Tag Archives: yields

Powell’s Revelation And A TIP For Defense

I think we would need to see a really significant move up in inflation that’s persistent before we even consider raising rates to address inflation concerns.” – Jerome Powell 10/30/2019

The recent quote above from Federal Reserve Chairman Jerome Powell is powerful, to say the least. We cannot remember a time in the last 30 years when a Fed Chairman has so clearly articulated such a strong desire for more inflation.

In particular, let’s dissect the bolded words in the quote for further clarification. 

  • “Really Significant”– Powell is not only saying that the Fed will allow a substantial boost to inflation but does one better by adding the word “really.”
  • “Persistent”– Unlike the prior few Fed Chairman who claimed to be vigilant towards inflation, Powell is clearly telling us that he will not react to inflation that is not only a “really significant” leap from current levels, but a rate that lasts for a while.
  • “Even Consider”– The language he uses here conveys the seriousness of the Fed’s commitment. The rise in inflation must not only be “really significant” but also “persistent.” Powell is saying both conditions must be met before they will even discuss rate hikes. A significant rise in inflation but one they do not deem to be persistent will not suffice. Nor would a persistent move in inflation but one they do not measure as significant. Both conditions must be present together based on his language.

We are stunned by the choice of words Powell used to describe the Fed’s view on inflation. We are even more shocked that the markets and the media are ignoring it. Maybe, they are failing to focus on the three bolded sections.

In fact, what they probably think they heard was:

I think we would need to see a move up in inflation before we consider raising rates to address inflation concerns.

Such a statement is more in line with traditional Fed-speak. The other alternative is that Powell has altered his language in so many different ways over the past year that nobody seems to be paying attention to his words anymore. If so, he has lost credibility.

This article presents Treasury Inflation-Protected Securities (TIPS) as a hedge against Jerome Powell and the Fed getting what they want.

Inflation and Stable Prices – Apples and Oranges

Before a discussion on using TIPS as a way to protect your investments from the deleterious effects of inflation, we need to examine how the Fed gauges inflation and debunk the narrative that terms inflation and price stability as one and the same. Price data going back about 250 years, as shown below, shows the stark difference between inflation and price stability.  

Data Courtesy: Lawrence H. Officer and Samuel H. Williamson, ‘The Annual Consumer Price Index for the United States, 1774-Present

The orange line plots annual price changes before the Fed was established in 1913. As shown, prices were volatile year to year, but cumulative inflation over the entire 138 year period was negligible at 23% or .15% annualized. Dare we say prices were stable?

Compare that to the era after the Fed’s creation (represented by the blue line above). Annual inflation rates were less volatile but largely positive. The cumulative growth of prices has been an astonishing 2491% in the post-Fed area, which equates to 3.1% annually. There is nothing stable about such massive price inflation. 

Here is another graph to shed more light on price stability.

Stable prices should be defined as prices that are constant. In other words, a dollar today can purchase the same basket of goods that it did yesterday. Inflation must be near zero over longer periods for this to occur.

The Fed’s definition of stable denotes a consistent rate of annual inflation. Based on their actions and words, they have little regard for the destruction of a dollar’s purchasing power caused by a steady inflation rate. The Fed benefits from this linguistic imprecision because it allows for economic expansion via the accumulation of debt while their Congressional mandates are achieved. This is why the Fed wants to produce inflation. It reduces the amount of debt on an inflation-adjusted basis. The Fed wants inflation but disguises it under the banner of price stability.

With Federal deficits now topping $1 trillion and corporate debt and consumer debt and financial liabilities at all-time highs as a percentage of GDP, we must think about hedging our equity and fixed income portfolios in case the Fed gets more inflation than the 2% goal they consider stable.

Despite what the Fed leads us to believe, they have little control over the rate of inflation and they do not know how to accurately measure it. As occurred 50 years ago, they can easily lose control of prices.

We urge you to focus on the forgotten leg of wealth, purchasing power. The opportunity costs of owning TIPS are minimal and the potential hedge value of TIPS tremendous. Change can happen in a hurry, and the only way to protect yourself or profit from it is to anticipate it.

The rest of this article is for RIA Pro subscribers only. If you are not a subscriber and want to learn about the mechanics of TIPS and how they can protect you in an inflationary or deflationary environment, please SIGN UP HERE for a 30-day free trial.

Powell’s Revelation And A TIP For Defense

I think we would need to see a really significant move up in inflation that’s persistent before we even consider raising rates to address inflation concerns.” – Jerome Powell 10/30/2019

The recent quote above from Federal Reserve Chairman Jerome Powell is powerful, to say the least. We cannot remember a time in the last 30 years when a Fed Chairman has so clearly articulated such a strong desire for more inflation.

In particular, let’s dissect the bolded words in the quote for further clarification. 

  • “Really Significant”– Powell is not only saying that the Fed will allow a substantial boost to inflation but does one better by adding the word “really.”
  • “Persistent”– Unlike the prior few Fed Chairman who claimed to be vigilant towards inflation, Powell is clearly telling us that he will not react to inflation that is not only a “really significant” leap from current levels, but a rate that lasts for a while.
  • “Even Consider”– The language he uses here conveys the seriousness of the Fed’s commitment. The rise in inflation must not only be “really significant” but also “persistent.” Powell is saying both conditions must be met before they will even discuss rate hikes. A significant rise in inflation but one they do not deem to be persistent will not suffice. Nor would a persistent move in inflation but one they do not measure as significant. Both conditions must be present together based on his language.

We are stunned by the choice of words Powell used to describe the Fed’s view on inflation. We are even more shocked that the markets and the media are ignoring it. Maybe, they are failing to focus on the three bolded sections.

In fact, what they probably think they heard was:

I think we would need to see a move up in inflation before we consider raising rates to address inflation concerns.

Such a statement is more in line with traditional Fed-speak. The other alternative is that Powell has altered his language in so many different ways over the past year that nobody seems to be paying attention to his words anymore. If so, he has lost credibility.

This article presents Treasury Inflation-Protected Securities (TIPS) as a hedge against Jerome Powell and the Fed getting what they want.

Inflation and Stable Prices – Apples and Oranges

Before a discussion on using TIPS as a way to protect your investments from the deleterious effects of inflation, we need to examine how the Fed gauges inflation and debunk the narrative that terms inflation and price stability as one and the same. Price data going back about 250 years, as shown below, shows the stark difference between inflation and price stability.  

Data Courtesy: Lawrence H. Officer and Samuel H. Williamson, ‘The Annual Consumer Price Index for the United States, 1774-Present

The orange line plots annual price changes before the Fed was established in 1913. As shown, prices were volatile year to year, but cumulative inflation over the entire 138 year period was negligible at 23% or .15% annualized. Dare we say prices were stable?

Compare that to the era after the Fed’s creation (represented by the blue line above). Annual inflation rates were less volatile but largely positive. The cumulative growth of prices has been an astonishing 2491% in the post-Fed area, which equates to 3.1% annually. There is nothing stable about such massive price inflation. 

Here is another graph to shed more light on price stability.

Stable prices should be defined as prices that are constant. In other words, a dollar today can purchase the same basket of goods that it did yesterday. Inflation must be near zero over longer periods for this to occur.

The Fed’s definition of stable denotes a consistent rate of annual inflation. Based on their actions and words, they have little regard for the destruction of a dollar’s purchasing power caused by a steady inflation rate. The Fed benefits from this linguistic imprecision because it allows for economic expansion via the accumulation of debt while their Congressional mandates are achieved. This is why the Fed wants to produce inflation. It reduces the amount of debt on an inflation-adjusted basis. The Fed wants inflation but disguises it under the banner of price stability.

With Federal deficits now topping $1 trillion and corporate debt and consumer debt and financial liabilities at all-time highs as a percentage of GDP, we must think about hedging our equity and fixed income portfolios in case the Fed gets more inflation than the 2% goal they consider stable.

Despite what the Fed leads us to believe, they have little control over the rate of inflation and they do not know how to accurately measure it. As occurred 50 years ago, they can easily lose control of prices.

We urge you to focus on the forgotten leg of wealth, purchasing power. The opportunity costs of owning TIPS are minimal and the potential hedge value of TIPS tremendous. Change can happen in a hurry, and the only way to protect yourself or profit from it is to anticipate it.

Part two of this article is for RIA Pro subscribers only. If you are not a subscriber and want to learn about the mechanics of TIPS and how they can protect you in an inflationary or deflationary environment, please SIGN UP HERE for a 30-day free trial.

TIPS Mechanics

Few investors truly understand the mechanics of TIPS, so let’s review the basics.

TIPS are debt securities issued by the U.S. government.  Like most U.S. Treasury securities, TIPS have a stated maturity and coupon. Unlike other securities, the principal value of TIPS adjust based on changes in the rate of inflation. The principal value can increase or decrease but will never fall below the bond’s initial par value. The semi-annual coupon on TIPS are a function of the yield of a like-maturity Treasury bond less the expected inflation rate over the life of the security, known as the break-even inflation rate.

The tables below compare the cash flows of a typical fixed coupon Treasury bond, referred to as a nominal coupon bond, and a TIPS bond to help further clarify.

The table above shows the cash flows that an investor pays and receives when purchasing a five-year bond with a fixed coupon of 4% a year. The investor initially invests $1,000 in the bond and in return receives $40 or 4% a year plus a return of the original investment ($1,000) at maturity. In our example, the annual return to the bondholder is 4%. While the price and yield of the security will change during the life of the bond, an investor holding the bond to maturity will be guaranteed the cash flows, as shown.

The TIPS table above shows the cash flows an investor pays and receives when purchasing a five-year TIPS bond with a fixed coupon of 2% a year. Like the fixed coupon bond, the investor initially pays $1,000 to purchase the bond. The similarities end here. Every six months the principal value adjusts for inflation. The coupon payment for each period is then calculated based on the new principal value (and not on the original par value. The principal value can adjust downward, but it cannot fall below the original value. This is an important safety feature that guarantees a minimum return equal to the coupon times the original principal value.  At maturity, the investor receives the final adjusted principal value, not the original principal value. Please note that if a TIPS is bought in the secondary market at a principal value exceeding its original value, the investor can lose the premium and returns can be negative in a deflationary environment.

In the hypothetical example above and excluding reinvestment of coupon payments, an investor in the nominal bond will receive $1,200 in cumulative cash flows over the life of the security. The TIPS investor would receive $1,209.12 in cumulative cash flows.

TIPS are a bet or a hedge on the breakeven inflation rate. If realized inflation over the life of a TIPS is less than the breakeven rate the investor earns a lower return than on a nominal Treasury bond with the same coupon rate. As shown in our example, if inflation is greater than the breakeven rate, then the TIPS investor earns a higher return than a nominal Treasury bond with the same coupon.

The following charts show the return profiles under various inflation scenarios, for the fixed coupon and TIPS examples used in the tables above.

The first graph shows the real (inflation-adjusted) coupon payments at various levels of inflation and deflation. In deflationary environments, both bonds provide positive real returns with the fixed coupon bond outperforming by the 2% breakeven rate. As inflation rises above the breakeven rate, the real return on the TIPS bond increasingly outperforms the fixed bond.

The next graph shows the nominal coupons of both bonds, assuming the investor holds them to maturity. The fixed bond earns the 4% coupon through all inflation scenarios. The TIPS bond earns a constant 2% coupon through all deflationary scenarios while the coupon rises in value as inflation increases. 

At any point in a TIPS life, investors may incur mark to market losses, and if the bonds are sold before maturity, this can result in a permanent loss. Any TIPS bond held from issuance to maturity will have a real positive gain assuming the coupon is above zero, the same is not true for a fixed rate bond.

Current environment

Various inflation surveys, as well as market-implied readings, suggest investors expect low levels of inflation to continue for at least the next ten years. The following graph provides a historical perspective on inflation trends and current long term inflation expectations as measured by 5, 10, and 20-year TIPS breakeven inflation rates.

Data Courtesy: St. Louis Federal Reserve (FRED)

The rate of inflation over the last 20 years, as measured by the consumer price index, has generally been decelerating. In other words, prices are rising but at a progressively slower pace.  Since 1985, the year over year change in inflation has averaged 2.6%, and since 2015, it has averaged 1.5%.

The market determined break-even inflation rate, or the differential between TIPS yields and like maturity fixed coupon yields, for the next 5, 10, and 20 years is currently 1.39%, 1.59%, and 1.65%, respectively. Inflation expectations for the next twenty years are consistent with the actual rate of inflation for the last ten years.

The Case For TIPS

While most forecasts are based on the past and therefore do not predict meaningful inflation, we must remain cognizant that since the Great Financial Crisis in 2008/09, the Federal Reserve (FED) and many other central banks have taken extraordinary monetary policy actions. The Fed lowered their targeted interest rates to zero while central banks in Japan and Europe have gone even further and introduced negative interest rates. Additionally, banks have sharply increased their balance sheets. These actions are being employed to incentivize additional borrowing to foster economic growth and boost inflation. More recently, as we are now seeing with a new round of QE, it appears the Fed is now using monetary policy to help facilitate trillion-dollar Federal deficits. 

Investors must be careful with the market’s assumption that the Fed’s efforts to stimulate inflation will lead to the same inflation rates of the past decade. Further, if “warranted”, a central bank can literally print money and hand it out to its citizens or directly fund the government. These alternative methods of monetary policy, deemed “helicopter money” by Ben Bernanke, would most likely cause prices to rise significantly.   

“Too much” inflation would be a detriment to the equity and bond markets. If inflation rates greater than three or four percent were to occur, a large majority of investors would pay dearly. Such circumstances would depreciate investor asset values and simultaneously reduce their purchasing power. With this double-edged sword in mind, TIPS should be considered by all investors.

The graph below, courtesy Doug Short and Advisor Perspectives, shows that equity valuations tend to be at their highest when inflation ranges between zero and two percent. Outside of that band, valuations are lower.  Currently, the market is making a big bet that valuations can remain near historical highs and inflation will remain in its recent range.

The worst case scenario for TIPS, as shown in the graphs, is a continuation of the inflation trends of yesterday. In those circumstances, TIPS would provide a return on par with or slightly less than comparable maturity nominal Treasury bonds. Investors also need to incorporate the opportunity cost of not allocating those funds towards stocks or riskier bonds should inflation remain subdued.

For those conservative investors sitting on excess cash, TIPS can be effectively employed as a surrogate to cash but with the added benefits of coupon payments and protection against the uncertainty of inflation.  In a worst case scenario, TIPS provide a return similar to those found on money market mutual funds. In the event of deflation and/or negative rates, TIPS should outperform these funds, which could easily experience negative returns.

Summary

Markets have a long history of assuming the future will be just like the past. Such assumptions and complacency work great until they don’t.  We do not profess to know when inflation may pick up in earnest, and we do not have a good economic explanation for what would cause that to happen. That being said, monetary policy around the world is managed by aggressive central bankers with strong and misplaced beliefs about the benefits of inflation. At some point, there is a greater than zero likelihood central bankers will be pushed to take actions that are truly inflationary. While the markets may initially cheer, the inevitable consequences may be dire for anyone not focused on preserving their purchasing power.

We urge you to focus on the forgotten leg of wealth, purchasing power. The opportunity costs of owning TIPS are minimal and the potential hedge value of TIPS is tremendous. Change can happen in a hurry, and the only way to protect and or profit from it is to anticipate it. As has been said, you cannot predict the future, but you can prepare for it.

We leave you with an important quote from our recent article- Warning, No Life Guards on Duty.

Another “lifeguard” is Daniel Oliver of Myrmikan Capital. In a recently published article entitled QE for the People, Oliver eloquently sums up the Fed’s policy situation this way:

The new QE will take place near the end of a credit cycle, as overcapacity starts to bite and in a relatively steady interest rate environment. Corporate America is already choked with too much debt. As the economy sours, so too will the appetite for more debt. This coming QE, therefore, will go mostly toward government transfer payments to be used for consumption. This is the “QE for the people” for which leftwing economists and politicians have been clamoring. It is “Milton Friedman’s famous ‘helicopter drop’ of money.” The Fed wants inflation and now it’s going to get it, good and hard.”

Will Monetary or Fiscal Stimulus Turnaround the Next Recession?

A recession is emerging with interest rate curves inverted, the end of the business cycle at hand, world trade falling, and consumers and businesses beginning to pull back on spending.  The question is: will monetary or fiscal stimulus turn around a recession? 

In this post, we find both stimulus alternatives likely to be too weak to have the necessary economic impact to lift the economy out of a recession. Finally, we will identify the key characteristics of a coming recession and the implications for investors.

Our economy is at the nexus of several major economic trends formed over decades that are limiting monetary and fiscal options. The monetary policy of central banks has caused world economies to be abundant in liquidity, yet producing limited growth. Central bankers in Japan and Europe have been trying to revive growth with $17 trillion injections using negative interest rates.  Japan can barely keep its economy growing with an estimate of GDP at .5 % through 2019. The Japanese central bank holds 200 % of GDP in government debt.  The European Central Bank holds 85 % of GDP in debt and uses negative interest rates as well. Germany is in a manufacturing recession with the most recent PMI in manufacturing activity at 47.3 and other European economies contracting toward near-zero GDP growth.  

Lance Roberts notes that the world economy is not running on a solid economic foundation if there is $17 trillion in negative-yielding debt in his blog, Powell Fails, Trump Rails, The Failure of Negative Rates. He questions the ability of negative interest policies to stabilize world economies,

You don’t have $17 Trillion in negative-yielding sovereign debt if there is economic and fiscal stability.”

Negative interest rates and extreme monetary stimulus policies have distorted financial relationships between debt and risk assets. This financial distortion has created a significantly wider gap between the 90 % and the top 1 % in wealth.

Roberts outlines in the six panel chart below how personal income, employment, industrial production, real consumer spending, real wages, and real GDP are all weakening in the U.S.:

Source: RIA – 8/23/19

Trillions of dollars of monetary stimulus have not created prosperity for all. The chart below shows how liquidity fueled a dramatic increase in asset prices while the amount of world GDP per money supply declined by about 25 %:

Sources: The Wall Street Journal, The Daily Shot – 9/23/19

Low interest rates have not driven real growth in wages, productivity, innovation, and services development that create real wealth for the working class. Instead, wealth and income are concentrated in the top 1 %. The concentration of wealth in the top one percent is at the highest level since 1929. The World Inequality Report notes inequality has squeezed the middle class between emerging countries and the U.S. and Europe. The top 1 % has received twice the financial growth benefits as the bottom 50 % since 1980:

Source: World Inequality Lab, Thomas Piketty, Gabriel Zucman et al – 2018

There are several reasons monetary stimulus by itself has not lifted the incomes of the middle class. One of the big causes is that stimulus money has not translated into wage increases for most workers.  U.S. real earnings for men have essentially been flat since 1975, while earnings for women have increased though basically flat since 2000:

Source: U.S. Census Bureau – 9/10/19

If monetary policy is not working, then fiscal investment from private and public sectors is necessary to drive an economic reversal.  But, will the private and public sector sectors have the necessary tools to bring new life to an economy in decline?

Wealth Creation Has Gone to the Private Sector

The last 40 years have seen the rise of private capital worldwide while public capital has declined. In 2015, the value of net public wealth (or public capital) in the US was negative -17% of net national income, while the value of net private wealth (or private capital) was 500% of national income. In comparison to 1970, net public wealth amounted to 36% of national income, while net private wealth was at 326 %.

Source: World Inequality Lab, Thomas Piketty, Gabriel Zucman et al – 2018

Essentially, world banks and governments have built monetary and fiscal economic systems that increased private wealth at the expense of public wealthThe lack of public capital makes the creation of public goods and services nearly impossible. The development of public goods and services like basic research and development, education and health services are necessary for an economic rebound. The economy will need a huge stimulus ‘lifting’ program and yet the capital necessary to do the job is in the private sector where private individuals make investment allocation decisions.  

Why is building high levels of private capital a problem?  Because, as we have discussed, private wealth is now concentrated in the top 1 %, while 70 % of U.S GDP is dependent on consumer spending.  The 90 % have been working for stagnant wages for decades, right along with diminishing GDP growth.  There is a direct correlation between wealth creation for all the people and GDP growth.

Corporations Are Not In A Position to Invest

Some corporations certainly have invested in their businesses, people, and technology.  The issue is the majority of corporations are now financially strapped.  Many corporate executives have made profit allocation decisions to pay themselves and their stockholders well at the expense of workers, their communities and the economy. 

S & P 500 corporations are paying out more cash than they are taking in, creating a cash flow crunch at a – 15 % rate (that’s right they are burning cash) to maintain stock buyback and dividend levels:

Source: Real Investment Advice

Sources: Compustat, Factset, Goldman Sachs – 7/25/19

In 2018 stock buybacks at $1.01 trillion were at the highest level they have ever been since buybacks were allowed under the 1982 SEC safe harbor provision decision. It is interesting to consider where our economy would be today if corporations spent the money they were wasting on boosting stock prices and instead invested in long term value creation.  One trillion dollars invested in raising wages, research, and development, cutting prices, employee education, and reducing health care premiums would have made a significant impact lifting the financial position of millions. This year stock buybacks have fallen back slightly as debt loads increase and sales fall:

Source: Dow Jones – 7/2019

Many corporations with tight cash flows have borrowed to purchase shares, pay dividends and keep their stock price elevated causing corporate debt to hit new highs as a percentage of GDP (note recessions followed three peaks):

Source: Federal Reserve Bank of Dallas – 3/6/2019

Corporate debt has ballooned to 46 % of GDP totaling $5.7 trillion in 2018 versus $2.2 trillion in 2008.  While the bulk of these nonfinancial corporate bonds have been investment grade, many bond covenants have become weaker as corporations seek more funding. Some bondholders may find their investment not as secure as they thought resulting in significantly less than 100 % return of principal at maturity.

In a recession, corporate sales fall, cash flow goes negative, high debt payments become hard to make, employees are laid off and management tries to hold on.  Only a select set of major corporations have cash hoards to ride out a recession, and others may be able obtain loans at steep interest rates, if at all.  Other companies may try going to the stock market which will be problematic with low valuations.  Plus, investors will be reluctant to buy stock in negative cash flow companies.

