NEW YORK (TheStreet) - Carlyle Group (CG - Get Report) co-founder William E. Conway has a refreshing long-term take on why investors shouldn't fear the Federal Reserve's tapering of its bond buying program.
The analysis, released on Wednesday, is a worthy read for investors who might be unclear about how to think about their investments heading into 2014.
The Fed's taper and an expected rise in long-term interest rates might not disturb stock markets and corporate valuations as much as some market watchers expect, according to Conway. "While a sharp sell-off in 2014 is surely possible, we think today's high prices are likely to be sustained for some time," Conway writes in the report co-authored with colleague Jason M. Thomas.
He raises a few important dynamics that may buffer stock market valuations.
Low interest rates are partly the result of the Fed's unprecedented easing, which has grown the central bank's balance sheet from $800 billion in assets prior to the crisis to a current size of nearly $4 trillion. Conway, however, believes the Fed's efforts aren't the only explanation for today's near-record low corporate interest rates. An alternate reason is a general lack of supply of financial assets for investors to bid upon.
Bond markets have been booming in recent years, but the issuance of new corporate debt has been notably low. Instead, corporations have used falling interest rates to refinance existing debts. In 2013, corporations also began increasing their leverage as a means to finance share repurchases or increase dividends. Still, the amount of new debt hitting markets may be far too little to meet investor demand.
With limited supply of new debt and rising demand for assets that yield a return, it is no surprise corporate bond rates have fallen so far. Those factors, however, are more indicative of a continued recovery in corporate confidence and growth expectations five years after the worst recession since the Great Depression.
Basically, corporations remain scared and unwilling to invest in new projects, by historical standards, indicating a slack in the economy. That slack and a consequent undersupply of financial assets help to keep interest rates low by historical standards. After speaking with many high-placed dealmakers, TheStreet noted such a scenario last November.
It is hard not to argue that low corporate interest rates and low discount rates used by investors to value assets are supporting both corporate earnings and overall market valuations. The fear, however, is that as the Fed tapers its bond buying, interest rates will rise in a manner that undermines those earnings and valuations. That's the conventional wisdom of investors that expect a market drop in 2014.
Conway, co-chief executive officer of Carlyle Group, one of the world's largest asset managers and a long-term investor in companies across many industries, doesn't believe the Fed's taper will play out in such a simplistic or dire manner. His alternate explanation of low corporate interest rates, which homes in on a lack of financing activity by corporations and a lingering slack in the economy, provides for a more optimistic outlook on higher interest rates.
Put simply, interest rates may rise as corporations begin to perceive better opportunities for growth and finance new investments and projects. That could increase the supply of financial assets available to investors, potentially causing rates to rise as demand for any individual asset becomes more diffuse.
"Today's high valuations are the product of low discount rates, which are anchored by a structural excess of savings over investment. The most likely scenario in which discount rates would rise would be one in which business investment increases to shrink the pool of excess savings," Conway writes.
In this environment, rates would rise, but so would corporate earnings as firms expand their businesses and pursue new projects. Discount rates and the terminal values that many investors use when pricing assets will be impacted.
Conway sees the latter as reason for investors to re-dedicate their efforts on identifying best-of-breed investments -- so-called "alpha" -- as asset prices between poor and well-run organizations begin to diverge after a significant convergence in recent years.
"After enjoying a spectacular ride from 'beta' over the past two years, investors should focus on 'alpha.' Incremental outperformance is most valuable when expected returns are low. Incremental returns from today's high prices will require superior investment selection and company management," Conway notes.