. As a result, differences in the performance of different types of companies can be indicative of the nature of the economic environment that is being discounted. At a high level, US stocks are discounting solid growth rates, low and stable inflation, and an abundant flow of liquidity. This is a modestly more bullish picture than what we have seen recently in economic stats. Of course, the pricing of markets reflects what is discounted, not necessarily what is happening or will happen, and these prices are formed by buying and selling, which is affected by squeezes and other forces. At this point in time, however, what is discounted in equity markets is broadly consistent with our views. Though we expect some short-term wiggles (especially related to the government shutdown), we broadly expect growth to continue at a moderate pace, fast enough to sustain the current pace of normalization in output and debt levels. Liquidity should also remain plentiful, supported by the continued printing of money by the Fed and an increasing amount of private sector credit creation.
The equity market can be deconstructed into various sets of companies whose cash flows reflect exposures to differing economic conditions. The performance of each of these sectors is indicative of what is going on with overall economic growth, its components and its drivers. At this point, performance suggests a growth picture that is modestly more bullish than would be implied by recent economic statistics, as indicated by the slowdown in our most recent aggregate measure of growth. Equity investors appear to be looking past the short-term wiggles.
Equity markets are discounting that growth will be sufficient to gradually lead to normalization of the economy. Further, the combination of moderate growth, led by the consumer, with abundant liquidity, weak capital spending, an interest-rate sensitive housing market and no inflation pressure is inconsistent with the magnitude of the rise in long-term and short-term interest rates that is currently discounted in the forward interest rate markets. A late cycle rise in interest rates is typically triggered when the demand for capital rises while the supply of capital contracts and inflation pressures mount, whereas equity markets are discounting weak demand for capital, plenty of supply and no inflationary pressure. As mentioned above, prices reflect what is discounted, but are formed by buying and selling, which includes an element of forward-looking fundamental analysis mixed in with numerous other forces. Given how prices are formed it is not unusual for different markets to discount different economic scenarios, and we see some of that going on now.
Assistant State Treasurer
Chief Investment Officer
State of Louisiana
Department of the Treasury