Thus, most corporations will be hard pressed to invest the billions of dollars necessary to turnaround a recession. Instead, they will be just trying to keep the doors open, the lights on, and maintain staffing levels to hold on until the day sales stop falling and finally turn up.

Public Sector is Also Tapped Out

In past recessions, federal policy makers have turned to fiscal policy – public spending on infrastructure projects, research development, training, corporate partnerships, and public services to revive the economy.  When the 2008 financial crisis was at its peak the Bush administration, followed by the Obama government pumped fiscal stimulus of $983 billion in spending over four years on roads, bridges, airports, and other projects. The Fed funds interest rate before the recession was at 5.25 % at the peak allowing lower rates to have plenty of impact. Today, with rates at 1.75-2.00 %, the impact will be negligible. In 2008, it was the combined massive injection of monetary and fiscal stimulus that created a V-shaped recession with the economy back on a path to recovery in 18 months. It was not monetary policy alone that moved the economy forward.  However, the recession caused lasting financial damage to wealth of millions. Many retirement portfolios lost 40 – 60 % of their value, millions of homeowners lost their homes, thousands of workers were laid off late in their careers and unable to find comparable jobs.  The Great Recession changed many people’s lives permanently, yet it was relatively short-lived compared to the Great Depression.

As noted in the chart above, public sector wealth has actually moved to negative levels in the U.S. at – 17 % of national income.  Our federal government is running a $1 trillion deficit per year.  In 2007, the federal government debt level was at 39 % of GDP. The Congressional Budget Office projects that by 2028 the Federal deficit will be at 100 % of GDP

Source: CBO – 4/9/19

We are at a different time economically than 2008. Today with Federal debt is over 100% of GDP and expected to grow rapidly. The Feds balance sheet is still excessive and they formally stopped reducing the size (QT).  In a recession federal policymakers will likely make spending cuts to keep the deficit from going exponential. Policy makers will be limited by the twin deficits of $22.0 trillion national debt and ongoing deficits of $1+ trillion a year, eroding investor confidence in U.S. bonds. The problem is the political consensus for fiscal stimulus in 2008 – 2009 does not exist today, and it will probably be even worse after the 2020 election. Our cultural, social and political fabric is so frayed as a result of decades of divisive politics it is likely to take years to sort out during a recession. Our political leaders will be fixing the politics of our country while searching for intelligent stimulus solutions to be developed, agreed upon and implemented.

What Will the Next Recession Look Like?

We don’t know when the next recession will come. Yet, present trends do tell us what the structure of a recession might look like, as a deep U- shaped, slow recovery measured in years not months:

  • Corporations Short of Cash – Corporations already strapped are short on cash, will lay off workers, pull back spending, and are stuck paying off huge debts instead of investing.
  • Federal Government Spending Cuts – The federal government caught with falling revenues from corporations and individuals, is forced to make deep cuts first in discretionary spending and then social services and transfer funding programs. The reduction of transfer programs will drive slower consumer spending.
  • Consumers Pull Back Spending – Consumers will be forced to tighten budgets, pay off expensive car loans and student debt, and for those laid off seeking work anywhere they can find a job.
  • World Trade Declines – World trade will not be a source of rebuilding sales growth as a result of the China – US trade war, and tariffs with Europe and Japan.  We expect no trade deal or a small deal with the majority of tariffs to stay in place. In other words, just reversing some tariffs will not be enough to restart sales. New buyer – seller relationships are already set, closing sales channels to US companies. New country alliances are already in place, leaving the US closed out of emerging high growth markets.  A successor Trans Pacific Partnership (TPP) agreement with Japan and eleven other countries was signed in March, 2018 without the US. China is negotiating a new agreement with the EU. EU and China trade totals 365 billion euros per year. China is working with a federation of African countries to gain favorable trade access to their markets.
  • ­Pension Payments in Jeopardy – Workers dependent on corporate and public pensions may see their benefits cut from pensions, which are poorly funded today with markets at all-time highs. GE just announced freezing pensions for 20,000 employees, the harbinger of a possible trend that will  reduce consumer spending
  • Investment Environment Uncertain – Uncertainty in investments will be extremely high, ‘get rich quick’ schemes will flourish as they did in 2008 – 2009 and 2000.
  • Fed Implements Low Rates & QE – The Fed is likely to implement very low interest rates (though not negative rates), and QE with liquidity in abundance but the economy will have low inflation, and declining GDP feeling like the Japanese economic stasis – ‘locked in irons’.

Implications for Investors

The following recommendations are intended for consideration just prior or during a recession with a sharp decline in the markets, not necessarily for today’s markets.

Cash – It is crucial to maintain a significant cash hoard so you can purchase corporate stocks when they cheapen. The SPX could decline by 40 – 50 % or more when the economy is in recession.  Yet, good values in some stocks will be available.  At the 1500 level, there is an excellent opportunity to make good long term growth and value investments based on sound research.

CDs – as Will Rogers noted during the Depression, “I’m more interested in Return of my Capital than Return on my Capital”, a prudent investor should be too.  CDs are FDIC insured while offering lower interest rates than other investments. Importantly, they provide return of capital and allow you to sleep at night.

Bonds – U.S. Treasuries certainly provide safety, return of principal, and during a recession will provide better overall returns than high-risk equity investments. Corporate bonds may come under greater scrutiny by investors even for so-called ‘blue chips’ like General Electric. The firm is falling on hard times with $156 billion in debt. GE is seeking business direction and selling off assets. The major conglomerate’s bonds have declined in value by 2.5 % last year with their rating dropped to BBB. Now with new management the price of GE bonds is climbing up slightly.

Utilities – are regulated to have a profit.  While they may see declining revenues due to less energy use by corporations and individuals, they still will pay dividends to shareholders as they did in 2008.  Consumer staple companies are likely to be cash flow strained; most did not pay dividends to investors during the 2008 – 2009 recession. REITs need to be evaluated on a company by company basis to determine how secure their cash streams are from leases. During the 2008 – 2009 downturn, some REITs stopped paying dividends due to declining revenues from lease defaults.

Growth & Value Equities– invest in new sectors that have government support or emerging demand based on social trends like climate change: renewables, water, carbon emission recovery, environmental cleanup. From our Navigating A Two Block Trade World – US and China post, we noted possible investments in bridge companies between the two trade blocks; services, and countries that act as bridges like Australia. Look for firms with good cash positions to ride out the recession, companies in new markets with sales generated by innovations, or problem solving products that require spending by customers.  For example, seniors will have to spend money on health services. Companies serving an increasingly aging population with innovative low cost health solutions are likely to see good demand and sales growth.

The intelligent investor will do well to ‘hope for the best, but plan for the worst’ in terms of portfolio management in a coming recession.  Asking hard questions of financial product executives and doing your own research will likely be keys to survival.

In the end, Americans have always pulled together, solved problems, and moved ahead toward an even better future. After a reversion to the mean in the capital markets and an economic recession things will improve.  A reversion in social and culture values is likely to happen in parallel to the financial reversion. The complacency, greed, and selfishness that drove the present economic extremes will give way to a new appreciation of values like self-sacrifice, service, fairness, fair wages and benefits for workers, and creation of a renewed economy that creates financial opportunities for all, not just the few.

Patrick Hill is the Editor of The Progressive Ensign, https://theprogressiveensign.com/ writes from the heart of Silicon Valley, leveraging 20 years of experience as an executive at firms like HP, Genentech, Verigy, Informatica and Okta to provide investment and economic insights. Twitter: @PatrickHill1677.

Market Implications For Removing Fed Chair Powell

  • John Kelly – White House Chief of Staff
  • James Mattis – Secretary of Defense
  • Jeff Sessions – Attorney General
  • Rex Tillerson – Secretary of State
  • Gary Cohn – Chief Economic Advisor
  • Steve Bannon – White House Chief Strategist
  • Anthony Scaramucci – White House Communications Director
  • Reince Priebus – White House Chief of Staff
  • Sean Spicer – White House Press Secretary
  • James Comey – FBI Director

Every week is shark week in the Trump White House,” wrote The Hill contributing author Brad Bannon in August of 2018.  A recent Brookings Institution study shows that the turnover in the Trump administration is significantly higher than during any of the previous five presidential administrations. The concern is that for a president without government experience, a rotating cast of top administration officials and advisors presents a unique challenge for the effective advancement of U.S. policies and global leadership. Bannon (no relation to former White House Chief Strategist Steve) adds, “Inexperience breeds incompetence.”

Although the sitting president has broken just about every rule of traditional politics, it is irresponsible and speculative to assume either ineffectiveness or failure by this one argument. One area of politics that falls within our realm of expertise is a “rule” that Donald Trump has not yet broken; firing the Chairman of the Federal Reserve.

Following the December Federal Open Market Committee (FOMC) meeting in which the Fed raised rates and the stock market fell appreciably, Bloomberg News reported that President Trump was again considering relieving the Fed Chairman of his responsibilities. This has been a continuing theme for Trump as his dissatisfaction with the Fed intensifies.

Not that Trump appears concerned about it, but firing a Fed Chairman is unprecedented in the 106-year history of the central bank. Having tethered all perception of success to the movements of the stock market, it is quite apparent why the president is unhappy with Jerome Powell’s leadership. Trump’s posture raises questions about whether he is more worried about his barometer of success (stock prices) or the long-term well-being of the economy. Acquiescing to either Trump or a genuine concern for the economic outlook, Chairman Powell relented in his stance on rate hikes and continuing balance sheet reduction.

Clamoring for Favor

Notwithstanding the abrupt reversal of policy stance at the Fed, President Trump continues to snipe at Powell and express dissatisfaction with what he considers to have been policy mistakes. Before backing out of consideration, Steven Moore’s nomination to the Fed board fits neatly with the points made above reflecting the President’s irritation with the Powell Fed. Moore was harshly critical of Powell and the Fed’s rate hikes despite a multitude of inconsistent remarks. Shortly after his nomination, Moore and the President’s Director at the National Economic Council, Larry Kudlow, stated that the Fed should immediately cut interest rates by 50 basis point (1/2 of 1%). Those comments came despite rhetoric from various fronts in the administration that the economy “has never been stronger.”

Now the Kudlow and Moore tactics are coming from within the Fed. St. Louis Fed President James Bullard dissented at the June 19th Federal Open Market Committee meeting in favor a rate cut. Then non-voting member and Minneapolis Fed President Neel Kashkari publicly stated that he was an advocate for a 50-basis point rate cut at the same meeting.

All this with unemployment at 3.6% and GDP tracking better than the 10-year average of 2.1%. Given Trump’s stated grievance with Powell, Bullard and Kashkari could easily be viewed as trying to curry favor with the administration. Even if that is not the case, to appear to be so politically inclined is very troubling for an institution and board members that must optically maintain an independent posture. It is unlikely that anyone has influence over Trump in his decision to replace or demote Powell. He will arrive at his conclusion and take action or not. If the first two years of his administration tells us anything, it is that public complaints about his appointed cabinet members precede their ultimate departure. Setting aside his legal authority to remove Powell, which would likely not stand in his way, the implications are what matter and they are serious.

For more on our thoughts on the ability of Trump to fire the Fed Chairman, please read our article Chairman Powell You’re Fired.

Prepare For This Tweet

Given Trump’s track record and his displeasure with Powell, we should prepare in advance for what could come as a surprise Tweet with little warning.

Ignoring legalities, if Trump were to demote or fire Powell, it is safe to assume he has someone in mind as a replacement. That person would certainly be more dovish and less prudent than Powell.

Under circumstances of a voluntary departure, a replacement with a more dovish disposition might be bullish for the stock market. However, the global economy is a complex system and there are many other factors to consider.

The first and largest problem is such a move would immediately erode the perception of Fed independence. Direct action taken to alter that independence would cast doubts on Fed credibility. Other sitting members of the Federal Reserve, appointed board members, and regional bank presidents, would likely take steps to defend the Fed’s independence and credibility which could create a functional disruption in the decision-making apparatus within the FOMC. Further, there might also be an active move by Congress to challenge the President’s decision to remove Powell. Although the language granting Trump the latitude to fire Powell is obtuse (he can be removed for “cause”), it is unclear that Presidential unhappiness affords him supportable justification. That would be an argument for the courts. Financial markets are not going to patiently await that decision.

With that in mind, what follows is an enumeration of possible implications for various key asset classes.

FX Markets

The most serious of market implications begin with the U.S. dollar (USD), the world’s reserve currency through which over 60% of all global trade transactions are invoiced.  The firing of Powell and the likely appointment of a Trump-friendly Chairman would drop the value of the USD on the expectations of a dovish reversal of monetary policy. The question of Fed independence, along with the revival of an easy money policy, would likely cause the dollar to fall dramatically relative to other key currencies. An abrupt move in the dollar would be highly disruptive on a global scale, as other countries would take action to stem the relative strength of their currencies versus the dollar and prevent weaker economic growth effects. The term “currency war” has been overused in the media, but in this case, it is the proper term for what would likely transpire.

Additionally, the weaker dollar and new policy outlook would heighten concerns about inflation. With the economy at or near full employment and most regions of the country already exhibiting signs of wage pressures, inflation expectations could spike higher.

Fixed Income

The bond market would be directly impacted by Fed turbulence. A new policy outlook and inflation concerns would probably cause the U.S. Treasury yield curve to steepen with 2-year Treasuries rallying on FOMC policy change expectations and 10-year and 30-year Treasury bond yields rising in response to inflation concerns. It is impossible to guess the magnitude of such a move, but it would probably be sudden and dramatic.

Indecision and volatility in the Treasury markets are likely to be accompanied by widening spreads in other fixed income asset classes.

Commodities

In the commodities complex, gold and silver should be expected to rally sharply.  While not as definitive, other commodities would probably also do well in response to easier Fed policy. A lack of confidence in the Fed and the President’s actions could easily result in economic weakness, which would lessen demand for many industrial commodities and offset the benefits of Fed policy changes.

Stock Market

The stock market response is best broken down into two phases. The initial reaction might be an extreme move higher, possibly a move of 8-10% or more in just a few days or possibly hours. However, the ensuing turmoil from around the globe and the potential for dysfunction within the Fed and Congress could cause doubt to quickly seep into the equity markets. Two things we know about equity markets is that they do not like changes in inflation expectations and they do not like uncertainty.

Economy

Another aspect regarding such an unprecedented action would be the economic effects of the firing of Jerome Powell. Economic conditions are a reflection of millions of households and businesses that make saving, investing, and consumption decisions on a day-to-day basis. Those decisions are dependent on having some certitude about the future.

If the disruptions were to play out as described, consumers and businesses would have reduced visibility into the future path for the economy. Questions about the global response, inflation, interest rates, stock, and commodity prices would dominate the landscape and hamstring decision-making. As a result, the volatility of everything would rise and probably in ways not observed since the financial crisis. Ultimately, we would expect economic growth to falter in that environment and for a recession to ensue.

Summary

Although economic growth has been sound and stocks are once again making record highs, the market and economic disruptions we have recently seen have been a long time coming. Market valuations across most asset classes have been engineered by excessive and imprudent monetary policy. The recent growth impulse is artificially high due to unprecedented expansion of government debt in a time of sound economic growth and low unemployment. In concert, excessive fiscal and monetary policy leave the markets and the economy vulnerable.

The evidence this year has been clear. Notwithstanding the Federal Reserve’s role in constructing this false reality, President Trump has not served the national interest well by his public criticism of the Fed. If Trump were to remove Powell as Fed chair, the prior sentence would be an understatement of epic proportions.

Chairman Powell – You’re Fired (Update)

Since President Trump first discussed firing Jerome Powell, out of a sense of frustration that his Fed Chair pick was not dovish enough, he has regularly expressed his displeasure at Powell’s lack of willingness to do whatever it takes to keep the economy booming beyond its potential. Strong economic growth serves Trump well as it boosts the odds of winning a second term.

This thought of firing the Fed Chair took an interesting turn yesterday when Mario Draghi, Jerome Powell’s counter-part in the ECB, commented that he was open to lowering interest rates and expanding quantitative easing measures if economic growth in the E.U. didn’t start to pick up soon.

This led to the following Trump tweet:

The bottom line is that the ECB will push Trump harder to lean on the Fed to be more aggressive with lower rates and QE. Trump’s urgency for Fed action also increases the odds that Powell could be replaced or demoted, as such a discussion was rumored to have been discussed. Look for fireworks on Trumps Twitter page today if the Fed does not take a dovish tact. We remind you:

“[Powell]’s my pick — and I disagree with him entirely,” Trump said last week in an interview with ABC News.

“Frankly, if we had a different person in the Federal Reserve that wouldn’t have raised interest rates so much we would have been at least a point and a half higher.”

The following article was published last October and is even more relevant today. If Powell becomes an impediment to aggressive Federal Reserve policy and therefore hurts Trump’s chances of winning in 2020, we might just see Chairman Powell get fired or demoted. Is that possible?


On Donald Trump’s hit TV show, The Apprentice, contestants competed to be Trump’s chief apprentice. Predictably, each show ended when the field of contestants was narrowed down by the firing of a would-be apprentice. While the show was pure entertainment, we suspect Trump’s management style was on full display. Trump has run private organizations his entire career. Within these organizations, he had a tremendous amount of unilateral control. Unlike what is required in the role of President or that of a corporate executive for a public company, Trump largely did what he wanted to do.

On numerous occasions, Trump has claimed the stock market is his “mark-to-market.” In other words, the market is the barometer of his job performance. We think this is a ludicrous comment and one that the President will likely regret. He has made this comment on repeated occasions, leading us to conclude that, whether he believes it or not, he has tethered himself to the market as a gauge of performance in the mind of the public. We have little doubt that the President will do everything in his power to ensure the market does not make him look bad.

Warning Shots Across the Bow

On June 29, 2018, Trump’s Economic Advisor Lawrence Kudlow delivered a warning to Chairman Powell saying he hoped that the Federal Reserve (Fed) would raise interest rates “very slowly.”

Almost a month later we learned that Kudlow was not just speaking for himself but likely on behalf of his boss, Donald Trump. During an interview with CNBC, on July 20, 2018, the President expanded on Kudlow’s comments voicing concern with the Fed hiking interest rates. Trump told CNBC’s Joe Kernen that he does not approve [of rate hikes], even though he put a “very good man in” at the Fed referring to Chairman Jerome Powell.

“I’m not thrilled,” Trump added. “Because we go up and every time you go up they want to raise rates again. I don’t really — I am not happy about it. But at the same time I’m letting them do what they feel is best.”

“As of this moment, I would not see that this would be a big deal yet but on the other hand it is a danger sign,” he said.

Two months later in August of 2018, Bloomberg ran the following article:

Trump Said to Complain Powell Hasn’t Been Cheap-Money Fed Chair

“President Donald Trump said he expected Jerome Powell to be a cheap-money Fed chairman and lamented to wealthy Republican donors at a Hamptons fundraiser on Friday that his nominee instead raised interest rates, according to three people present.”

On October 10, 2018, following a 3% sell-off in the equity markets, CNBC reported on Donald Trump’s most harsh criticism of the Fed to date.  Trump said, “I think the Fed is making a mistake. They’re so tight. I think the Fed has gone crazy.”

Again-“I think the Fed has gone crazy

These comments and others come as the Fed is publicly stating their preference for multiple rate hikes and further balance sheet reduction in the coming 12-24 months. The markets, as discussed in our article Everyone Hears the Fed but Few are Listening, are not priced for the same expectations. This is becoming evident with the pickup in volatility in the stock and bond markets.  There is little doubt that a hawkish tone from Chairman Powell and other governors will increasingly wear on an equity market that is desperately dependent on ultra-low interest rates.

Who can stop the Fed?

We think there is an obstacle that might stand in the Fed’s way of further rate hikes and balance sheet reductions.

Consider a scenario where the stock market drops 20-25% or more, and the Fed continues raising rates and maintaining a hawkish tenor.

We believe this scenario is well within the realm of possibilities. Powell does not appear to be like Yellen, Bernanke or Greenspan with a finger on the trigger ready to support the markets at early signs of disruption. In his most recent press conference on September 26, 2018, Powell mentioned that the Fed would react to the stock market but only if the correction was both “significant” and “lasting.”

The word “significant” suggests he would need to see evidence of such a move causing financial instability. “Lasting” implies Powell’s reaction time to such instability will be much slower than his predecessors. Taken along with his 2013 comments that low rates and large-scale asset purchases (QE) “might drive excessive risk-taking or cause bubbles in financial assets and housing” further seems to support the notion that he would be slow to react.

Implications

President Trump’s ire over Fed policy will likely boil over if the Fed sits on their hands while the President’s popularity “mark-to-market” is deteriorating.

This leads us to a question of utmost importance. Can the President of the United States fire the Chairman of the Fed? If so, what might be the implications?

The answer to the first question is yes. Pedro da Costa of Business Insider wrote on this topic. In his article (link) he shared the following from the Federal Reserve Act (link):

Given that the President can fire the Fed Chairman for “cause” raises the question of implications were such an event to occur.  The Fed was organized as a politically independent entity. Congress designed it this way so that monetary policy would be based on what is best for the economy in the long run and not predicated on the short-term desires of the ruling political party and/or President.

Although a President has never fired a Fed Chairman since its inception in 1913, the Fed’s independence has been called into question numerous times. In the 1960’s, Lyndon Johnson is known to have physically pushed Fed Chairman William McChesney Martin around the Oval Office demanding that he ease policy. Martin acquiesced. In the months leading up to the 1972 election, Richard Nixon used a variety of methods including verbal threats and false leaks to the press to influence Arthur Burns toward a more dovish policy stance.

If hawkish Fed policy actions, as proposed above, result in a large market correction and Trump were to fire Fed Chairman Jerome Powell, it is plausible that the all-important veil of Fed independence would be pierced. Although pure conjecture, it does not seem unreasonable to consider what Trump might do in the event of a large and persistent market drawdown. Were he to replace the Fed chair with a more loyal “team player” willing to introduce even more drastic monetary actions than seen over the last ten years, it would certainly add complexity and risk to the economic outlook. The precedent for this was established when President Trump recently nominated former Richmond Fed advisor and economics professor Marvin Goodfriend to fill an open position on the Fed’s Board of Governors. Although Goodfriend has been critical of bond buying programs, “he (Goodfriend) has a radical willingness to embrace deeply negative rates.” –The Financial Times

Such a turn of events might initially be very favorable for equity markets, but would likely raise doubts about market values for many investors and raise serious questions about the integrity of the U.S. dollar. Lowering rates even further leaves the U.S. debt problem unchecked and potentially unleashes inflation, a highly toxic combination. A continuation of overly dovish policy would likely bolster further expansion of debt well beyond the nation’s ability to service it. Additionally, if inflation did move higher in response, bond markets would no doubt eventually respond by driving interest rates higher. The can may be kicked further but the consequences, both current and future, will become ever harsher.

Clues from the Fed II – A Review of Jerome Powell’s Speech 11/28/2018

The following speech by Jerome Powell, Chairman of the Federal Reserve, was given on November 28, 2018. Highlighted below are quotes which we believe are important in helping to determine current Fed posture and inclination. Intertwined within his speech you will find our comments and explanations. Please also see our summary thoughts following the speech below. If you have not read our review of Vice-Chairman Richard Clarida’s speech from yesterday you can find it HERE.


The Federal Reserve’s Framework for Monitoring Financial Stability

Chairman Jerome H. Powell

At The Economic Club of New York, New York

It is a pleasure to be back at the Economic Club of New York. I will begin by briefly reviewing the outlook for the economy, and then turn to a discussion of financial stability. My main subject today will be the profound transformation since the Global Financial Crisis in the Federal Reserve’s approach to monitoring and addressing financial stability. Today marks the publication of the Board of Governors’ first Financial Stability Report. Earlier this month, we published our first Supervision and Regulation Report. Together, these reports contain a wealth of information on our approach to financial stability and to financial regulation more broadly. By clearly and transparently explaining our policies, we aim to strengthen the foundation of democratic legitimacy that enables the Fed to serve the needs of the American public.

Outlook and Monetary Policy
Congress assigned the Federal Reserve the job of promoting maximum employment and price stability. I am pleased to say that our economy is now close to both of those objectives. The unemployment rate is 3.7 percent, a 49-year low, and many other measures of labor market strength are at or near historic bests. Inflation is near our 2 percent target. The economy is growing at an annual rate of about 3 percent, well above most estimates of its longer-run trend.

For seven years during the crisis and its painful aftermath, the Federal Open Market Committee (FOMC) kept our policy interest rate unprecedentedly low–in fact, near zero–to support the economy as it struggled to recover. The health of the economy gradually but steadily improved, and about three years ago the FOMC judged that the interests of households and businesses, of savers and borrowers, were no longer best served by such extraordinarily low rates. We therefore began to raise our policy rate gradually toward levels that are more normal in a healthy economy. Interest rates are still low by historical standards, and they remain just below the broad range of estimates of the level that would be neutral for the economy‑‑that is, neither speeding up nor slowing down growth. My FOMC colleagues and I, as well as many private-sector economists, are forecasting continued solid growth, low unemployment, and inflation near 2 percent.


RIA Pro commentIn these first two paragraphs Jerome Powell points out that the economy is running above its longer-term trend in large part due to the support of “near zero” interest rates (Fed monetary policy). Given recent above-trend economic growth and a sustained recovery from the financial crisis, the Fed raised rates to get to a less simulative level.

He states that “interest rates are still low by historical standards” and “remain just below” what they would consider neutral for the economy. The phrasing “remain just below” is the key line from the speech as it was only a month ago, on October 3rd, when he said they were a “long way” from neutral. In no uncertain terms, this abrupt change in posture is a clear signal to the market that the Fed may be close to ending their hiking cycle.

There are two other important points regarding the neutral rate worth discussing. First, the Federal Reserve does not know with any real precision what the “neutral” rate of interest for the economy is or should be. This is best left to un-manipulated markets and the independent buyers and sellers that drive them. Second, if indeed Powell and the Fed did know with certainty where the neutral rate should be, it likely would not be at a real rate near zero, with economic growth running above 3% and the unemployment rate at 50 year lows as is currently the case.


There is a great deal to like about this outlook. But we know that things often turn out to be quite different from even the most careful forecasts. For this reason, sound policymaking is as much about managing risks as it is about responding to the baseline forecast. Our gradual pace of raising interest rates has been an exercise in balancing risks. We know that moving too fast would risk shortening the expansion. We also know that moving too slowly–keeping interest rates too low for too long–could risk other distortions in the form of higher inflation or destabilizing financial imbalances. Our path of gradual increases has been designed to balance these two risks, both of which we must take seriously.

We also know that the economic effects of our gradual rate increases are uncertain, and may take a year or more to be fully realized. While FOMC participants’ projections are based on our best assessments of the outlook, there is no preset policy path. We will be paying very close attention to what incoming economic and financial data are telling us. As always, our decisions on monetary policy will be designed to keep the economy on track in light of the changing outlook for jobs and inflation.


RIA Pro comment- Powell is parroting the substance of Clarida’s speech yesterday essentially saying that the Fed is no longer on rate-hiking auto-pilot. They will raise rates or abstain from raising rates based on what economic and financial data tell them (data dependency). As we mentioned yesterday, the increased emphasis on data dependency by definition reduces their reliance on forward guidance which will introduce more volatility to the markets. Prior reliance on forward guidance helped suppress volatility, so it follows that less reliance on it will make them less predictable and naturally raises the level of uncertainty for investors.


Under the dual mandate, jobs and inflation are the Fed’s meat and potatoes. In the rest of my comments, I will focus on financial stability–a topic that has always been on the menu, but that, since the crisis, has become a more integral part of the meal.

We omitted the rest of the speech as its focus is a historical perspective of financial stability and less relevant to current monetary policy. The entire speech can be found HERE

RIA Pro Summary

It is clear from this speech, as well as recent trial balloons put out by the Fed, that they are taking a more dovish stance. This does not mean they will halt their rate hikes, but in our opinion it is clear that once we move beyond the scheduled hike in December, all bets are off the table. Barring signs of wage growth, stronger inflation or sustained economic growth above 3%, they are unlikely to raise rates further.

The stock market rocketed higher on what is perceived as a dovish speech with the strong possibility that Fed hikes will be halted come 2019. Time will tell if the gains are sustainable and if the market is interpreting his speech correctly. It is worth mentioning however that a recession followed the last three times that the Fed Funds rate hit a cycle high. 

 

 

 

 

Clues from the Fed – A Review of Richard Clarida’s Speech 11/27/2018

The Following Speech by Richard Clarida, Vice Chairman of the Federal Reserve, was given on November 27, 2018. Highlighted below are quotes which we believe are important in helping to determine current Fed posture and inclination. More specifically, given Clarida’s role as the Vice Chairman, he is one of the main sources of communicating whether the Fed is indeed considering reversing to a more dovish stance in the months ahead. Intertwined within his speech you will find our comments and explanations. Please also see our summary thoughts following the speech below.


Data Dependence and U.S. Monetary Policy

Vice Chairman Richard H. Clarida

At The Clearing House and The Bank Policy Institute Annual Conference, New York, New York

I am delighted to be speaking at this annual conference of the Clearing House and the Bank Policy Institute. Today I will discuss recent economic developments and the economic outlook before going on to outline my thinking about the connections between data dependence and monetary policy. I will close with some observations on the implications for U.S. monetary policy that flow from this perspective.

Recent Economic Developments and the Economic Outlook
U.S. economic fundamentals are robust, as indicated by strong growth in gross domestic product (GDP) and a job market that has been surprising on the upside for nearly two years. Smoothing across the first three quarters of this year, real, or inflation-adjusted, GDP growth is averaging an annual rate of 3.3 percent. Private-sector forecasts for the full year–that is, on a fourth-quarter-over-fourth-quarter basis–suggest that growth is likely to equal, or perhaps slightly exceed, 3 percent. If this occurs, GDP growth in 2018 will be the fastest recorded so far during the current expansion, which in July entered its 10th year. If, as I expect, the economic expansion continues in 2019, this will become the longest U.S. expansion in recorded history.

Likewise, the labor market remains healthy. Average monthly job gains continue to outpace the increase needed to provide jobs for new entrants to the labor force over the longer run, with payrolls rising by 250,000 in October. And, at 3.7 percent, the unemployment rate is the lowest it has been since 1969. In addition, after remaining stubbornly sluggish throughout much of the expansion, nominal wage growth is picking up, with various measures now running in the neighborhood of 3 percent on an annual basis. 

The inflation data in the year to date for the price index for personal consumption expenditures (PCE) have been running at or close to our 2 percent objective, including on a core basis‑‑that is, excluding volatile food and energy prices. While my base case is for this pattern to continue, it is important to monitor measures of inflation expectations to confirm that households and businesses expect price stability to be maintained. The median of expected inflation 5-to-10 years in the future from the University of Michigan Surveys of Consumers is within–but I believe at the lower end of–the range consistent with price stability. Likewise, inflation readings from the TIPS (Treasury Inflation-Protected Securities) market indicate to me that financial markets expect consumer price index (CPI) inflation of about 2 percent to be maintained. That said, historically, PCE inflation has averaged about 0.3 percent less than CPI inflation, and if this were to continue, the readings from the TIPS market would indicate that expected PCE inflation is running at somewhat less than 2 percent.


RIA Pro commentClarida believes the economy is growing at a healthy clip and wage growth is relatively strong in the 3% range. These statements by themselves argue that the Fed is woefully behind the curve in raising rates. Based on historical precedence, one would expect Fed Funds to currently reside in the 3.50-5.00% range versus the current 2.25%. One explanation for the low Fed Funds rate, as Clarida implies, is that inflation and inflation expectations remain low. In the next two paragraphs, he goes on to explain why inflation may remain low and not rise to levels that would overly concern the Fed.


What might explain why inflation is running at or close to the Federal Reserve’s long-run objective of 2 percent, and not well above it, when growth is strong and the labor market robust? According to the Bureau of Labor Statistics, productivity growth in the business sector, as measured by output per hour, is averaging 2 percent at an annualized rate this year, while aggregate hours worked in the business sector have risen at an average annual rate of 1.8 percent through the third quarter. This decomposition–in which the growth in output is broken down into measures of aggregate supply, the growth of aggregate hours and the growth of output per hour–suggests that the growth rates of productivity and hours worked in 2018 each have been exceeding their respective longer-run rates as estimated by the Congressional Budget Office. In other words, while growth in aggregate demand in 2018 has been above the expected long-run growth rate in aggregate supply, it has not been exceeding this year’s growth in actual aggregate supply.

Ultimately, hours growth will likely converge to a slower pace because of demographic factors. But how rapidly this happens will depend in part on the behavior of labor force participation. And recent years’ developments suggest there may still be some further room for participation in the job market‑‑especially in the prime-age group of 25-to-54-year-olds‑‑to rise. Labor participation by prime-age women has increased around 2 percentage points in the past three years and is now at its highest level in a decade. That said, it is still 1-1/2 percentage points below the peak level reached in 2000. Labor force participation among 25- to 54-year-old men has risen by roughly 1 percentage point in the past several years. But it is still 2 percentage points below levels seen a decade ago, and it is 3 percentage points below the levels that prevailed in the late 1990s.

As for productivity growth, there is considerable uncertainty about how much of the rebound in productivity growth that we have seen in recent quarters is cyclical and how much is structural. I believe both factors are at work. The structural, or trend, component of productivity growth is a function of capital deepening through business investment as well as a multifactor component sometimes referred to as the “Solow residual.” Initial estimates from the recent GDP release indicate that equipment and software investment in the third quarter moderated from the rapid pace recorded in the first half of the year. One data point does not make a trend, but an improvement in business investment will be important if the pickup in productivity growth that we have seen in recent quarters is to be sustained.


RIA Pro comment- The highlighted sentences in the paragraph above are important to understand. Productivity growth, demographics and levels of debt/money are the primary components of economic growth. Given, for the most part, that the amount of debt and demographic trends are a known commodity, productivity growth is the marginal determinant of growth. His statements above suggest that productivity growth has picked up recently but “one data point does not make a trend.” This means that a failure of continuing strength in capital investment by corporations will imply weaker productivity growth and therefore will signal weaker economic growth ahead.


As for the economic outlook, in the most recent Summary of Economic Projections (SEP) released in September, participants had a median projection for real GDP growth of 3.1 percent in 2018 and 2-1/2 percent in 2019. The unemployment rate was expected to decline to 3‑1/2 percent next year. And, for total PCE inflation, the median projection remains near 2 percent.

With a robust labor market and inflation at or close to our 2 percent inflation goal and based on the baseline economic outlook for 2019 I have just laid out, I believe monetary policy at this stage of the economic expansion should be aimed at sustaining growth and maximum employment at levels consistent with our inflation objective. At this stage of the interest rate cycle, I believe it will be especially important to monitor a wide range of data as we continually assess and calibrate whether the path for the policy rate is consistent with meeting our dual-mandate objectives on a sustained basis.


RIA Pro comment- As he implies above, the Fed is becoming more “data dependent.” Clarida has made that comment explicitly in prior speeches. In other words, their path towards more rate hikes or a suspension of hikes will be more heavily influenced by incoming economic data. This likely means that markets will become more volatile around major economic data releases. Furthermore, if the Fed does become more data dependent, that also suggests a reduced reliance on “forward guidance.” We will expand more on that later, but be aware that forward guidance is the Fed’s way of telegraphing to the markets where they expect rates to be in the future. In the past this guidance has proved comforting to the markets.


Data Dependence of Monetary Policy: What It Means and Why It Is Important
Economic research suggests that monetary policy should be “data dependent.” And, indeed, central banks around the world, including the Federal Reserve, often describe their policies in this way. I would now like to discuss how I think about two distinct roles that data dependence should play in the formulation and communication of monetary policy.

It is important to state up-front that data dependence is not, in and of itself, a monetary policy strategy. A monetary policy strategy must find a way to combine incoming data and a model of the economy with a healthy dose of judgment–and humility!–to formulate, and then communicate, a path for the policy rate most consistent with our policy objectives. In the case of the Fed, those objectives are assigned to us by the Congress, and they are to achieve maximum employment and price stability. Importantly, because households and firms must make long-term saving and investment decisions and because these decisions‑‑directly or indirectly‑‑depend on the expected future path for the policy rate, the central bank should find a way to communicate and explain how incoming data are or are not changing the expected path for the policy rate consistent with best meeting its objectives. Absent such communication, inefficient divergences between public expectations and central bank intentions for the policy rate path can emerge and persist in ways that are costly to the economy when reversed.


RIA Pro comment- Clarida alludes to something we wrote about in Everyone Hears the Fed, But Few Listen. Essentially, the comment highlighted above is in reference to the fact that the Fed is still projecting another 1% increase in the Fed Funds rate, while the market is currently estimating a smaller increase of .37%. Whether the Fed backs down from their forecast or they talk the market up to their level is important to follow. The reason it is important comes back to the topic of forward guidance. The difference in rate expectations (1% versus 0.37%) is evidence of less investor certainty about what the Fed may do. That uncertainty contributes to volatility by challenging the notion, as John Maynard Keynes put it, “that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons to expect a change.”


Within this general framework, let me now consider two distinct ways in which I think that the path for the federal funds rate should be data dependent. U.S. monetary policy has for some time and will, I believe, continue to be data dependent in the sense that incoming data reveal at the time of each Federal Open Market Committee (FOMC) meeting where the economy is at the time of each meeting relative to the goals of monetary policy. This information on where the economy is relative to the goals of monetary policy is an important input into the policy decision. If, for example, incoming data in the months ahead were to reveal that inflation and inflation expectations are running higher than projected at present and in ways that are inconsistent with our 2 percent objective, then I would be receptive to increasing the policy rate by more than I currently expect will be necessary. Data dependence in this sense is easy to understand, as it is of the type implied by a large family of policy rules in which the parameters of the economy are known.

But what if key parameters that describe the long-run destination of the economy are unknown? This is indeed the relevant case that the FOMC and other monetary policymakers face in practice. The two most important unknown parameters needed to conduct‑‑and communicate‑‑monetary policy are the rate of unemployment consistent with maximum employment, u*, and the riskless real rate of interest consistent with price stability, r*. As a result, in the real world, monetary policy should, I believe, be data dependent in a second sense: that incoming data can reveal at each FOMC meeting signals that will enable it to update its estimates of r* and u* in order to obtain its best estimate of where the economy is heading. And, indeed, as indicated by the SEP, FOMC participants have, over the past nearly seven years, revised their estimates of both u* and r* substantially lower as unemployment fell and real interest rates remained well below prior estimates of neutral without the rise in inflation or inflation expectations those earlier estimates would have predicted. And these revisions to u* and r* almost certainly did have an important influence on the path for the policy rate that was actually realized in recent years. I would expect to revise my estimates of r* and u* as appropriate if incoming data on future inflation and unemployment diverge materially and persistently from my baseline projections today.


RIA Pro comment- Clarida resorts to economic jargon in the paragraph above to affirm his belief in the Phillips Curve. He is saying that lower levels of unemployment spur wage growth, and if that is occurring, interest rates should be higher to offset the effects of higher inflation caused by wage growth. This statement tells us that the monthly labor report from the Bureau of Labor Statistics (BLS) should be followed closely for signs of further strength in employment. Within the labor report, other important statistics include hours worked, wages and the participation rate.


Consequences for Monetary Policy

What does this mean for the conduct of monetary policy? As the economy has moved to a neighborhood consistent with the Fed’s dual-mandate objectives, risks have become more symmetric and less skewed to the downside than when the current rate cycle began three years ago. Raising rates too quickly could unnecessarily shorten the economic expansion, while moving too slowly could result in rising inflation and inflation expectations down the road that could be costly to reverse, as well as potentially pose financial stability risks.

Although the real federal funds rate today is just below the range of longer-run estimates presented in the September SEP, it is much closer to the vicinity of r* than it was when the FOMC started to remove accommodation in December 2015. How close is a matter of judgment, and there is a range of views on the FOMC. As I have already stressed, r* and u* are uncertain, and I believe we should continue to update our estimates of them as new data arrive. This process of learning about r* and u* as new data arrive supports the case for gradual policy normalization, as it will allow the Fed to accumulate more information from the data about the ultimate destination for the policy rate and the unemployment rate at a time when inflation is close to our 2 percent objective.


RIA Pro comment- In the final two paragraphs, Clarida is essentially relaying that the Fed Funds rate is much closer to its terminal value than when they started raising rates in 2015. While obvious, the statement seems to convey a feeling that future rate hikes will require more robust data than that seen over the last three years.


RIA Pro Summary:

In general, we are not swayed that Clarida is looking to stop Fed Funds rate hikes, but he makes it apparent that weakening economic growth and any slowdown in employment data will result in a more dovish Fed. As is now customary for Federal Reserve officials, Clarida is making a bold attempt to “have his cake and eat it too.” Broadcasting the Fed’s tendencies with regard to interest rates through forward guidance has afforded the Fed tremendous power over guiding market expectations and thereby reducing volatility. Their wish is to maintain that influence, but doing so while raising interest rates is a very different circumstance than doing so while lowering them.

As was the case when the Fed expressed 100% certainty about implementing extraordinary policies, they are now desperately trying the same approach but while keeping a foot in the exit door. More than anything else, what they want to avoid is being caught dead wrong as they were about the housing market and economy in 2007-2008.

Simply said, on the one hand, Clarida wants to convey certitude about the economic outlook and the Fed’s path, on the other hand, he is trying to reserve the right to be wrong. We would applaud an honest acknowledgment of possible alternative outcomes, but his approach in this speech was more than a little ham-handed.

Municipal CEFs – A Potential Home Run for Bond Bulls

In July of 2015 and again in late November of 2016, bond yields were surging higher which prompted us to recommend that our readers consider investing in Closed-End Funds (CEF) that hold municipal bonds (Muni CEF). In the wake of rising yields, there were some dislocations which we believed presented a great opportunity for investors who felt that increase in yields was temporary. In both instances, yields halted their increases shortly after our recommendation, and as we suspected, readers that followed our advice were rewarded with double-digit returns in a relatively short time frame.

Since mid-2016, the yield on the 10-year U.S. Treasury Note has risen nearly 2% and stands at levels last seen in 2011. For those who believe the recent rise in interest rates is at or near a peak, we believe Muni CEFs once again offer similar opportunities. The following article shares highlights from our prior articles that help explain what Muni CEFs are and what drives their return. The article concludes with a fresh analysis of six funds that we believe can produce favorable returns going forward.

Before preceding, we want to stress that this recommendation is for those that think yields are at or near their short-term peak. If yields continue to rise it is quite possible that Muni CEFs, due to their leverage, could underperform individual municipal bonds and other fixed income sectors.

What are CEF’s?

Closed-End Funds (CEF’s) are mutual funds with a fixed number of shares, unlike most other mutual funds whose share count fluctuates daily with investor interest. Also differentiating CEF’s from open-ended mutual funds is the fact that CEF shares are bought or sold on exchanges, not via direct transactions with the associated mutual fund company. It is this unique feature that results in CEF’s trading at a premium or discount to their net asset value (NAV).

The three biggest factors which determine why a CEF might trade at a premium or discount to its NAV are:

  1. Strong demand and/or low supply of the fund may result in a premium, while weak demand and/or excess supply will frequently result in a discount
  2. Quality of the fund management team
  3. The liquidity of the underlying fund holdings

The change in the premium or discount to NAV is just one factor determining total return for CEFs. The table below highlights all of the factors influencing the total return for M-CEF’s.

Total Return Factor Comment
Price of underlying municipal bond As yields decrease, prices increase helping total return. The opposite occurs when yields increase.
Dividend (coupon)/Yield Most of the CEF’s we researched have a yield ranging from 5% to 8%.
Discount divergence from NAV As the discount normalizes towards zero, the price of the M-CEF increases. If the discount widens, the price falls.
Leverage Leverage used by the M-CEFs amplify price changes (gains and losses) and dividends.
Expense ratio The fee that the fund manager extracts from the M-CEF’s return. Higher fees erode returns.

 

The following table from our 2015 article highlights key statistics from the date we recommended the funds to the date we recommended taking profits. Reviewing the sources of returns allows us to better understand how gains may be achieved this time around.

Sources of 2015 gains:

  • Coupon yield- The funds we recommended had an average yield of 6.41% which provided reliable income.
  • Price appreciation due to yield- After a six month period, the yield on the funds declined to 5.98%. As a result, the prices of the underlying bonds and therefore the net asset value of the CEF’s rose by approximately 2.50%. Because the funds are leveraged the price appreciation was closer to 3.50%.
  • Price appreciation due to discount to NAV- In July of 2015 the average discount was at or near the respective lows since 2013. Over the next six months the average discount to NAV would rise from -11.19 to -8.03, resulting in an additional 16% of price gains on the CEF’s.

Current Recommendation

Yields are currently on a trajectory higher for a number of reasons. First and foremost is a widely held concern amongst bond investors that strong economic growth and low unemployment will push wages higher and spur more inflation. Second, the U.S. Treasury will offer over $1 trillion of debt this year and is forecast to do the same over the next few years. The heavy supply is creating an imbalance that has pushed yields higher. As an aside, we will have more to say about who is buying U.S. Treasury debt and why it matters in an upcoming article.

The following paragraph was from 2016, the second time we recommended Muni CEFs. We believe it is just as pertinent today:

“Having begun in 1981, the current bull market in bonds is well-seasoned and no doubt much closer to the end than the beginning.  At the same time, the velocity of money is still declining in the U.S., the U.S. dollar is strengthening versus other currencies and global deflationary forces emanating from abroad remain influential.  The U.S. economy is more sensitive than ever to the level of interest rates and economic stress resulting from higher yields could easily halt economic growth and push the economy into recession. In such an instance, the Fed would likely end the normalization of rates and take actions to bring the Federal Funds rate back to zero or even lower.  Additionally, the Fed could re-introduce QE. If some form of these events unfold, Japan remains the most reliable model for the path of interest rates in the U.S.”

Higher interest rates are already depressing economic activity in interest rate sensitive sectors such as housing and autos. There is little doubt in our mind that as the benefits of fiscal stimulus erode over the coming quarters and the Fed continues to raise rates and reduce their balance sheet (QT), the economy will slow and inflationary impulses will subside. Such a result would help put a lid on rising interest rates. While timing is difficult and yields can certainly rise further, we believe that yields will peak, either now or within the next few months, and Muni CEF’s will offer similar opportunities as in the past.

We selected the following six Muni CEFs based on a number of qualifications, including but not limited to leverage, credit, expense ratio, and discount to NAV.

Summary

Given the move in interest rates in 2018, reluctance to take on investments that are negatively affected by higher rates is understandable. However, due to the nature of our highly leveraged economy, past episodes of rising interest rates have been met with faltering economic growth, deflationary impulses and ultimately lower interest rates.

Muni CEFs offer a counter-trend position to take advantage if interest rates reverse course. Further they offer a margin of safety in the form of steep discounts to their NAV.

 

Disclaimer: This material is subject to change without notice. This document is for information and illustrative purposes only. It is not, and should not be regarded as “investment advice” or as a “recommendation” regarding a course of action, including without limitation as those terms are used in any applicable law or regulation.

Is It Time To Buy The Home Building Sector (XHB)

Throughout modern financial history, the ability to borrow at a 5% rate on a 30-year mortgage was considered a great deal. Over the past ten years, mortgage rates falling to between 3% and 4% have warped perceptions. Evidence of this fact can be found by the sticker shock and home buyer consternation that the currently available 5% mortgage rate is causing. The rate shock is not limited to home buyers; the home building sector has fallen over 30% since it recorded a record high in January 2018. Notably, a month before hitting that record, the popular SPDR S&P Homebuilders ETF (XHB) surpassed the previous record high established at the peak of the housing bubble in 2006.

Mortgage rates play a large role in housing affordability, which greatly affects housing sales and prices, economic growth and the profits or losses for those involved in the housing sector. We discussed and quantified housing affordability dynamics in our article, The Headwind Facing Housing. In this article, we consider whether the housing sector has fallen far enough to warrant investment consideration.

Headwinds Redux

In The Headwind Facing Housing, we produced two graphs that quantify the effect varying mortgage rates have on housing affordability. We modified those graphs, as shown below, to highlight how recent changes in 30-year mortgage rates have affected mortgage payments and housing affordability.

In the first graph, the monthly mortgage payment (excluding taxes, insurance, and other fees) for a buyer purchasing a $500,000 house has risen 12% since 2016. The second graph illustrates the purchase price a buyer can afford for a fixed $2,500 mortgage payment. Since 2016, the purchase price has dropped from $530,000 to almost $470,000. The data in both graphs are based on 30-year mortgage rates rising from 3.87% in January 2016 to 4.83% as of the most recent data from the Federal Reserve. Effectively, as the graphs show, a 1% rise in mortgage rates reduced affordability and increased monthly mortgage payments by about 10-12% in the current environment.

Higher mortgage rates dictate that buyers either take on larger mortgage payments or buy cheaper houses. The burden of higher rates does not solely fall on buyers; it also hurts sellers and those in the housing construction business.

Home Builders

Equity investors appear to be keenly aware of the toxic relationship between mortgage rates and homebuilder profits. The graph below compares the year to date price return for the S&P Homebuilders ETF (XHB) and the S&P 500.

Data Courtesy Bloomberg

Note that while XHB and the S&P 500 both fell in the first quarter, the S&P regained its footing and went on to new record highs before its recent stumble. Conversely, XHB drifted slightly lower following the first quarter decline. More recently, as interest rates rose, XHB fell precipitously. As shown, XHB is underperforming the S&P 500 by almost 25% year to date.

Looking back further, we find that since the recovery from the financial crisis beginning in March of 2009, XHB greatly outperformed the S&P 500. As shown below, in January of 2018, XHB had outperformed the S&P 500 by about 200% since March of 2009. That differential has collapsed over the last few months.

Data Courtesy Bloomberg

Statistically, XHB and the S&P have had a strong long-term correlation (2006-present) of +.71, meaning that 71% of XHB’s price can be explained by changes in the price of the S&P 500.

Interestingly, XHB has a +.21 correlation with ten-year U.S. Treasury yields over the same period. The positive relationship is not what one should expect as it implies that yields and XHB have risen and fallen together. Keep in mind, the relationship is not strong but the positive relationship is notable.

Recently, however, as bond yields broke out of ten-year ranges, reached five-year highs and brushed up against key long-term technical levels, XHB investors became concerned. Since September 2018, the correlation between XHB and ten-year Treasury yields has been -.58 and greatly reflects the lagged effects of rising interest rates on housing activity. We suspect this statistically relevant negative correlation will persist and perhaps strengthen as long as rates keep rising.

Investment Implications

The rest of this article, including our investment conclusions, is only available for subscribers of RIA Pro. To try out this new service with a 14 day free trial period visit us at RIA Pro.

 

 

 

Is It Time To Buy The Homebuilders (XHB) – RIA Pro

Please note this article will be distributed on our free site tomorrow but the Investment Implications section is only available for RIA Pro subscribers.

Throughout modern financial history, the ability to borrow at a 5% rate on a 30-year mortgage was considered a great deal. Over the past ten years, mortgage rates falling to between 3% and 4% have warped perceptions. Evidence of this fact can be found by the sticker shock and home buyer consternation that the currently available 5% mortgage rate is causing. The rate shock is not limited to home buyers; the home building sector has fallen over 30% since it recorded a record high in January 2018. Notably, a month before hitting that record, the popular SPDR S&P Homebuilders ETF (XHB) surpassed the previous record high established at the peak of the housing bubble in 2006.

Mortgage rates play a large role in housing affordability, which greatly affects housing sales and prices, economic growth and the profits or losses for those involved in the housing sector. We discussed and quantified housing affordability dynamics in our article, The Headwind Facing Housing. In this article, we consider whether the housing sector has fallen far enough to warrant investment consideration.

Headwinds Redux

In The Headwind Facing Housing, we produced two graphs that quantify the effect varying mortgage rates have on housing affordability. We modified those graphs, as shown below, to highlight how recent changes in 30-year mortgage rates have affected mortgage payments and housing affordability.

In the first graph, the monthly mortgage payment (excluding taxes, insurance, and other fees) for a buyer purchasing a $500,000 house has risen 12% since 2016. The second graph illustrates the purchase price a buyer can afford for a fixed $2,500 mortgage payment. Since 2016, the purchase price has dropped from $530,000 to almost $470,000. The data in both graphs are based on 30-year mortgage rates rising from 3.87% in January 2016 to 4.83% as of the most recent data from the Federal Reserve. Effectively, as the graphs show, a 1% rise in mortgage rates reduced affordability and increased monthly mortgage payments by about 10-12% in the current environment.

Higher mortgage rates dictate that buyers either take on larger mortgage payments or buy cheaper houses. The burden of higher rates does not solely fall on buyers; it also hurts sellers and those in the housing construction business.

Home Builders

Equity investors appear to be keenly aware of the toxic relationship between mortgage rates and homebuilder profits. The graph below compares the year to date price return for the S&P Homebuilders ETF (XHB) and the S&P 500.

Data Courtesy Bloomberg

Note that while XHB and the S&P 500 both fell in the first quarter, the S&P regained its footing and went on to new record highs before its recent stumble. Conversely, XHB drifted slightly lower following the first quarter decline. More recently, as interest rates rose, XHB fell precipitously. As shown, XHB is underperforming the S&P 500 by almost 25% year to date.

Looking back further, we find that since the recovery from the financial crisis beginning in March of 2009, XHB greatly outperformed the S&P 500. As shown below, in January of 2018, XHB had outperformed the S&P 500 by about 200% since March of 2009. That differential has collapsed over the last few months.

Data Courtesy Bloomberg

Statistically, XHB and the S&P have had a strong long-term correlation (2006-present) of +.71, meaning that 71% of XHB’s price can be explained by changes in the price of the S&P 500.

Interestingly, XHB has a +.21 correlation with ten-year U.S. Treasury yields over the same period. The positive relationship is not what one should expect as it implies that yields and XHB have risen and fallen together. Keep in mind, the relationship is not strong but the positive relationship is notable.

Recently, however, as bond yields broke out of ten-year ranges, reached five-year highs and brushed up against key long-term technical levels, XHB investors became concerned. Since September 2018, the correlation between XHB and ten-year Treasury yields has been -.58 and greatly reflects the lagged effects of rising interest rates on housing activity. We suspect this statistically relevant negative correlation will persist and perhaps strengthen as long as rates keep rising.

Investment Implications

Despite its label of “Homebuilder ETF,” XHB holds many companies that are not homebuilders. For instance, Whirlpool, Williams Sonoma and the Home Depot represent three of the ETF’s top six holdings. These non-home builders, many of which are categorized as cyclicals, have helped buffet the recent decline. On average, the top five homebuilders in the ETF are down 34% year to date or about 7% more than the ETF.

While it is tempting to buy XHB given its sharp decline, the risks are onerous. The biggest risk is that yields keep rising. This will continue to be a headwind for home builders as housing affordability declines and mortgage payments rise. It will also further pressure the stock market and the economy in general which bodes poorly for the cyclical stocks in the ETF.

Higher mortgage rates will also make it less tempting for consumers to perform cash-out mortgage refinancings or take out home equity loans. Both have translated into a sizable source of revenue for Home Depot, Lowes and other companies in the ETF that profit from home remodeling and furnishing. Those sources of funding for consumer purchases is quickly drying up. Per the Mortgage Bankers Association (MBA): “MBA’s Weekly Applications Survey refinance index averaged 1,013 in June, the lowest monthly average since December 2000. The weekly index value dropped below 1,000 in three of the past six weeks, a level that it has not gone below since December 2000 as well.

Even if yields peak at current levels and begin to trend lower, we are concerned that the reason for such a reversal in yields would be economic weakness. Heavy stimulus in the form of tax cuts and fiscal spending have boosted GDP by 0.8% so far this year. As the benefits of the stimulus fade, as is widely expected, economic growth should slow and have adverse effects on consumers. The recent takeover of the House of Representatives by the Democrats make new stimulus much less likely to counteract economic weakness.

Despite being in the midst of the second longest economic expansion in modern U.S. economic history, the Congressional Budget Office (CBO) is not currently forecasting a recession for the next ten years as shown above. We, on the other hand, realize that such a forecast is idiotic and, even more concerning, believe the probability of a recession within the next year is significant. A recession would likely result in lower mortgage rates, but the benefits to homebuilders and buyers will likely be offset by job losses, weaker consumer activity and declining consumer sentiment(home buyers).

Despite the recent decline versus the S&P 500 and other sectors, we currently recommend selling or reducing exposure to the homebuilders and the XHB ETF. We believe it is best to wait until the interest rate and economic environment becomes more clear. In our opinion, it’s too early to catch the proverbial falling knife.

To stay abreast of the situation, we recommend following the weekly MBA purchase and refinance surveys as well as 30-year mortgage rates furnished by the St. Louis Federal Reserve (LINK). Other housing data, such as housing starts and new homes sales are helpful, but the data lags significantly, so caution is advised when using that data to infer something about the demand for housing.

 

 

 

“Blind Faith” Isn’t A Strategy For “Late-Cycle” Markets

 The journey of a thousand miles begins with one step.”  – Lao Tzu

In a tiny first step on December 16, 2015, the Federal Reserve (Fed) did something they had not done in over nine years. From the unprecedented starting point of zero, they raised the Fed Funds rate. Since, they have begun to allow their swollen balance sheet to contract in what can only be characterized as another unprecedented event. Although monetary policy remains extreme and real rates only recently have turned positive, these measures mark the end of an era of maintaining extreme financial crisis monetary policy in the United States.

Reversing these experimental policies initiates a new set of dynamics which will gradually reduce excessive liquidity from the financial system. Just as quantitative easing (QE) and zero interest rates were a grand experiment, the removal of these policy measures is equally experimental. Now, over 325 million domestic lab rats and the rest of the world wait to see how it plays out.  Importantly, if the Fed continues down this path, investors should carefully consider potential risks and the appropriate market exposure in this brave new world.

Despite the multitude of unanswerable questions about the implications of these events, what we know is that the economy is in the late stages of an economic expansion. Just as low tides follow high tides, we can use prior cycles as a guide to consider prudent, late-stage portfolio positioning.

Market Expectations

As discussed in, Everyone Hears the Fed but Few Listen, the difference between Fed officials’ expected path of Fed rate hikes and market expectations for the Fed Funds rate is important. The implications for the market and investors are especially compelling when considering asset allocation weightings. For example, if the Fed continues on their path of more rate hikes and surpasses market expectations, stocks are likely to struggle as much needed liquidity evaporates. The bond market, on the other hand, will probably continue to do what it has been doing, but to a greater extent. A flatter and possibly an inverted yield curve would be in order unless inflation rises by more than is currently expected. Conversely, if the Fed backs away from their current commitment, it will likely be bullish for risk assets and the yield curve would probably steepen, led by a decline in 2-year Treasury yields.

Context

Through September this year, the U.S. economy has posted an average growth rate of 3.3% (average quarterly annualized) and S&P 500 earnings have grown over 20% so far this year. The news from consumer and business surveys is favorable, and the country is essentially at full employment. That all sounds good, but is it sustainable?

The table below, courtesy of the Committee for a Responsible Fiscal Budget (CRFB), shows that recent tax and budget legislation along with soybean purchases in anticipation of trade tariffs drove recent economic growth at the margin.

While the stimulative impact of fiscal policy remains favorable, it will steadily decline toward neutral for the rest of this year and throughout 2019. Policies regarding tariffs and trade are likely to weigh on economic growth throughout this year and next year. Most importantly, the Fed is clear that their plans are to continuing raising rates and reducing the holdings on their balance sheet that resulted from QE.

Late-Cycle Adjustments

Since the end of the recession in June 2009, the economy has clearly moved from recovery to expansion. That means the U.S. economy is nearing the “slowdown” phase of the cycle and heading toward the contraction (recession) phase. The evidence of the U.S. now being in a late-cycle environment is compelling and strongly suggests that investors modify their asset allocation weightings to protect against losses as the cycle progresses.

The Path Forward

The past does not provide investors with perfect information about how we should invest, but it does offer excellent clues. It may be helpful to look at the major asset classes and consider portfolio adjustments for late-cycle positioning.

U.S. Stocks: To evaluate late-cycle performance, we looked at equity performance by sector in the 12-months leading up to each of the prior three recessions (1990, 2001, and 2007).

Data Courtesy Bloomberg

Every environment is different, and what outperformed in the past may not on this occasion as the cycle unfolds. Prior to the last three recessions, investors preferred defensive sectors, such as staples, healthcare, utilities, energy and industrials during late-cycle periods.

U.S. Bonds: Using the same framework, we looked at various bond categories in the period leading up to the three prior recessions (due to limited data, some categories do not have return information for the 1990 period).

Data Courtesy Bloomberg

The important takeaway is that investors prefer lower risk bonds leading into a recession. This is also evident across the rating categories of the high yield bond market.  Note how much better BB-rated bonds perform relative to lower-rated B and CCC bonds.

The quality of the securities within both the investment grade and high yield market is so poor in this cycle (highly levered, high percentage of covenant-lite structures, high percentage of BBB-rated securities in the IG sector) that we urge a very conservative position in both cases. Indeed, the “up-in-quality” theme holds for any credit instrument in the late stages of the cycle.

Commodities: Despite the rise in oil and gas prices in 2018, commodities remain the most undervalued of all major asset classes. Some soft and hard commodities have been hurt by the tariffs initiated by the Trump administration, but there is a reason they are characterized as “commodities.” We need them, and they are staples to our standard of living. Supply fluctuations will occur between nations as trade negotiations evolve, but the demand will remain intact.

Additionally, global central bank interventionism remains alive and well as demonstrated by recent actions of the Peoples Bank of China (PBOC). To the extent that central bankers continue to take the easy route of solving problems by printing money to calm markets when disruptions occur, natural resources and agricultural products will likely do well as a store of value – much like gold. They all reside in the same zip code as a means of protecting wealth.

Cash is King: In addition to the ideas illustrated above, it is always a good late-cycle idea to raise cash. As American financier and statesman, Bernard Baruch said, “I made my money selling too soon.” Although the low return on cash is a disincentive, the discipline affords opportunity and peace of mind. Having cash on hand is also a reflection of the discipline of selling into high prices, a skill at which most investors fail. Cash is an undervalued asset class heading into a recession because most investors panic as markets correct. Those with “dry powder” are better able to rationally assess market changes and more clearly see opportunities as certain assets fall out of favor and are cheap to acquire.

Investment Tourist

Many investors elect to leave the “serious” decision-making to their investment advisors on the assumption that the advisor will make the right decision “on my behalf.” They delegate with full autonomy the task of adjusting risk posture, when the advisor ultimately bears far less risk in the equation. Being inquisitive, asking good questions and challenging the “hired help” is a proper prerogative.  One should always operate and engage with humility but never on blind faith.

Given the complexities and the risks of the current environment, investors should not be silent passengers on the journey. One who has wealth and takes that responsibility seriously should have valid questions that are both difficult to answer and enlightening to debate. Iron sharpens iron as the proverb says.

Summary

The Fed has now taken eight steps in their path to normalizing interest rates and trying to set the economy on a sustainable growth path. Although he probably did not consider its application in the realm of monetary policy, Sir Isaac Newton’s law of inertia states that a body in motion will remain in motion unless acted upon by an outside force. Rate hikes are in motion and likely to remain so for the foreseeable future unless and until some outside force comes in to play (crisis).

Given the extreme nature of past policy actions and the likely impact of their reversal, forecasting future events and market behavior promises to be more difficult than usual. Reliable guideposts of prior periods may or may not hold the same predictive power. Although unlikely to afford investors with prescriptive solutions this time around, there is value to doing that analytical homework and gaining awareness of those patterns. Finally, as the cycle unfolds, successfully navigating what is to come and preserving wealth will also require investors to apply sound decision-making using clear guidance and input from those who dare to be contrary.

The Fed’s Mandate To Pick Your Pocket – The Real Price Of Inflation

Inflation is everywhere and always a monetary phenomenon.” – Milton Friedman

This oft-cited quote from the renowned American economist Milton Friedman suggests something important about inflation. What he implies is that inflation is a function of money, but what exactly does that mean?

To better appreciate this thought, let’s use a simple example of three people stranded on a deserted island. One person has two bottles of water, and she is willing to sell one of the bottles to the highest bidder. Of the two desperate bidders, one finds a lonely one-dollar bill in his pocket and is the highest bidder. But just before the transaction is completed, the other person finds a twenty-dollar bill buried in his backpack. Suddenly, the bottle of water that was about to sell for one-dollar now sells for twenty dollars. Nothing about the bottle of water changed. What changed was the money available among the people on the island.

As we discussed in What Turkey Can Teach Us About Gold, most people think inflation is caused by rising prices, but rising prices are only a symptom of inflation. As the deserted island example illustrates, inflation is caused by too much money sloshing around the economy in relation to goods and services. What we experience is goods and services going up in price, but inflation is actually the value of our money going down.

Historical Price Levels

The chart below is a graph of price levels in the United States since 1774. In anticipation of a reader questioning the comparison of the prices and types of goods and services available in 1774 with 2018, the data behind this chart compares the basics of life. People ate food, needed housing, and required transportation in 1774 just as they do today. While not perfect, this chart offers a reasonable comparison of the relative cost of living from one period to the next.

Chart Courtesy: Oregon State LINK

Three characteristics about this chart leap off the page.

  1. Prices were relatively stable from 1774 to 1933
  2. Before 1933, disruptions in the price level coincided with major wars
  3. The parabolic move higher in price levels after 1933

Pre-1933

As is evident in the graph, prior to 1933 major wars caused inflation, but these episodes were short lived. After the wars ended, price levels returned to pre-war levels. The reason for the temporary bouts of inflation is the surge in deficit spending required to fund war efforts. This type of spending, while critical and necessary, has no productive value. Money is spent on making highly specialized technical weaponry which are put to use or destroyed. Meanwhile, the money supply expands from the deficit spending.

To the contrary, if deficit spending is incurred for the purposes of productive infrastructure projects like roads, bridges, dams and schools, the beneficial aspects of that spending boosts productivity. Such spending lays the groundwork for the creation of new goods and services that will eventually offset inflationary effects.

Post 1933

After 1933, price levels begin to rise, regardless of peace or war, and at an increasing rate. This happened for two reasons:

First, President Franklin D. Roosevelt (FDR) took the United States off the gold standard in June 1933, setting the stage for the government to increase the money supply and run perpetual deficits. FDR, through executive order 6102, forbade “the hoarding of gold coin, gold bullion and gold certificates within the continental Unites States.” Further, this action ordered confiscation of all gold holdings by the public in exchange for $20.67 per ounce. Remarkably, one year later in a deliberately inflationary act, the government, via the Gold Reserve Act, increased the price of gold to $35 per ounce and effectively devalued the U.S. dollar. This move also had the effect of increasing the value of gold on the Federal Reserve’s balance sheet by 69% and allowed a further increase in the money supply while meeting the required gold backing.

That series of events was followed 38 years later by President Nixon formally closing the “gold window”, which was enabled by the actions of FDR decades earlier. This act prevented foreign countries from exchanging U.S. dollars for gold and essentially eliminated the gold standard. Nixon’s action eradicated any remaining monetary restrictions on U.S. budget discipline. There would no longer be direct consequences for debauching the currency through expanded money supply. For more information on Nixon’s actions, please read our article The Fifteenth of August.

The second reason prices escalated rapidly is that, following World War II, the U.S. government elected not to dismantle or meaningfully reduce the war apparatus as had been done following all prior wars. With the military industrial complex as a permanent feature of the U.S. economy and no discipline on the budget process, the most inflationary form of government spending was set to rapidly expand. Excluding World War I, defense spending during the first 40 years of the 1900’s ran at approximately 1% of GDP. Since World War II it has averaged around 5% of GDP.

Returning to Milton Friedman’s quote, it should be easier to see exactly what he meant. Re-phrasing the quote gives us an effective derivation of it.  Inflation is a deliberate act of policy.

Fed Mandate

The Fed’s dual mandate, which guides their policy actions, is a commitment to foster maximum employment and price stability. Referring back to the price level graph above, the question we ask is which part of that graph best represents a picture of price stability? Pre-1933 or post-1933? If someone earned $1,000 in 1774 and buried it in their back yard, their great, great, great grandchildren could have dug it up 150 years later and purchased an equal number of goods as when it was buried. Money, over this long time period, did not lose any of its purchasing power. On the other hand, $1,000 buried in 1933 has since lost 95% of its purchasing power.

What does it mean to live in the post-1933, Federal Reserve world of so-called “price stability”? It means we are required to work harder to keep our wages and wealth rising quicker than inflation. It means two incomes are required where one used to suffice. Both parents work, leaving children at home alone, and investments must be more risky in an effort to retain our wealth and stay ahead of the rate of inflation. Somehow, the intellectual elite in charge of implementing these policies have convinced us that this is proper and good. The reality is that imposing steadily rising price levels on all Americans has severe consequences and is a highly destructive policy.

Cantillon Effect

The graph below uses the same data as the price level graph above but depicts yearly changes in prices.

Chart Courtesy: Oregon State LINK

What is clear is that, prior to 1933, there were just as many years of falling prices as rising prices and the cumulative price level on the first chart remains relatively stable as a result. After 1933, however, Friedman’s “monetary phenomenon” takes hold. The money supply continually expands and periods of falling prices that offset periods of rising prices disappear altogether. Prices just continue rising.

There is an important distinction to be made here, and it helps explain why sustained inflation is so important to the Fed and the government. It is why inflation has been undertaken as a deliberate act of policy. As mentioned, periods of falling prices are not necessarily periods of deflation. Falling prices may be the result of technological advancements and rising productivity. Alternatively, falling prices may result from an accumulation of unproductive debt and the eventual inability to service that debt. That is the proper definition of deflation. This occurs as a symptom of excessive debt build-ups and speculative booms which lead to a glut of unfinanceable inventories. This is followed by an excess of goods and services in the market and falling prices result.

Furthermore, there are periods of hidden inflation. This occurs when observed price levels rise but only because of policies that intentionally expanded the money supply. In other words, healthy improvements in technology and productivity that should have brought about a healthy and desirable drop in prices or the cost of living are negated by easy monetary policy acting against those natural price moves. By keeping their foot on the monetary gas pedal and myopically using low inflation readings as the justification, the Fed enables a sinister and criminal transfer of wealth.

This transfer of wealth euthanizes the economy like deadly fumes which cannot be smelled, seen or felt. It works via the Cantillon Effect, which describes the point at which different parts of the population are impacted by rising prices. Under our Fed controlled monetary system, new money enters the economy through the banking and financial system. The first of those with access to the new money – the government, large corporations and wealthy households – are able to invest it before the uneven effects of inflation have filtered through the economic system. The transfer of wealth occurs quietly between the late receivers of new money (losers) and the early receivers of it (winners). Although a proponent of inflationary policies as a means of combating the depression, John Maynard Keynes correctly observed that “by continuing a process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens.”

Conclusion – Investment Considerations

In the same way that only a very small percentage of recent MBA grads could, with any coherence, tell you what inflation truly is, the investing public has been effectively brainwashed into thinking that they should benchmark their investment performance against the movements of the stock market. Unfortunately, wealth is only accumulated when it grows faster than inflation. In our modern society of continually comparing ourselves with those around us on social media, we obsess about what the S&P 500 or Dow Jones are doing day by day but fail to understand that wealth should be measured on a real basis – net of inflation.  For more on this concept, please read our article: A Shot of Absolute – Fortifying a Traditional Investment Portfolio.

Mainstream economists, either unable to decipher this process of confiscation or intentionally complicit in its rationalization, have convinced an intellectually lazy populace that some degree of rising prices is “optimal” and normal. Individuals that buy this jargon are being duped out of their wealth.

Holding elected and unelected officials accountable for a clear and proper measurement of inflation is the only way to uncover the truth of the effects of inflation. In his small but powerful book, Economics in One Lesson, Henry Hazlitt reminded us that policies should be judged based on their effect over the longer term and for society as a whole. On that simple and clear basis, we should dismiss the empty counterfactuals used as the central argument behind inflation targeting and most other monetary and fiscal policy platitudes. The policy and process of inflation is both toxic and malignant.

A Preferred Way to Generate Yield – Part 2 Trade Idea

The following article expands on, A Preferred Way to Generate Yield, by exploring the preferred shares of Government Guaranteed Agency-Backed Mortgage Real Estate Investment Trusts (REIT) and discussing a compelling trade idea within this sector. Neither the common nor the preferred equity classes of this style of REIT are widely followed, which helps explain why the opportunity of relatively high dividends without excessive risk exists.

What is a Mortgage REIT?

Real estate investment trusts, better known as REITs, are companies that own income-producing real estate and/or the debt backing real estate. REITs are legally required to pay out at least 90% of their profits to shareholders. Therefore, ownership of REIT common equity, preferred equity and debt requires that investors analyze the underlying assets and liabilities as well as the hierarchy of credit risks and investor payments within the capital structure.

The most popular types of REITs are called equity REITs (eREIT). They own apartment and office buildings, shopping centers, hotels and a host of other property types. There is a smaller class of REITs, known as mortgage REITs (mREIT), which own the debt (mortgage) on real-estate properties. Within this sector is a subset known as Agency mREITs that predominately own securitized residential mortgages guaranteed against default by Fannie Mae, Freddie Mac, Ginnie Mae and ultimately the U.S. government.

The main distinguishing characteristic between eREITs and mREITs is in their risk profiles.  The shareholders of eREIT securities primarily assume credit risk associated with rising vacancies and declining property values. Most mREITs, on the other hand, take on less credit risk. Instead, their dividends are largely based on interest rate risk or the yield spread between borrowing rates and the return on assets. Agency mREITS that solely own agency guaranteed mortgages take on no credit risk. Mortgage and equity REITs frequently employ leverage which enhances returns but adds another layer of risk.

Mortgage REIT Capital Structures

MREIT’s use debt, common equity, preferred equity and derivatives to fund and hedge their portfolios. Debt is the largest component of their capital structure, often accounting for more than 75% of the financing. Common equity is next in line and preferred equity is typically the smallest. The REITs choice of financing is generally governed by a balance between cost and desired leverage.

When a REIT issues common or preferred equity, leverage declines. Conversely, when debt is employed, leverage rises. The decision to increase or decrease leverage is often a function of balance sheet preferences, hedging strategies, market views and the respective costs of each type of financing. The choice between preferred and common is frequently a function of where the common stock is trading versus its book value as well as the financing costs and liquidity of the two options.

Selecting Agency mREIT Preferred Shares

Agency mREIT (again holding predominately government-guaranteed mortgages) preferred shares currently offer investors a reasonable return with manageable risk. In the current environment there are two primary reasons why we like preferred securities versus their common shares:

  • Discount to Book Value- Currently, several of the Agency mREITs that offer preferred alternatives are trading at price -to- book values below 1.0. While below fair value, we are worried shareholders might get diluted as they are at or near levels where new equity was issued in the past. We prefer to buy the common shares at even deeper discounts (in the .80’s or even .70’s) for this reason. Discriminating on price in this way offers a sound margin of safety where the upside potential is enhanced and risk of new share issuance diminished.
  • Interest Rate Risk- The Fed is raising rates and the yield curve is generally flattening. Profitability of mREITs is largely based on the spread between shorter-term borrowing rates and longer-term mortgage rates. As this differential converges, mREIT profitability declines. Also, as mentioned in our Technical Alert – 30 Year Treasury Bonds, longer-term yields might be reversing a multi-decade pattern of declining yields. While the funding spread is a key performance factor, rising yields introduce complexities not evident in a falling rate environment. Namely, hedging is more difficult and asset prices decline as rates rise. While we still think probabilities favor lower yields, a sustainable break in the long-term trend must be given proper consideration as a risk.

Before selecting a particular REIT issuer and specific preferred shares, we provide a list of all Agency mREIT preferred shares that meet our qualifications.

Data Courtesy Bloomberg

As shown in the Yield -to- Worst column (far right), the lowest expected yields are somewhat similar for all of the issues with five or more years remaining to the next call date.

To help further differentiate these issues, the table below highlights key risk factors of the REITs.

Data Courtesy Bloomberg

The bullet points below describe the four factors in the table:

  • Leverage Multiple– This is the ratio of total assets to common and preferred equity. Higher leverage multiples tend to result in bigger swings in profitability and the potential for a reduction in common and preferred dividends. It is important to note that leverage can change quickly based on the respective portfolio managers view on the markets.
  • Price -to- Book Value (P/B)– This is the ratio of the market capitalization of the common stock to the value of the assets. As the P/B approaches fair value (1.00) the odds increase that common or preferred equity may be issued, putting shareholders at the risk of dilution. The column to the right of P/B provides context for the range of P/B within the last five years.
  • 1 and 3 Year Price Sensitivity– This measures the change in book value as compared to the change in U.S. Treasury yields over selected time periods. This is an indication of hedging practices at each of the firms. The lower the number, the more aggressively they are hedging to protect against changes in yields. This measure, like leverage, can change quickly based on the actions of the firm’s portfolio managers.
  • Preferred as a Percent of Total Equity– This metric offers a gauge of the percentage of preferred shares relative to all equity shares. Preferred shareholders would rather this ratio be small. However, if the number is too low versus competitors, it might mean that preferred shares will be issued soon which would temporarily pressure the price of existing preferred shares.

Trade Idea

Given the current interest rate volatility and the potential for large binary moves in mortgage rates, we think Two Harbors Investment Corporation (TWO) appears to present the least overall risk based on the measures above. In particular, we are focused on their aggressive hedging strategy which has resulted in the lowest interest rate sensitivity over the one and three year time periods. A closer look at performance since June 2016, the point at which interest rates began to rise, also argues in favor of TWO as they have produced superior risk-adjusted total returns.

Data Courtesy Bloomberg

We are largely indifferent between the preferred issues of TWO (A, B and C) shown in the first table. The investor must choose between a preference for a higher coupon and a price above par ($25), and a lower coupon but price below par. On a total return basis, they yield similar results.

TWO spun off Granite Point in the fourth quarter of 2017 and therefore data related to that transaction was adjusted in the table to compensate for the event.

Disclaimer: This material is subject to change without notice. This document is for information and illustrative purposes only. It is not, and should not be regarded as “investment advice” or as a “recommendation” regarding a course of action, including without limitation as those terms are used in any applicable law or regulation.

Higher Rates Are Crushing Investors

There is an old saying that proclaims, “it’s not the size of the ship, but the motion of the ocean.” Since this is a family-friendly publication, we will leave it at that. However, the saying has a connotation that is pertinent to the bond market today. Much of the media’s focus on the recent surge in yields has been on the absolute increase in numerical terms. The increase in rates and yields, while important, fails to consider the bigger forces that can inflict pain on bond holders, or sink the ship. When losses accumulate and fear of further losses mount, volatility and other instabilities can arise in the bond market and bleed to other markets, as we are now beginning to see in the equity markets.

Since 1983, fixed-income investors have been able to put their portfolios on autopilot, clip coupons and watch prices rise and yields steadily fall. Despite a few bumps on this long path, which we will detail, yields, have declined gradually from the mid-teens to the low single digits.

In this piece, we discuss the effect that higher yields are having on debt investors today and compare it to prior temporary increases in yield. It is from the view of debt investors that we can better appreciate that the “motion” is much bigger today than years past.

The Motion of the Bond Ocean

As we alluded in the opening, the losses felt by bond investors cannot be calculated based solely on the amount that yields rise. For instance, if someone told you that yields suddenly rose by 1%, you have no way of estimating the dollar losses that entails for any investor or the entire universe of bond holders. For example, an investor holding a 1-month Treasury bill will have a temporary and inconsequential loss of less than 0.10%, but it will be erased when the bill matures next month. Conversely, a holder of a 30-year bond will see the bond’s value drop by approximately 20%. This example demonstrates why a bond’s duration is so important. In addition to duration, it is critical to know the cumulative amount of bonds outstanding to understand the effects of changes in yields or interest rates.

Comparing yield changes to prior periods without respect for duration and amount of debt outstanding is a critical mistake and has led to an under-appreciation of the losses already incurred by the recent rise in rates and the potential future losses if rates increase further. The importance of this analysis comes back to the central premise of an investor’s objective – wealth is most effectively compounded by avoiding large losses. In the end, we care less about the change in interest rates than we do the impact of that change on the value of a portfolio.

Amount of Debt Outstanding: Since 1993 total U.S. debt outstanding, including federal government, municipalities, consumers, and corporations have risen from about $14 trillion to nearly $60 trillion, a 318% increase as graphed below. The table below the graph compares the surge in outstanding debt among the various issuers of debt as well as the nation’s GDP.

Data Courtesy: Bloomberg

Duration of Debt Outstanding: The duration of a bond is a measure of the expected change of a bond’s price for a given change in yield. For example, the U.S. Treasury 10-year note currently has a duration of 8.50, meaning a 1% change in its yield should result in an approximate 8.50% decline in price. Since it quantifies the price change of a bond for a given change in interest rates, it affords a pure measure of risk. For simplicity’s sake, we omit a discussion of convexity, which measures the second order effect of how duration changes as yields change.

Think of duration as a fulcrum as shown below.

As illustrated, an investor of these cash flows would receive the weighted average of the present value of all of the expected cash flows at the three year mark.

Duration is a function of the current level of yields, the nominal coupon of the security, and the time to maturity of the debt issued.

The following graph highlights that the weighted average duration of total U.S. debt outstanding (including Federal, consumer, municipal and corporate) has increased by approximately 1.30 years to almost 6 years since 1993. All else equal, a 1% increase in yields today would result in an approximate 6.0% loss across all U.S. debt versus a 4.7% loss in the early 1990’s.

Data Courtesy: Bloomberg

The table above shows the changes in duration for various classes of fixed-income instruments since 1993. Consumer debt includes mortgages, credit cards and student loans. As an aside, the increase in yields since 2016 has caused the duration of mortgage-backed securities (MBS) to increase by over 3.0 years from 2.25 to 5.30 years.

Duration and Amount of Debt Outstanding

If we combine the duration and debt outstanding charts, we gain a better appreciation for how fixed-income risk borne by investors has steadily increased since 1993. The following graph uses the data above to illustrate the sensitivity of bond investors’ wealth to a 1% change in yields. For this analysis, we use the change in 5-year U.S. Treasury yields as it closely approximates the aggregate duration of the bond universe.

Data Courtesy: Bloomberg

The table below displays the way that the recent uptick in bond yields has been commonly portrayed over the prior few months.

Tables like the one above have been used to imply that the 2.13% increase in the 5-year U.S. Treasury yield since 2016 is relatively insignificant as three times since 1993 the trough to peak yield change has been larger. However, what we fear many investors are missing, is that the change in rates must be contemplated in conjunction with the amount of debt outstanding and the duration (risk) of that debt.

The table below combines these components (yield change, duration, and debt outstanding) to arrive at a proxy for cumulative dollar losses. Note that while yields have risen by only about two-thirds of what was experienced in 1993-1994, the dollar loss associated with the change in yield is currently about three times larger. Said another way, yields would have needed to increase by 9.73% in 1993-1994 to create losses similar to today.

Data Courtesy: Bloomberg

Summary

We have often said that our current economic environment is much more sensitive to changes in interest rates because of the growth in debt outstanding since the financial crisis and the recent emergence from the ultra-low interest rate period that crisis produced. Although 5-year yields have only risen by 2.13% from the 2016 lows, losses, as shown above, are accumulating at a faster pace than in years past.

Furthermore, because of the difference between the amount of debt outstanding and the actual currency in the economic system, most of that debt represents leverage. It is beyond the scope of this article to explore those implications but, as illustrated in the table above, rising rates will decidedly reveal the instabilities we fear are embedded in our economy but have yet to fully emerge.

If we are near the peak in interest rates for this cycle, then unrealized losses are likely manageable despite the anxiety they have induced. On the other hand, if we are in the process of a secular change in the direction of rates and they do continue higher, then nearly every fixed-income investor, household, corporation and the government will be adversely impacted.

A Preferred Way to Generate Yield

In the current environment investors must dig a little deeper and into less traversed areas of the capital markets to find value. In this article we provide a base knowledge of preferred equity shares, discuss the benefits and risks associated with owning them, and provide comparisons versus other asset classes. This article lays the groundwork for a forthcoming article that will analyze a sub-sector of the preferred market and make a specific trade recommendation.

Fixed-income investors in search of stable income and sufficient yield but wary of excessive risks are likely settling for assets that are sub-optimal. For instance, High-yield corporate debt yields have fallen to near record low levels and yield spreads versus safer fixed-income assets are at their tightest levels in at least the last 20 years. As stated in “High Risk in High Yield” – “As such, the risk/reward proposition for HY appears negatively skewed, and chasing additional outperformance at this point in the cycle appears to be a fool’s errand.”

Equity investors can find somewhat dependable, high-single-digit/low- teen dividend yields in the Master Limited Partnership (MLP) and Real Estate Investment Trust (REIT) sectors. The primary risk of these investments is price volatility which can frequently negate the dividend and much more in adverse conditions.

Fortunately for higher income seekers, there is the preferred stock sector that lies between equity and fixed- income assets in corporate capital structures. This sector tends to be largely underfollowed and not well understood. Because of its relative obscurity and inefficiencies, it can present rewarding options versus other highly followed markets.

What is Preferred Stock? 

Preferred stock is a class of equity issued primarily by financial companies. In a textbook corporate capital structure, preferred shares are a hybrid of debt and equity. In the event of a corporate default, preferred shareholders have a claim on the company’s assets that is secondary to unsecured creditors, such as debt holders, but superior to common equity holders. This hierarchy applies to the distribution of dividends in the normal course of business as well. Debt coupons are paid in full first, then preferred dividends and lastly common equity dividends.

To help offset the risk of non-payment of a preferred dividend, most issues are cumulative, meaning that any missed dividends must be paid before any common equity dividends are paid.

Preferred stock is most commonly issued at a $25 price (par value) and price changes from that point are based on changes to the dividend yield. For example, if a company’s credit conditions are deteriorating or if interest rates in general rise, the price of preferred shares will decline to produce a higher current dividend yield. Prices of preferred shares tend to be relatively stable compared to underlying equity shares. In this respect they are much more bond-like, with price changes a function of the general creditworthiness of the issuer, supply and demand for the issue and the general level of interest rates.

Unlike bonds, most preferred offerings do not have a fixed maturity date.  However, most issues are callable, which allows the company to repurchase the shares at par ($25) after a specified call date. Dividends paid on preferred shares are taxed as long-term capital gains, in contrast with bond coupons which are taxed as income.

The following are key risks to preferred shares:

  • Callable- The ability of the issuer to call, or repurchase, the securities at par ($25) is a risk if the shares are trading above $25. Obviously, the incentive to call preferred shares increases as the price rises. In assessing this risk, the yield – to -call should be calculated.
  • Interest Rate Risk- Like bonds, the price of preferred shares will rise as interest rates fall and fall as rates rise.
  • Credit Risk- Preferred shares fall behind debt in the credit structure. As such, the loss in the event of default could be severe. Further, deterioration of a company’s credit situation will likely push prices lower.
  • Voting Rights- Preferred shareholders do not have voting rights and therefore the holder’s influence on the company’s management is greatly limited.
  • Liquidity- Shares are not as frequently traded as those of common stock. Therefore, bid/offer spreads can widen at times. For those looking to trade in large share blocks, patience over a longer period is required, a contrast with the immediacy of execution for most common shares.

Performance and Risk Comparisons

The table below compares total return performance and yields for the ETF’s of preferred shares and other comparable asset classes. We include a modified Sharpe Ratio which calculates the current dividend/coupon yield to price volatility (risk). This ratio provides a gauge of the amount of risk incurred per unit of dividend. The traditional Sharpe Ratio is backward looking, comparing prior total return performance versus volatility over the same period.

Performance over the last five years has favored preferred shares over corporate debt and has been mixed versus higher yielding equity choices. Importantly, if we presume that price volatility stays at current levels, preferred stocks offer the highest dividends/coupon per level of risk (modified Sharpe).  It is important to note that volatility has been abnormally low for all asset classes over the last five years, and investors in all of the assets shown should expect and account for higher volatility going forward.

Summary

Since preferred shares are not widely followed, they can offer investors a value proposition that is elusive in the more traditional markets at times. However, like all higher-yielding securities, they offer above-average yields for a reason. In the case of preferred shares, this is attributable to lower levels of liquidity, and the real and present danger of credit risk. Given the credit assessment required to invest in preferred shares, experience in the fixed- income markets is beneficial in assessing the risks.

As stated above, financial companies are among the most frequent issuers of preferred shares. As such, a bank/financial system-centric economic crisis as experienced in 2008 could be devastating. The preferred ETF (PGF) declined nearly 70% through 2008 and early 2009. Once the Fed halted the decline in the financial sector with the provision of excess liquidity, bailouts, and favorable accounting changes, the sector roared back. By January 2010, PGF had totally recovered all losses while the ETF representing equities of the financial sector (XLF) was still down over 50% from its 2008 highs. Importantly, PGF made all dividend payments during the crisis, and the dividend amounts were on par to slightly higher than those preceding the crisis.

As mentioned, we will soon follow-up to this article with a recommendation of a unique preferred sector and specific shares.

 

Chairman Powell – You’re Fired

I’m a low interest rate person – Donald Trump 2016

On Donald Trump’s hit TV show, The Apprentice, contestants competed to be Trump’s chief apprentice. Predictably, each show ended when the field of contestants was narrowed down by the firing of a would-be apprentice. While the show was pure entertainment, we suspect Trump’s management style was on full display. Trump has run private organizations his entire career. Within these organizations, he had a tremendous amount of unilateral control. Unlike what is required in the role of President or that of a corporate executive for a public company, Trump largely did what he wanted to do.

On numerous occasions, Trump has claimed the stock market is his “mark-to-market.” In other words, the market is the barometer of his job performance. We think this is a ludicrous comment and one that the President will likely regret. He has made this comment on repeated occasions, leading us to conclude that, whether he believes it or not, he has tethered himself to the market as a gauge of performance in the mind of the public. We have little doubt that the President will do everything in his power to ensure the market does not make him look bad.

Warning Shots Across the Bow

On June 29, 2018, Trump’s Economic Advisor Lawrence Kudlow delivered a warning to Chairman Powell saying he hoped that the Federal Reserve (Fed) would raise interest rates “very slowly.”

Almost a month later we learned that Kudlow was not just speaking for himself but likely on behalf of his boss, Donald Trump. During an interview with CNBC, on July 20, 2018, the President expanded on Kudlow’s comments voicing concern with the Fed hiking interest rates. Trump told CNBC’s Joe Kernen that he does not approve [of rate hikes], even though he put a “very good man in” at the Fed referring to Chairman Jerome Powell.

“I’m not thrilled,” Trump added. “Because we go up and every time you go up they want to raise rates again. I don’t really — I am not happy about it. But at the same time I’m letting them do what they feel is best.”

“As of this moment, I would not see that this would be a big deal yet but on the other hand it is a danger sign,” he said.

Two months later in August of 2018, Bloomberg ran the following article:

Trump Said to Complain Powell Hasn’t Been Cheap-Money Fed Chair

“President Donald Trump said he expected Jerome Powell to be a cheap-money Fed chairman and lamented to wealthy Republican donors at a Hamptons fundraiser on Friday that his nominee instead raised interest rates, according to three people present.”

On October 10, 2018, following a 3% sell-off in the equity markets, CNBC reported on Donald Trump’s most harsh criticism of the Fed to date.  Trump said, “I think the Fed is making a mistake. They’re so tight. I think the Fed has gone crazy.”

Again-“I think the Fed has gone crazy

These comments and others come as the Fed is publicly stating their preference for multiple rate hikes and further balance sheet reduction in the coming 12-24 months. The markets, as discussed in our article Everyone Hears the Fed but Few are Listening, are not priced for the same expectations. This is becoming evident with the pickup in volatility in the stock and bond markets.  There is little doubt that a hawkish tone from Chairman Powell and other governors will increasingly wear on an equity market that is desperately dependent on ultra-low interest rates.

Who can stop the Fed?

We think there is an obstacle that might stand in the Fed’s way of further rate hikes and balance sheet reductions.

Consider a scenario where the stock market drops 20-25% or more, and the Fed continues raising rates and maintaining a hawkish tenor.

We believe this scenario is well within the realm of possibilities. Powell does not appear to be like Yellen, Bernanke or Greenspan with a finger on the trigger ready to support the markets at early signs of disruption. In his most recent press conference on September 26, 2018, Powell mentioned that the Fed would react to the stock market but only if the correction was both “significant” and “lasting.”

The word “significant” suggests he would need to see evidence of such a move causing financial instability. “Lasting” implies Powell’s reaction time to such instability will be much slower than his predecessors. Taken along with his 2013 comments that low rates and large-scale asset purchases (QE) “might drive excessive risk-taking or cause bubbles in financial assets and housing” further seems to support the notion that he would be slow to react.

Implications

President Trump’s ire over Fed policy will likely boil over if the Fed sits on their hands while the President’s popularity “mark-to-market” is deteriorating.

This leads us to a question of utmost importance. Can the President of the United States fire the Chairman of the Fed? If so, what might be the implications?

The answer to the first question is yes. Pedro da Costa of Business Insider wrote on this topic. In his article (link) he shared the following from the Federal Reserve Act (link):

Given that the President can fire the Fed Chairman for “cause” raises the question of implications were such an event to occur.  The Fed was organized as a politically independent entity. Congress designed it this way so that monetary policy would be based on what is best for the economy in the long run and not predicated on the short-term desires of the ruling political party and/or President.

Although a President has never fired a Fed Chairman since its inception in 1913, the Fed’s independence has been called into question numerous times. In the 1960’s, Lyndon Johnson is known to have physically pushed Fed Chairman William McChesney Martin around the Oval Office demanding that he ease policy. Martin acquiesced. In the months leading up to the 1972 election, Richard Nixon used a variety of methods including verbal threats and false leaks to the press to influence Arthur Burns toward a more dovish policy stance.

If hawkish Fed policy actions, as proposed above, result in a large market correction and Trump were to fire Fed Chairman Jerome Powell, it is plausible that the all-important veil of Fed independence would be pierced. Although pure conjecture, it does not seem unreasonable to consider what Trump might do in the event of a large and persistent market drawdown. Were he to replace the Fed chair with a more loyal “team player” willing to introduce even more drastic monetary actions than seen over the last ten years, it would certainly add complexity and risk to the economic outlook. The precedent for this was established when President Trump recently nominated former Richmond Fed advisor and economics professor Marvin Goodfriend to fill an open position on the Fed’s Board of Governors. Although Goodfriend has been critical of bond buying programs, “he (Goodfriend) has a radical willingness to embrace deeply negative rates.” –The Financial Times

Such a turn of events might initially be very favorable for equity markets, but would likely raise doubts about market values for many investors and raise serious questions about the integrity of the U.S. dollar. Lowering rates even further leaves the U.S. debt problem unchecked and potentially unleashes inflation, a highly toxic combination. A continuation of overly dovish policy would likely bolster further expansion of debt well beyond the nation’s ability to service it. Additionally, if inflation did move higher in response, bond markets would no doubt eventually respond by driving interest rates higher. The can may be kicked further but the consequences, both current and future, will become ever harsher.

High Risk in High Yield

Tesla’s corporate debt is rated B2 and B- by Moody’s and Standard & Poors respectively. In market parlance, this means that Tesla debt is rated “junk”. This term is often a substitute way of saying “low-rated” or frequently the term “high-yield” is used interchangeably. Tesla’s bond maturing in October of 2021 pays a 4.00% coupon and has a current yield to maturity of 6.29% based on a market price of $93.625 per $100 of face value. Based on prices in the credit default swap markets, Tesla has a 41% percent chance of defaulting within the next five years.

  • The upside of owning this Tesla bond is 6.29% annually
  • The bond’s annual expected return, factoring in the odds of a default and a generous 50% default recovery rate, is 0.17%
  • Should Tesla default an investor could easily lose half of their initial investment.

Tesla is, in many ways, symbolic of the poor risk/return proposition being offered throughout the high-yield (HY) corporate bond market. Recent strength in the HY sector has resulted in historically low current yields to maturity and tight spreads versus other fixed income classes deemed less risky. Given the current state of yields and spreads and the overall risks in the sector, we must not assume that the outperformance of the HY sector versus other sectors can continue. Instead, we must ask why the HY sector has done so well to ascertain the expected future returns and inherent risks of an investment in this sector.

In this article we’ll examine:

  • What is driving HY to such returns?
  • How much lower can yields on HY debt go?
  • Is further spread tightening possible?
  • What does scenario analysis portend for the HY sector?

All data in this article is courtesy of Barclays.

HY Returns

The HY sector, again also known as “junk bonds”, is defined as corporate bonds with credit ratings below the investment grade (IG) rating of BBB- and Baa3 using Standard and Poors and Moody’s rating scales respectively.

The table below presents returns over various time frames and the current yields for six popular fixed income sectors as well as Barclay’s aggregate fixed income composite. As shown, the HY sector is clearly outperforming every other sector on a year-to-date basis and over the last 12 months.

We believe the outperformance is primarily due to four factors.

First, many investors tend to treat the HY sector as a hybrid between a fixed-income and an equity security. The combination of surging equity markets, low HY default rates and historically low yields offered by alternative fixed-income asset classes has led to a speculative rush of demand for HY from equity and fixed income investors.

The following graph compares the performance between the HY aggregate index and its subcomponents to the S&P 500 since 2015. Note that highly risky, CCC-rated bonds have offered the most similar returns to the stock market.

The next graph further highlights the correlation between stocks and HY. Implied equity volatility (VIX) tends to be negatively correlated with stocks. As such, the VIX tends to rise when stocks fall and vice versa. Similar, HY returns tend to decline as VIX rises and vice versa.

Second, the supply of high yield debt has been stable while the supply of higher rated investment grade (IG) bonds has been steadily rising. The following graph compares the amount of BBB rated securities to the amount of HY bonds outstanding. As shown, the ratio of the amount of BBB bonds, again the lowest rating that equates to “investment grade, to HY bonds has been cut in half over the last 10 years.  This is important to note as increased demand for HY has not been matched with increased supply thus resulting in higher prices and lower yields.

Third, ETF’s representing the HY sector have become very popular. The two largest, HYG and JNK, have grown four times faster than HY issuance since 2008. This has led many new investors to HY, some with little understanding of the intricacies and risk of the HY sector.

Fourth, the recent tax reform package boosted corporate earnings overall and provided corporate bond investors a greater amount of credit cushion. While the credit boost due to tax reform applies to most corporate issuers of debt, HY investors tend to be more appreciative as credit analysis plays a much bigger role in the pricing of HY debt. However, it is important to note that many HY corporations do not have positive earnings and therefore are currently not impacted by the reform.

In summation, decreased supply from issuers relative to investment grade supply and increased demand from ETF holders, coupled with better earnings and investors desperately seeking yield, have been the driving forces behind the recent outperformance of the HY sector.

HY Yields and Spreads

Analyzing the yield and spread levels of the high yield sector will help us understand if the positive factors mentioned above can continue to result in appreciable returns. This will help us quantify risk and reward for the HY sector.

As shown below, HY yields are not at the lows of the last five years, but they are at historically very low levels. The y-axis was truncated to better show the trend of the last 30 years.

Yields can decline slightly to reach the all-time lows seen in 2013 and 2016, which would provide HY investors marginal price gains. However, when we look at HY debt on a spread basis, or versus other fixed-income instruments, there appears to be little room for improvement. Spreads versus other fixed income products are at the tightest levels seen in over 20 years as shown below in the chart of HY to IG option adjusted spread (OAS) differential.

The table below shows spreads between HY, IG, Treasury (UST) securities and components of the high-yield sector versus each other by credit rating.

The following graph depicts option adjusted spreads (OAS) across the HY sector broken down by credit rating. Again, spreads versus U.S. Treasuries are tight versus historical levels and tight within the credit stack that comprises the HY sector.

Down in Credit

As mentioned, the HY sector has done well over the last three years. Extremely low levels of volatility over the period have provided further comfort to investors.

The strong demand for lower rated credits and lack of substantial volatility has led to an interesting dynamic. The Sharpe Ratio is a barometer of return per unit of risk typically measured by standard deviation. The higher the ratio the more return one is rewarded for the risk taken.

When long term Sharpe ratios and return performance of IG and HY are compared, we find that HY investors earned greater returns but withstood significantly greater volatility to do so.  Note the Sharpe Ratios for IG compared to HY and its subcomponents for the 2000-2014 period as shown below. Now, do the same visual analysis for the last three years. The differences can also be viewed in the “Difference” section of the table.

The bottom line is that HY investors were provided much better returns than IG investors but with significantly decreased volatility. Dare we declare this recent period an anomaly?

Scenario Analysis

Given the current state of yields and recent highs and lows in yield, we can build a scenario analysis model. To do this we created three conservative scenarios as follows:

  • HY yields fall to their minimum of the last three years
  • No change in yields
  • HY yields rise to the maximum of the last three years

Further, we introduce default rates. As shown below, the set of expected returns on the left is based on the relatively benign default experience of the last three years, while the data on the right is based on nearly 100 years of actual default experience.

Regardless of default assumptions and given the recent levels of volatility, the biggest takeaway from the table is that Sharpe Ratios are likely to revert back to more normal levels.

The volatility levels, potential yield changes and credit default rates used above are conservative as they do not accurately portray what could happen in a recession. Given that the current economic cycle is now over ten years old, consider the following default rates that occurred during the last three recessions as compared to historical mean.

Needless to say, a recession with a sharp increase in HY defaults accompanied with a surge in volatility would likely produce negative returns and gut wrenching changes in price. This scenario may seem like an outlier to those looking in the rear view mirror, but those investors looking ahead should consider the high likelihood of a recession in the coming year or two and what that might mean for HY investors.

Summary

An interest rate is the cost for borrowing money and the return for lending money. Most importantly for investors, interest rates or yields help ascertain the amount of risk investors believe is inherent in a security. When one’s risk expectation and those of the market are vastly different, an opportunity exists.

Given the limited ability for yields, spreads, volatility and default rates to decline further, we think the reward for holding HY over IG or other fixed income sectors is minimal. Not surprisingly, we believe the risk of a recession, higher yields, wider spreads, higher default rates and increased volatility carries a higher probability weighting. As such, the risk/reward proposition for HY appears negatively skewed, and chasing additional outperformance at this point in the cycle appears to be a fool’s errand.

For those investors using ETF’s to replicate the performance of the HY sector, you should also be especially cautious. As a point of reference, Barclays HY ETF (JNK) fell 33% in the last few months of 2008. A repeat of that performance or even a fraction thereof would be a high price to pay for the desire to pick up an additional 2.03% in dividend yield over an IG ETF such as LQD.

The bottom line: Markets are not adequately paying you to take credit risk, move up in credit!

Why Fed’s Monetary Policy Is Still Very Accommodative

Here are two statements from the Federal Reserve’s Federal Open Market Committee (FOMC) immediately following their interest rate decisions of August 1, 2018 and September 26, 2018.

August 1, 2018 – In view of realized and expected labor market conditions and inflation, the Committee decided to maintain the target range for the federal funds rate at 1.75-2.00%. The stance of monetary policy remains accommodative, thereby supporting strong labor market conditions and a sustained return to 2 percent inflation.

September 26, 2018 – In view of realized and expected labor market conditions and inflation, the Committee decided to maintain the target range for the federal funds rate at 2.00-2.25%. The stance of monetary policy remains accommodative, thereby supporting strong labor market conditions and a sustained return to 2 percent inflation.

As you can see, the second statement eliminated language around its belief that monetary policy remained accommodative, which it clearly stated in the August release. Since the media and analysts closely track changes in Fed statements to glean intent with regards to future rate increases and current and future economic conditions, the natural conclusion was that the 25 bps rate hike in September moved the Fed from “accommodative” to “not accommodative”, though not necessarily “restrictive”.

Interestingly, Chairman Powell’s subsequent comments to PBS six days after the September FOMC meeting seem to cast doubts on that conclusion.

“The really extremely accommodative low interest rates that we needed when the economy was quite weak, we don’t need those anymore. They’re not appropriate anymore,” Powell said.

Interest rates are still accommodative, but we’re gradually moving to a place where they will be neutral,” he added. “We may go past neutral, but we’re a long way from neutral at this point, probably.”

So, is monetary policy currently accommodative or not?

This article provides a few charts aimed toward making sense of the contradictory statements from Fed officials so you can decide for yourself if policy is accommodative. Given the importance that monetary policy plays in asset pricing, a clear understanding of the Fed’s intent is extremely valuable. For more on our latest thoughts regarding Fed policy intentions and market expectations, please read our article Everyone Hears the Fed, But Few Listen.

Fed Funds

The Fed manages the level of the fed funds rate to influence other interest rates and thus meet their congressionally mandated employment and price objectives for the U.S. economy. To do so, the Fed conducts various operations in the money markets.

The graph below shows fed funds rate and its long-term average.  Since the end of 2015, the fed funds rate has risen 2% from its level near 0% that persisted for many years in the wake of the financial crisis.  Yet, the fed funds rate is still at a level that has only been experienced in a few short-lived instances in the last 70 years.

Data Courtesy: St. Louis Federal Reserve

Comparing the fed funds rate over time is not the best determinant of whether policy is accommodative or restrictive. Better context is gained by looking at the fed funds rate relative to the rate of nominal economic growth (GDP) and inflation (CPI).

Data Courtesy: St. Louis Federal Reserve

As shown in the graphs, the current fed funds rate is 3.69% below the rate of nominal economic growth (based on Q2 2018 data) and 0.95% below the rate of inflation. It is also worth noting that longer-term real (adjusted for inflation) Treasury yields, as shown in the second graph, are all near zero. This means that the current yields on Treasury securities are about equal with the current rate of inflation. While real rates have finally risen from financial crisis-era levels, history shows us that real rates remain far from normal.

To better understand why this is important, please read our article Wicksell’s Elegant Model.

The bottom line is that, while the fed funds rate is on the rise, it is far below absolute and relative levels that serve as historical norms. Based on the data shown above, further increases of 2-4% would put the fed funds rate on par with historical comparisons.

Balance Sheet

In 2009, with the fed funds rate pinned at zero percent, the Fed introduced Quantitative Easing (QE). Through three separate acts of buying U.S. Treasuries and mortgage backed securities (QE 1,2, and 3) the Fed’s balance sheet rose five-fold from about $800 billion to $4.3 trillion. The graph below charts the monetary base, which soared as a direct result of QE and has recently begun to decline due to Quantitative Tightening (QT), the Fed’s active effort to reduce the amount of assets on their balance sheet.

Data Courtesy: St. Louis Federal Reserve

Quantifying Stimulus

The next graph marries the two methods the Fed uses to conduct policy to quantify the amount of stimulus in interest rate terms. The amount of excess fed funds rate stimulus (teal) is calculated as nominal GDP growth less the fed funds rate. QE related stimulus (orange) is based on a rule Ben Bernanke laid out in 2010. He approximated that every additional $6-10bn of excess reserves held by banks (a byproduct of QE) was roughly equivalent to lowering interest rates one basis point. Together the total represents the amount of interest rate stimulus.

Data Courtesy: St. Louis Federal Reserve

Currently, between QE and a historically low fed funds rate, the amount of stimulus being applied would, under normal conditions, be equivalent to dropping the Fed Funds rate by 6.08%. While that figure may seem beyond belief, consider that excess reserves are currently $1.9 trillion as compared to near zero for the decades preceding the financial crisis and the fed funds rate is currently 3.69% below nominal GDP.

Essentially, the combination of an abnormally low fed funds rate coupled with the still outsized, but declining gradually, effects of QE argue that stimulus is still grossly accommodative. Incredibly, this is all occurring at a point in time when most economists believe the economy to be at full employment, growth is improving, stocks are at all-time highs and all sentiment indicators are at or near record high levels.

Global Accommodation

Thus far, we have only focused on the amount of accommodation provided by the Fed. Also worthy of consideration, the policies of the world’s largest economic powers have an impact on the U.S. economy. The following graph demonstrates the amount of stimulus being provided by the largest central banks.

Data Courtesy: St. Louis Federal Reserve and Bloomberg

Summary

Is Fed policy accommodative?

YES!

If you believe, as we do, that it is not only accommodative but irresponsibly accommodative, you will also appreciate the fact that the Fed has room to raise interest rates far more than investors are currently pricing in. Furthermore, any threats of inflation will likely push the Fed to restrain rising prices by acting more aggressively. This too falls outside the realm of current market expectations.

What we know is that financial asset prices have been the primary beneficiary of years of accommodative monetary policy at the expense of economic and social stability. As Stanley Druckenmiller said in his recent interview on RealVision TV:

“You know, intuitively, you can make a case that we’re going to have a financial crisis bigger than the last one because all they (the central bankers) did was triple down on what, in my opinion, caused it. I don’t know who the boogeyman is this time. I do know that there are zombies out there. Are they going to infect the banking system the way they did the last time? I don’t know. What I do know is we seem to learn something from every crisis, and this one we didn’t learn anything. And in my opinion, we tripled down on what caused the crisis. And we tripled down on it globally.”

Given the boost to asset prices caused by Fed policy, investors would be well-advised to pay close attention to the Fed’s words, their actions and critically, their inconsistencies.

Monthly Fixed Income Review – September 2018

September’s surge higher in benchmark interest rates set the stage for a challenging month in the fixed-income markets. In our broad asset class categories, as shown below, there were two exceptions as high yield and emerging markets had a solid month of performance. On a year-to-date basis, only the high-yield sector is positive. Similar performance data was observed in the popular ETF’s for these sectors as shown in the second table.

Short term interest rates continue to march higher in response to the hawkish message being telegraphed by the Federal Reserve (Fed). At the same time, the long end of the yield curve remains range-bound although in September yields moved back to the upper end of that range with 10-year U.S. Treasury note yielding 3.06% and the 30-year U.S. Treasury bond at 3.21%. The move across the term structure of interest rates was parallel and for the first time since February, the 2-10s yield curve did not flatten. The chart below illustrates this shift in rates across the Treasury curve for the month of September.

The Federal Open Market Committee (FOMC) meeting at the end of the month produced few surprises and maintains that the Fed Funds target rate will top out between 3.25-3.50% in early 2020. The trajectory of Fed rate hikes suggests another move in December, three rate hikes in 2019 and one more in 2020. If maintained, that path means that interest rates at the short end of the yield curve will continue to rise and argues for an inverted yield curve in the not too distant future. Although an inverted yield curve has in the past implied a looming recession, Fed Chairman Powell and his colleagues on the FOMC are not yet expressing any concerns.

With that backdrop, it seems plausible that the outlook for fixed-income remains challenging as rising interest rates will continue to keep pressure on returns. At the same time, the consensus view is that the economy will remain strong which should be supportive of credit markets. Evidence of this dynamic is showing up in the performance differential between high yield credit and most other fixed-income sectors. As discussed in prior months, part of the performance in high yield is due to falling supply, a shorter duration profile and other technical factors.

The chart below shows the differential between spreads on BBB-rated credits, the lowest rung of the investment grade universe, and BB-rated credit, the highest rung of junk debt. Amazingly, at a mere 73 basis points, that difference is now very close to the historic low levels observed in the heady months leading up to the financial crisis of 2008. It is also over 100 basis points below the average for the last 12 years.

Emerging market (EM) credit bounced back from a poor August but the rebound seems unlikely to be durable. There remain a multitude of factors which urge caution including tight U.S. dollar funding conditions, on-going trade tensions as well as macro problems in several EM countries. Furthermore, this backdrop is creating the need for counter-measures (rate hikes) by the central banks of affected countries. While that may help matters in the near term as was the case in September, it may also create adverse conditions in terms of the outlook for economic growth. Capital outflows remain a significant risk until some of these issues are meaningfully relieved.

All Data Courtesy Barclays

Technical Alert – 30 Year Treasury Bonds

One of the biggest economic and market concerns that we harbor is the enormous burden of debt residing on public and private balance sheets. There are two facets to the debt issue that are worth keeping in mind. First, debt plays a large role in funding current economic activity. Second, significant debts from public and private consumption of years past are still outstanding and must be serviced and ultimately paid off.

The technical alert and trade idea discussed in this article is not just for bond investors and traders.  The gravity and ubiquity of this problem is of utmost importance for those forecasting economic growth as well as investors of equities and every other asset class whose returns are predicated on economic activity.

The Lower Forever Scheme

Through inflation targeting and abnormally low interest rates, the Federal Reserve has been complicit in pushing the growth of debt beyond the aggregated ability to pay for it. One look at total debt or the ratio of government debt to GDP graphs makes this clear. Despite a few disruptions, this deliberate policy has driven economic growth but at a very high cost.

The problem for us to consider is that a large amount of economic activity is predicated on ever declining interest rates. Further, the performance of most asset classes has clearly benefited from abnormally low interest rates. Most notably, stocks have once again soared to extremely high valuations in large part for the following reasons:

  • Low interest rates make equities attractive versus low yielding bonds
  • A lower discounting factor makes the present value of future corporate earnings higher
  • Corporations have been able to drastically lower their interest expense while at the same time raising increasing aggregate debt levels
  • Corporations have been able to borrow at will to buy back their stock
  • Individuals and institutions have used excessive margin debt to leverage up their investments
  • Private and public consumption as a result of debt has greatly benefited earnings

There are a variety of questions vital to investors. Among these are the following:

  • Can rates continually keep going lower?
  • Can low interest rates be sustained indefinitely?
  • Can individuals, corporations and the government continue to endlessly accumulate debt with no consequence?

We firmly believe the answer to all of these questions is no. Even with lower rates the burden of debt will become too overwhelming and force various forms of default. That said we are fairly certain the Federal Reserve will do everything in their power to keep rates as low as they can and try to avoid the inevitable.

Chart of the Decade

While this long game plays out we must carefully watch the amount of debt outstanding and more importantly the level of interest rates. Of particular current interest is the long term charts below.

The first graph is the monthly closing price of the 30 year U.S. Treasury bond and its 100 month moving average. The six labeled data points show the times when yields came close to breaching the 100 month moving average but were rebuffed. The second graph compares the monthly closing yield on the bond with the 100 month moving average.

Since October of 1985 the yield on the bond has never been above the moving average on a monthly closing basis. That is until Friday, September 29th, when the closing 30 -year yield on the U.S. Treasury bond was 3.197% and the 100 month moving average was 3.160%. As shown on the second graph, this is the first time the moving average has failed as a point of resistance in over 30 years.

A few basis points is cause for concern but not yet a technical break in our opinion. Despite breaching it by only 3.70 basis points we think it is quite possible that yields turn lower and prove the moving average as valid resistance.  We emphasize caution however with this view, if yields are truly breaking out to the upside, investors of bonds and most other asset classes should be on alert.

Trade Idea

From a trading perspective, the current set-up in the 30-year bond offers a favorable risk/return construct. Taking a long position in the bond with a tight stop loss level, limits risk and allows for upside if yields bounce off of the resistance line.

The table below provides three and six month total return figures for the six instances labeled in the graph above. As shown all six instances provided investors substantive three and six month total returns. Further, at any point during the six periods any temporary losses were more than offset by coupon payments.

The trade can be executed using the 30-year U.S. Treasury bond, 30-year U.S. Treasury bond futures or iShares Barclays 20+ Year U.S. Treasury Bond ETF (TLT). We recommend a stop loss of ten basis points of yield which would result in a possible loss of approximately 1.95% less any coupon earned during the holding period.

If you are using TLT to execute this trade, 10 basis points is equal to approximately 2 points based on the current price of 117.38 and a duration of 17 years for the ETF.

 

Disclaimer: This material is subject to change without notice. This document is for information and illustrative purposes only. It is not, and should not be regarded as “investment advice” or as a “recommendation” regarding a course of action, including without limitation as those terms are used in any applicable law or regulation.

 

 

We The People

We want capitalism and market forces to be the slave of democracy rather than the opposite.” – Thomas Piketty

The essential underlying elements of supply, demand, scarcity, and prosperity described in our first article in this series, The Forgotten Path to Prosperity, are keys to gaining a better understanding of what constitutes a well-functioning economy. In this article, we further consider those dynamics and within that context begin to evaluate why current economic growth is stagnating. Our view necessarily advocates for a focus on supply-side economics. In other words, the talent, skills, and work that people do to acquire resources and how the resulting productivity growth from those endeavors most effectively relieves scarcity and poverty.

In his best-selling book Capitalism in the 21st Century, Thomas Piketty advocates for a mandated redistribution of wealth through a progressive global tax. His perspective of economics centers on the allocation of resources and making sure that it is fair and just. What is made very clear in Piketty’s arguments is that he and a few other intellectual elites, so-called “Davos-men,” ultimately know better than the collective decision-making of the citizens of a nation about how resources should be allocated and what should be mandated as “fair and just.” Piketty and many other economists elect to ignore the fact that the world runs most fairly and efficiently when individuals are free to pursue their separate interests. Said differently, free-market capitalism, although imperfect, remains the single best means of relieving people from the ubiquity of scarcity. As we have repeatedly seen throughout history, nations that relinquish their liberties to oligarchs crumble from the inside-out.

Importantly, Piketty’s idea runs perfectly counter to the central precepts laid out in the United States Constitution, the Declaration of Independence, the Pledge of Allegiance, and scores of other important documents that foster the basic tenets of life, liberty and the pursuit of happiness in this country.  The challenges capitalism and free markets face are not due to a lack of government imposition of laws and regulation to ensure fairness and justice, they are due to the failure of the United States government to do the primary thing incumbent upon it – defend the rights of liberty as laid out in the founding documents of our country. What Piketty suggests implies a massive expansion of government power in ways that would at a minimum erode and at worst destroy the vitality and dynamism of a capitalistic and free market society. What is most worrisome is that these concepts are not just the ruminations of the latest economic “rock star,” they are fully in play in every developed nation and go a long way toward explaining the accumulation of sovereign debt and the deterioration of economic growth in those countries.

Data Courtesy: Bank of International Settlements (BIS)

Unwanted Intrusions

Economic inequality is and always has been a feature of human existence. The degree of inequality ebbs and flows across time and geography but will never be eradicated because scarcity is also a permanent feature of human existence. Yet, for a variety of complex reasons, western civilization enjoyed an economic system that delivered unmatched prosperity and economic equality over the last 500 years and nowhere was it more pronounced than in the United States of America.

Capitalism does not solve the perpetual and age-old problem of poverty, but it offers an advantage to those societies who trust in it and depend on the government to protect against unwanted intrusions, especially those emanating from the government itself. Societies are most prosperous where individuals are incentivized to be productive because their individual liberties and private property are protected. Those societies imposed upon by over-bearing governments issuing mandates about how earnings and property will be re-directed are less prosperous and eventually bankrupt themselves.

Free Markets and the Freedom to Choose

As described in The Forgotten Path to Prosperity, everyone has a set of ideas about how markets function.  These ideas are established on the basis of our everyday experiences about how we will use our resources.  Our decision-making is prioritized by attending to those things we need first and then, provided the budget allows, moving on to those things we want – needs and desires. Whether at the grocery store or in the executive suite of a multi-national corporation, economic choices are framed in the context of economic reasoning.

Resources are limited so individuals must make decisions – choices – about how to best use the resources he or she has.  At the same time, we accumulate resources by engaging in productive activities, through the use of the factors of production – land, labor and capital – and productive activities are enabled and enhanced by the freely collaborative efforts among and between people.

With Liberty and Justice for All

So how does one go about being “freely collaborative”? What is it about a culture or society that is constrained from being so? We take such benefits for granted in the United States but even here many of those foundational freedoms are eroding.  What is really being described here is liberty which means “I rule myself.” It is a “negative right” that restrains other people or governments by limiting their actions toward the right holder.  By contrast, a “positive right” provides someone with a claim against another person or the state for some good or service (i.e., housing, healthcare, education). Liberty represents an individual’s freedom from oppressive restrictions imposed by authority on one’s way of life, behavior or political views. In other words, liberty (and freedom) can best be defined as a condition in which a man’s will regarding his own person and property is unopposed by any other will. The limits to liberty, according to Thomas Jefferson, are “drawn around us by the equal rights of others.”

The 17th-century philosopher (and indirect contributor to the Declaration of Independence), John Locke framed it this way:

“All men are naturally in a state of perfect freedom to order their actions and dispose of their possessions and persons as they think fit, within the bounds of the law of Nature, without asking leave or depending upon the will of any other man.”

Paraphrasing Jefferson and Locke, we should be allowed to do whatever we want, so long as we do not impose upon or hurt others in doing it.

Reflecting for a moment on those important closing words in the Pledge of Allegiance, “with liberty and justice for all,” we may now have a grasp on liberty but what does this have to do with justice or Thomas Piketty, for that matter?

Thomas Piketty envisions a world, quite literally a global government authority, which actively redistributes wealth, resources and property as that authority sees fit and fair without regard for the liberties of individuals. Social justice does not and cannot reconcile with the form of justice that is referenced in The Pledge of Allegiance precisely because it is adjoined to liberty. Social justice requires an imposition on some members of society in order for others to receive positive rights assigned to them. It means someone else rules over the choices and resources taken from me. The only justice that can be “for all” involves defending negative rights – prohibitions laid out against others, especially the government, to prevent unwanted impositions and intrusions.

Summary

An increasingly interventionist government, either through un-elected and unaccountable authorities like those at the Federal Reserve or those elected by constituents who demand more positive rights, will continually stray from its delegated authority. The erosion of negative rights in the name of “fairness” and “justice” achieves neither. Free markets are not allowed to function fluidly as Fed officials step in to bailout hedge funds and bankers in the name of “the greater good.” Economic growth deteriorates as capital is used to buy back stock to boost executive compensation instead of being invested in long-term growth and innovation. Entire industries wither kept alive only by artificially low-interest rates leeching resources from others who might use them more productively. Standards of living deteriorate as the cost of housing, healthcare, and education skyrocket while worker pay remains stagnant. All of these examples and many others can be found in today’s post-crisis economy and serve as markers for poor growth, weak productivity, and broad public dissatisfaction. They point to misguided policies that subordinate the inalienable, negative rights of liberty to the selfish demands of a society that risk losing her most precious asset – the talents and contributions of an inspired and motivated population.

If, as Piketty advocates in the opening quote, capitalism and market forces are to be the slave of democracy, then democracy will most assuredly be the slave to corruption. Piketty’s wish is to subordinate the cumulative independent decisions and property rights of billions of human beings – basic liberties – to a few pious intellectual elites claiming to know what is best for the global population. Without these liberties, capitalism and market forces will be neither subject to honest men elected to represent a constituency nor capable of carrying out the duties of sponsoring free collaboration. The Davos Men will rule and they will direct markets and capital as they wish (and to their benefit) picking their winners until the façade collapses under the weight of the bulging obligations of socialism. The problem with socialism, as Margaret Thatcher pointed out, is that you eventually run out of other people’s money.

To restate Milton Friedman yet again:

There is no alternative way so far discovered of improving the lot of the ordinary people that can hold a candle to the productive activities that are unleashed by a free enterprise system.”

Seeking Alpha Exclusive Interview

On September 7th we were one of three investment professionals interviewed on Seeking Alpha’s Marketplace about the markets, the Federal Reserve and other topical issues. Please enjoy our contribution to the conversation.

Summary

The Fed’s annual Jackson Hole Symposium is over; what should investors look out for now?

For the near term, interest rates will continue their steady, gradual rise, says Chairman Powell. Our authors agree.

The markets’ trajectory keeps going up – when will it fall, and what will be the catalyst?

Look for opportunities in high yield and China.

With the Federal Reserve’s 2018 Jackson Hole Economic Symposium now over, markets continuing to hit new highs, and the economy seemingly humming on all cylinders (lots of people are employed, corporate profits are strong, and the Q2 gross national product was just north of 4%), we thought it would be a good time to check in with some of our macro-minded experts on Marketplace to get their take on interest rates, inflation, and where the economy might be headed next (just how close are we to a recession, anyway?). The authors we spoke to agree that rates will continue to rise gradually and steadily in the near term; that inflation risk, while small at this point, would be problematic for investors; and that, as common sense would dictate, the timing and severity of recessions is tough to pin down. They also propose some timely investing ideas to consider in the current environment, including high-yield instruments and a contrarian play on Chinese stocks. To find out more about how our authors are thinking about the current state of the economy and what investors should be watching for, keep reading.


Seeking Alpha: Federal Reserve Chairman Jerome Powell said at Jackson Hole that he expects rate hikes to continue. Do you foresee the two planned additional hikes coming this year? When do you think the Fed will stop raising interest rates?

Lance Roberts: The Fed under Jerome Powell has been very clear that they intend to keep raising rates at a gradual but steady pace. Real rates remain very low and stimulative relative to the extent of the economic recovery. That should fuel rising levels of inflation, especially given the recent rounds of fiscal stimulus at a time of full employment. The current circumstance offers further incentive for the Fed to maintain the path of rate hikes. Powell likely wants to build room to employ traditional monetary policy stimulus while the economy is giving him the latitude to do so. Ultimately, the stock market is the Fed’s barometer on terminal Fed Funds and will tell Powell when enough is enough.


SA: Why are market expectations different from the Fed’s expectations, according to the Fed’s most recent dot plot?

LR: We recently wrote extensively about this divergence in an article we penned for our Marketplace community: “Everyone Hears The Fed… But Few Listen.” One of the key takeaways from the article was as follows: “Market participants and Fed watchers seem to have been too well-conditioned to the PhD-like jargon of Greenspan, Bernanke, and Yellen and fail to recognize the clear signals the current Chairman is sending.” In short, since the financial crisis, the market has become accustomed to a Fed that has failed to deliver on rate hike promises. That seems to have changed with plain-speaking Chairman Powell.


SA: What’s the deal with inflation? Is the Fed being too complacent about inflation risk and their ability to “control it” at all costs? What are the odds of inflation upside?

LR: Yes! Yes! And who knows. First, it is important to clarify that rising prices are a symptom of inflation caused by too much money in the economic system. Given the actions of central bankers over the past 10 years, there is no question that condition exists on a global scale as never before. The manifestation has been different in this cycle than in the past and is showing itself in asset prices as opposed to the costs of goods and services. The biggest risk, albeit small at this point, is the combination of inflation and recession (stagflation). In this event, the Fed would be forced to reduce liquidity and raise rates. This is a scenario that has not been witnessed in decades and would be a difficult combination for most stock/bond investors.


SA: There’s a chart we saw recently that shows the S&P 500 steadily climbing to dizzying heights over the past decade. At what point do you think the Fed tightening will derail the S&P 500 and the bull market?

LR: Market valuations are clearly at historical peaks. It is being driven largely by behavioral tendencies and importantly central bank liquidity. As the Fed further reduces liquidity and the ECB and BOJ begin to take similar steps, the odds increase that equity markets falter. We are already seeing the effects of reduced liquidity in Turkey and other emerging market nations. That said, picking a date is a fool’s game as this market seems to be very good at ignoring reality.


SA: Recession: are we there yet? How close (or far) are we from an economic slump?

LR: We have had some close calls since 2010, especially in late 2015 and early 2016, but central bank intervention has delayed the rhythm of these cycles. In the same way, however, that suppressing forest fires eventually result in even more uncontrollable outbreaks, this seems to be a similar likelihood for the global economy. Debt (and leverage) is the lowest common denominator as a determinant for a recession and, again, the level of interest rates will eventually be the trigger. Rate hikes naturally are bringing us closer to that point, but the trigger is unknowable. Watch real rates, the yield curve, and credit spreads.


SA: The US dollar is key for many asset classes and critical for potential emerging market issues. What’s your outlook for the US dollar both near and long term?

LR: Given the global demand dynamics and the pressures being imposed by a Fed that maintains a path of rate hikes, the dollar should sustain it recent strength and continue to move higher in the short to intermediate term. Long term, the dollar outlook is problematic due to the amount of U.S. debt outstanding, the extent of money printing that will likely have to occur in order to avert a default and the converging global efforts by major economies (especially China) to reduce their reliance on dollar-based transactions.


SA: What would you say to investors who are looking to protect themselves against potential market and inflation risks?

LR: We own house and car insurance for events that are highly unlikely. Why shouldn’t we consider owning financial insurance, especially when the risks of a significant drawdown are substantial? As Falstaff said in Shakespeare’s King Henry the Fourth, “Caution is preferable to rash bravery.”

Why Foreigners Shun Higher Yielding U.S. Bonds : Reader Question – RIA Pro

Recently we received the following question from a reader and thought it might be helpful to answer it for all of our subscribers. The question is as follows:

“Who buys a French bond with a negative yield when they can buy a safer U.S. Treasury bond yielding over 2%?”

The simple answer: the economic incentive for a foreigner to own higher yielding U.S. Treasuries is significantly diminished or entirely erased when adjusted for currency and credit risks.

Following is a detailed analysis explaining the answer.

That question was recently posed following the publishing of Deficits Do Matter. In that article, we presented data showing the pace of foreign buying of U.S. Treasury securities had slowed considerably in recent years. Of concern, the amount of debt foreigners are currently buying is not keeping up with the increasing issuance of Treasury debt. Given that foreign holders are the largest investors in U.S. Treasuries, accounting for over 40% ownership, as well as their large holdings of corporate and securitized individual debts, this change in behavior should be followed closely.

Why are foreign investors shunning U.S. Treasuries despite significantly higher yields than many other sovereign debt issuers? The question is even more perplexing when one considers that U.S. Treasury securities are believed to be safer from a credit perspective and offer more liquidity than any bond outstanding, sovereign or otherwise.

When considering bonds of different countries, the analysis is not as simple as comparing yields. When factors such as foreign exchange (FX) rates and credit quality are factored in, the math becomes more complicated, and the results tell a very different story.

Buy and Hold

In this article, we walk through the calculations that buy and hold investors of sovereign bonds use to effectively compare yields on bonds from different countries. Before going into details, it is important to note that there are two other types of buyers and their decision making is different from that discussed in this article. One investor grouping consists of the banks, brokers and hedge funds that speculate on a short-term basis to take advantage of an expected change in yields. The other type of “investors” are the central banks and/or treasuries of countries that hold U.S. dollars for trade purposes. These dollar reserves are typically invested in highly liquid fixed income securities, with U.S. Treasuries generally the most desired.

Global bond mutual funds, pension funds and other types of institutional investors that buy foreign government bonds tend to hold them to maturity. These investors are constantly assessing yields, credit risk, liquidity status and many other factors to help them achieve the highest returns possible. This task is not as simple as comparing the stated yield of a German bund to a U.S. Treasury bond of similar maturity. As mentioned, two other important risk factors one must consider, assuming the investor holds to maturity, are expected currency exchange rate changes and credit risk.

Assume the perspective of a German-based sovereign bond fund. The German portfolio manager, when valuing various sovereign bonds, must take two steps to re-calculate yields so they are comparable on a risk-adjusted basis.

The first step is to quantify the credit risk. This is a relatively easy task as credit default swaps (CDS) provide a real-time market assessment of credit risk. These swaps are essentially insurance policies where the writer/seller of the swap receives semi-annual premium payments, and the buyer of the swap is entitled to be made whole if the bonds default. The less risky the bond, the lower the premium. Our German investor might buy a related CDS in conjunction with a Treasury bond to hedge the credit risk.

The second step is to gauge the foreign exchange risk. For our German portfolio manager to buy a U.S. dollar bond, he must first convert his Euros to U.S. Dollars. Going forward, each interest payment and the ultimate payment of principal the portfolio manager receives must be converted back from U.S. Dollars to Euros. The risk the portfolio manager bears is the changing FX conversion rate of future interest and principal payments from U.S. dollars back into Euros.

Our manager can assess and hedge the risk, if he chooses, using FX forward swaps. These swaps represent the “price” at which an investor can lock in an exchange rate between two currencies in the future. Investment banks facilitate a swap where mutually agreed upon future exchange rates can be negotiated. This transaction allows the investor to buy the foreign bond and establish certainty around the exchange rate at which future payments will be received and converted.

To walk through a transaction, let’s compare a 2-year German bund to a 2-year U.S. Treasury note. The yield on the German bund is currently -0.58% and the U.S. note yields +2.64%. At first blush, one might surmise that a German investor can pick up 3.22% (2.64% – (-0.58%) buying the 2-year U.S. Treasury. However, as we stated, the investor would then be assuming foreign exchange risk.

Currently, the two-year forward euro/dollar exchange rate is priced at 6.57% (3.23% annualized) higher than the spot exchange rate. If the Euro were to appreciate 3.23% each year, the previously stated 3.22% annual pickup in yield (benefit) would be entirely offset with a 3.23% currency loss, resulting in the German portfolio manager being largely indifferent between the two bonds.

In selecting the German bund over the U.S. Treasury, the investor is also taking on additional credit risk, as Germany is considered slightly riskier than the U.S. The current German two-year credit default swap (CDS) swap costs five basis points a year more than U.S. CDS. Factoring in the CDS swap, the new rate differential slightly favors the U.S. Treasury by 0.04%.

The table below provides this same analysis for Germany and four other countries.

As highlighted above in the Net Yield Difference column, investors in Japan are better off on a risk-adjusted basis (.21%) by buying their domestic 2-year bonds with a negative yield than buying 2-year U.S. Treasury notes at 2.64%. German and French investors are indifferent, while Italian and UK investors should favor U.S. bonds.

While the math can get confusing the important takeaway is as follows: For the countries shown above and many others not included in the table, the economic incentive to own higher yielding U.S. Treasuries is significantly diminished or entirely erased when adjusted for currency and credit risks.

Interest Rate Parity

This article is based on what economists call interest rate parity, a theory in which the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate.

Financial theory, in general, rests on a bedrock that states that risk-free arbitrage opportunities, such as those shown above, should not exist. In reality, there are other factors such as capital requirements, liquidity concerns, and regulations that add costs and preclude some investors from participating in such opportunities and thus allow them to exist as highlighted above.

Summary

This analysis addresses the common misconception that U.S. Treasury bonds and notes offer significant relative value based solely on yield levels. As exhibited, there is little if any financial incentive currently for foreign buyers to choose U.S. bonds over European, British or Japanese bonds despite significantly higher yields on U.S. Treasuries. Required adjustments incorporating the foreign exchange component into the equation negates any optical advantage of higher yields in the U.S.

While there is certainly a yield that is attractive to foreign investors and will incentivize foreigners to fund U.S. deficits, based on the math that yield resides somewhere north of current levels. Either that or the U.S. dollar would have to strengthen further to offset the foreign exchange adjustments in play. A stronger dollar however presents other economic challenges beyond the scope of this discussion.

Considering the size of the current debt overhang in the U.S. and the increased supply of Treasuries projected to be coming forth over the next several quarters, this is an important and largely overlooked challenge. Each additional basis point required to meet funding needs raises the interest expense on the debt as well as the interest expense on all corporate, muni and individual new issues and floating rate debt. Given the excessive financial leverage employed by the U.S. economy, every basis point has a detrimental economic effect.

Monthly Fixed Income Review – August 2018

Monthly Fixed Income Review – August 2018

Interest rate and credit markets in the U.S. continued to demonstrate resilience in August despite rising global problems. With the exception of emerging market (EM) credits, all major fixed-income sectors registered positive returns for the month. The constructive momentum from July carried over and picked up steam in August. Meanwhile, EM gave back most of the prior month’s gain.

Data Courtesy Barclays

U.S. Treasuries – As the best performer of the month, the largest gains in the sector were in the long maturities of the yield curve. This is a reflection of the character of the persistent curve flattening. Maturities beyond 10 years had a total return for the month of between 1.33% and 1.64% while the 1-3 year sector was up only 0.33%. For the moment, the Treasury market is shrugging off the heavy supply pipeline needed to fund growing deficits.

Corporates – Strength in corporate fundamentals on display in the Q2 earnings parade no doubt played a role in last month’s performance. Investment grade (IG) performance again lagged that of the high yield sector for the third month in a row but supply dynamics largely help explain the divergence. High yield issuance fell for the 7th straight month while merger and acquisition driven issuance is fueling supply in the investment grade sector. Despite a typically quiet week heading into the Labor Day holiday, IG new issuance for the month was heavy at $86.5 billion, the third largest August on record. Looking ahead, those trends are likely to continue as September is normally the second largest issuance month behind May.

Emerging Markets – Fixed-income securities came under the same withering pressure that EM currencies and equity markets have seen since April. So far, there appear to be no signs of the stress letting up as the Trump administration and strengthening U.S. dollar continue to apply pressure. EM credit returns have been negative in six of the eight months this year and the word on every investor’s mind at this stage is “contagion”. The chart below offers a detailed look at the breakout of EM returns by broad geography and the progression of stress since the beginning of the year.

Data Courtesy Barclays  (EMEA – Europe/Middle East/Africa)

Even though the risks seem concentrated in just a few countries (Turkey, Argentina, Brazil, South Africa), the concern is that investors begin to treat all developing countries the same and reduce risk on a wholesale basis. It traditionally begins, as we are now observing, with weakness spreading across the more vulnerable EM countries and eventually engulfs even the stronger hands. If that scenario develops as it did beginning in 1997, it will bring with it a multitude of opportunities to acquire quality assets in those countries that are being unjustifiably beaten down. Those would include the stronger exporters with current-account surpluses like South Korea and Taiwan.

The following table provides returns for selected ETF’s that mirror the major fixed income asset classes.

Data Courtesy Barclays

What Turkey Can Teach Us About Gold

If you were contemplating an investment at the beginning of 2014, which of the two assets graphed below would you prefer to own?

Data Courtesy: Bloomberg

In the traditional and logical way of thinking about investing, the asset that appreciates more is usually the preferred choice.

However, the chart above depicts the same asset expressed in two different currencies. The orange line is gold priced in U.S. dollars and the teal line is gold priced in Turkish lira. The y-axis is the price of gold divided by 100.

Had you owned gold priced in U.S. dollar terms, your investment return since 2014 has been relatively flat.  Conversely, had you bought gold using Turkish Lira in 2014, your investment has risen from 2,805 to 7,226 or 2.58x. The gain occurred as the value of the Turkish lira deteriorated from 2.33 to 6.04 relative to the U.S. dollar.

 

Although the optics suggest that the value of gold in Turkish Lira has risen sharply, the value of the Turkish Lira relative to the U.S. dollar has fallen by an equal amount. A position in gold acquired using lira yielded no more than an investment in gold using U.S. dollars.

Data Courtesy: Bloomberg

This real-world example is elusive but important. It helps quantify the effects of the recent economic chaos in Turkey. Turkey’s economic future remains uncertain, but the reality is that their currency has devalued as a result of large fiscal deficits and heavy borrowing used to make up the revenue shortfall. Inflation is not the cause of the problem; it is a symptom. The cause is the dramatic increase in the supply of lira designed to solve the poor fiscal condition.

A Turkish citizen who held savings in lira is much worse off today than even two months ago as the lira has fallen in value. She still has the same amount of savings, but the savings will buy far less today than only a few weeks ago. Her neighbor, who held gold instead of lira, has retained spending power and therefore wealth. This illustration highlights the ability of gold to convey clear comparisons of various countries’ circumstances. It also illustrates the damage that imprudent monetary policy can inflict and the importance of gold as insurance against those policies.

Penalty

Using Turkey as an example also helps illustrate why we say that inflationary regimes impose a penalty on savers. Inflation encourages and even forces people to spend, invest or speculate to offset the effects of inflation. Investing and speculating entail risk, however, so in an inflationary regime one must assume risk or accept a decline in purchasing power.

Most people think of inflation as rising prices. Although that is the way most economists represent inflation, the truth is that inflation is actually your money losing value. Inflation is not caused by rising prices; rising prices are a symptom of inflation. The value of money declines as a result of increasing money supply provided by the stewards of monetary discipline, the Federal Reserve or some other global central bank.

This is difficult to conceptualize, so let’s bring it home in a simple example. If you live in a country where the annual inflation rate is a steady 2%, the value of the currency will decline every year by 2% on a compounded basis. At this rate, the purchasing power of the currency will be cut in half in less than 35 years.

Now consider a country, like Turkey, that has been running chronic deficits, printing money rapidly to make up a revenue shortfall, and begins to experience accelerating inflation. The annual inflation rate in Turkey is now estimated to be over 100% or 8.30% per month, a difficult number to comprehend. The value of their currency is currently falling at an accelerating pace so that what might have been purchased with 500 lira 9 months ago now requires 1,000 lira.

Put another way, for the prudent retiree who had 10,000 lira in cash stashed away nine months ago, the inflation-adjusted value of that money has now fallen to less than 5,000 lira. If inflation persists at that rate, the 10,000 will become less than 1,000 in 29 months.

Believe it or not, Turkey is, so far, a relatively mild example compared to hyperinflationary episodes previously seen in Germany, Czechoslovakia, Venezuela, and Zimbabwe. These instances devastated the currencies and the wealth of the affected citizens. Fiscal imprudence is a real phenomenon and one that eventually destroys the financial infrastructure of a country. For more on the insidious role that even low levels of inflation have on purchasing power, please read our article: The Fed’s Definition of Price Stability is Likely Different than Yours.

Summary

There are over 3,800 historical examples of paper currencies that no longer exist. Although some of these currencies, like the French franc or the Greek drachma disappeared as a result of being replaced by an alternative (euro), many disappeared as a result of government imprudence, debauching the currency and hyperinflation. In all of those cases, persistent budget deficits and printed money were common factors. This should sound worryingly familiar.

Modern day central banks function by employing a steady dose of propaganda arguing against the risks of deflation and in favor of the benefits of a “modest” level of inflation. The Fed’s Congressional mandate is to “foster economic conditions that promote stable prices and maximum sustainable employment” but promoting stable prices evolved into a 2% inflation target. The math is not complex but it is difficult to grasp. Any number, no matter how small, compounded over a long enough time frame eventually takes on a parabolic, hockey stick, shape. The purpose of the inflation target is clearly intended to encourage borrowing, spending and speculating as the value of the currency gradually erodes but at an ever-accelerating pace. Those not participating in such acts will get left behind.

In the same way that rising prices are a symptom of inflation attributable to too much printed money in the system, deflation is falling prices due to unfinanceable inventories and merchandise pushed on to the market caused by too much debt. Contrary to popular economic opinion, deflation is not falling prices caused by a technology-enhanced decline in the costs of production – that is more properly labeled as “progress.” The Fed is either knowingly or unknowingly conflating these two separate and very different issues under the deflation label as support for their “inflation target”. In doing so, they are creating the conditions for deflation as debt burdens mount.

Gold, for all its imperfections, offers a time-tested, stable base against which to measure the value of fiat currencies. Accountability cannot be denied.  Despite the unwillingness of most central bankers to acknowledge gold’s relevance, the currencies of nations will remain beholden to the “barbarous relic”, especially as governments continue to prove feckless in their application of fiscal and monetary discipline.

Running On Empty

We would like to introduce you to Sam and his finances. Currently, Sam does well for himself, earning $100,000 a year. Sam loves the good life, and to maintain it he consistently spends more than he earns. To fund this continual budget shortfall, he borrows money. The graph below shows his rising income (green) and accumulating debts (red) since 1966.

Unfortunately, Sam is not a hypothetical person. Sam, as represented in the graph above, is really Uncle Sam. The graph proportionately scales U.S. tax revenue and government debt outstanding data to Sam’s current income of $100,000. Currently, annual tax revenue stands at $1.908 trillion while the total amount of government debt outstanding is $21.090 trillion.

To further emphasize the growing divergence between tax revenue and debt outstanding, consider that debt grew by 6.26% and revenue shrank by 6.03% over the last year. While the recent decline in revenue is largely a function of the new tax legislation and may not last, the long-term trends are not encouraging. Over the last five and ten years, tax revenue increased annually by 2.22% and 2.09% respectively, while debt outstanding increased by 4.69% and 8.37% annually.

If the graph above were truly the financial situation of a guy named Sam, we would confidently tell you he went bankrupt 20 years ago. Fortunately for us, Uncle Sam or the U.S. government is not just any guy named Sam. The U.S. has had very little trouble borrowing well beyond its means. The U.S. dollar, acting as the world’s reserve currency, has enabled fiscal imprudence and is more of a curse than a blessing.

Consider the graph below, showing the ratio of tax revenue to the debt outstanding. Currently, for every dollar of debt there are only nine cents of revenue to cover it.

Interest Expense

Interest rates have been in a multi-decade declining trend. In 1981 the ten-year Treasury yield was approaching 15%, and today, even after rising 1%, it stands at a paltry 2.90%. This trend lower in rates greatly benefited the government’s finances as the interest expense on debt remained relatively low. In the third quarter of 1997, the interest expense on $5.413 trillion of debt was $367 billion. In the third quarter of 2009, the interest expense was an identical $367 billion despite outstanding debt more than doubling to $11.909 trillion over the prior twelve years. Over that period, the yield on the ten-year U.S. Treasury Note declined from 6.57% to 2.74%.

Over the last ten years, interest expense has been less contained, in large part because interest rates cannot decline nearly as much as they did in prior years to offset the increase in debt.  In the second quarter of 2009, the ten-year yield was 3.32%, or about 0.40% higher than the current rate. Despite the slight drop in yield, interest expense has grown by over 50% in this time frame as the amount of debt outstanding has risen substantially.

The Congressional Budget Office (CBO) expects government debt outstanding to rise by over $1 trillion per year for each of the next four years. At the same time, neither we nor the CBO expect to see interest rates decline meaningfully. However, and of grave concern, the possibility of higher rates is real. Given the outlook for rising debt and flat to rising interest rates, interest expense will continue to make Uncle Sam’s financial problems even more daunting.

Summary

Judging by historically low-interest rates, investors, ourselves included, are not concerned that the U.S. government will default. Given the government has a printing press, we see little reason for such a concern.

That said, we are greatly worried that the growing imbalance between debt outstanding and the means to pay it off will encourage further reckless monetary policy. The Federal Reserve has been complicit in this scheme by keeping rates artificially low. Further, they have used QE to manipulate interest rates lower when investors were not willing to help. As such, the financial imbalance, which will likely only worsen appreciably, leaves little doubt in our mind that policy tools such as QE and negative interest rates will be used when the fiscal imbalances become more obvious to investors.

The Weaponization of the Dollar

The Uncivil Civil War discussed the sanguine approach many investors take towards equity risk despite clear signs of domestic political turbulence. The article put the upcoming elections and the growing political divisions amongst the populace into context with market risks.

While we read plenty of politically related articles and many more investment related articles, we have found precious few that bridge the gap and gauge the effect politics has on markets. The intersection of markets and politics is important and should be followed closely, especially with a mid-term election months away. As so eloquently described by the late Charles Krauthammer, “You can have the most advanced and efflorescent cultures. Get your politics wrong, however, and everything stands to be swept away. This is not ancient history. This is Germany 1933.

In this article, we readdress politics and markets from an international perspective. In particular, we focus on suspicions we have regarding Donald Trump’s negotiation tactics and goals for the U.S. relationship with Turkey.

Emerging Markets and the Dollar

China, Turkey, and Iran are all classified as emerging markets. While the classification is broad and includes a diverse group of countries, these countries have many things in common. One is that their currencies, for the most part, are not liquid or highly valued. Thus, they heavily rely on the world’s reserve currency, the U.S. dollar, to conduct international trade.

As an example, when Pakistan buys oil from Qatar, they transact in U.S. dollars, not rupees or riyals. To facilitate trade efficiently, these countries must hold excess dollars in reserve. In almost all cases, emerging market nations rely on U.S. dollar-denominated debt for their transactional needs.

Dollar-denominated debt is currently the cause of much economic pain for Turkey. To understand why, we present a simplified example. Suppose on January 1, 2018, a Turkish corporation borrowed $100 million U.S. dollars with an agreement to pay it back with interest of 5% on August 15th, 2018. The company, as is typical, converts the loaned dollars to Turkish Lira.  On August 15, 2018, the company will convert the Lira back to dollars in order to pay the principal and interest due on the loan.

The following graph charts the Turkish Lira versus the Dollar over the life of the loan.

On January 1, 2018, one U.S. Dollar was worth 3.79 Lira. Over the next eight months, the U.S dollar appreciated significantly versus the Lira such that one U.S. dollar was worth approximately 5.81 Lira. As such, the company will now need 5.81 Lira to purchase each dollar it needs to repay the loan. Due to the strengthening of the U.S. dollar versus the Lira over the time period of the outstanding loan, the company would need 584,282,000 Lira to pay back what was originally a 378,750,000 Lira loan. In other words, the true all-in cost of borrowing was not 5% but 54%.

Turkey’s public and private sector dollar denominated loans outstanding are currently estimated to be around $500 billion. Turkish borrowers must grapple with repaying outstanding dollar-denominated loans by using more Lira to acquire the necessary dollars, and with the fact that interest rates, as set by Turkey’s central bank, have risen from 8% to 17.75%. To make matters even worse, the annualized rate of inflation is estimated to be over 100% in Turkey. Needless to say, dollar appreciation versus the Lira is bringing the Turkish economy to its knees.

Enter Donald Trump

Donald Trump, who authored a book entitled “The Art of the Deal,” takes great pride in his negotiating skills. Readers of this book know he highly values leverage in negotiations. As the President of the United States, Trump clearly has enormous leverage to change the global landscape. In the case of trade negotiations, we have seen repeated threats of tariffs against Mexico, Canada, Europe, and China. We believe the goal is to force these countries to renegotiate prior trade treaties or remove tariffs. For Trump, the leverage is the threat, which does the heavy lifting by forcing countries to negotiate or face still retaliatory tariffs or other penalties.

We suspect that Trump may also be using dollar appreciation to force nations, especially emerging markets, to comply with his demands. If you are looking for clues, consider the following Tweet from Donald Trump (8/16/2018): “Money is pouring into our cherished DOLLAR like rarely before.” Based on his bragging it seems Trump has few qualms about the recent strength of the U.S. dollar.

Regardless of the causes of the recent ascent of the U.S. dollar versus most other currencies, there is little doubt that Trump is using the dollar as a negotiating tactic to get what he wants.

There are a few reasons that Trump would manipulate the dollar, verbally or in actuality, to bring Turkey to the negotiating table. While we have no unique insight, the following reasons should be considered:

  • Turkey opposes U.S. sanctions on Iran and vows to ignore them
  • Turkey sits at a strategically important geographic intersection surrounded by Europe and Asia through which much east-to-west international trade passes
  • If in a position to provide Turkey with a bailout, the administration can slow the growing de-dollarization trend

The bottom line is that it is likely that Trump is angling to sway Turkey towards stronger relationships with the U.S. in order to influence its relationship with China, Russia, and Iran. Keep in mind China’s One Belt One Road (OBOR) project, thought of as a new silk road, would provide increased economic competition and harm to America’s economic interests. China relies on Turkey’s participation to complete this project.  As we put the finishing touches on this article, we also learned that Turkey, Iran, and Russia are in talks to schedule a trilateral summit.

Domestic Concerns

There is a healthy debate to be had about whether or not the dollar is being used as a negotiating lever. Since we may never know the answer, we focus on the potential outcomes if it is. If the dollar does strengthen further, how might it affect economic activity and assets?

The following graph, courtesy David Rosenberg at Gluskin Sheff, shows the recent decline of many assets that are sensitive to the value of the U.S. dollar.

Of the assets above, only oil and U.S. homebuilders are having much effect on the U.S. economy or the performance of domestic investments. We think these losses will be broader-based globally and involve the US stock and bond markets if the dollar continues to appreciate. The following are potential domestic issues that could be brought about by further strengthening of the U.S. dollar:

  • Deflation
  • Worsening trade deficit, possibly prompting tougher sanctions and tariffs
  • Reduced corporate earnings
  • Contagion from a banking crisis in emerging markets spreading to domestic banks

When those and other economic headwinds become more evident, it is likely all markets will react. That reaction may move from asset class to asset class sequentially, as we are currently observing, or it may hit all assets at once in a sudden cascade of revaluation.

Summary

As we wrote this article, the U.S. stock market is showing some signs of weakness. Earnings-per-share forecasts for the S&P 500 have risen by 18% this year but the index is up only 6%. This might be an acknowledgment by investors of the international and domestic problems associated with dollar strength, or it may be something else entirely like liquidity constraints. If the market continues to stagnate as the dollar moves higher, we should turn our attention to the Administration for signs of rising concern over the value of the U.S. dollar.

If in fact they do change their stance on the “cherished DOLLAR”, we would take this as a signal that either the domestic pain of a rising dollar has reached its threshold, or Turkey is acquiescing to U.S. demands. If the dollar fails to respond to verbal or direct manipulation, then it would be clear the market has another agenda and our concerns would be much graver.

For additional context on the role of the U.S. dollar in the global economy, we recommend our prior article Triffin Warned Us.

Late Cycle Dumpster Diving – RIA Pro

With the current economic expansion now nearly ten years old and the stock market days away from being the longest bull market in modern U.S. history, the only way to characterize the current environment is “late cycle”. Economic growth has recently improved, predominately thanks to a surge in fiscal spending and tax cuts but higher volatility and tighter monetary policy should raise concerns about the durability of the U.S. economy’s winning streak.

Among the asset classes that would be most affected by a change in the contours of this expansion, high yield corporate bonds (a.k.a. junk debt), those rated below BBB-, rank near the top. To analyze the risk/reward tradeoff inherent in this sector, the following article relies heavily on charts and tables of data.  You are invited to draw your own conclusions, we certainly have ours.

Current Circumstances

Despite credit concerns in the retail sector in 2017, the high yield credit sector generated a 7.30% total return for the year. The strong performance continued in the first few weeks of 2018 as witnessed by a healthy 0.60% gain. The sudden surge in equity volatility at the end of January pushed returns in to the red. Like the equity market struggling to recapture January’s all-time highs, the high yield sector is in the black but not by much, having returned only 1.26% so far this year. Interestingly however, that performance ranks first among the major fixed-income categories as everything else except municipal bonds have negative returns for the year.

To what does the high yield sector owe this status of best performer at this point in 2018?

Technical dynamics explain most of the outperformance. High yield corporate issuers have provided much less supply in an environment where demand remains strong and despite the scare early in the year, volatility has returned to mid-January levels. Additionally, the recent boost in corporate earnings growth is providing fundamental support. Lastly, the high yield sector in general has a shorter duration (risk) profile than the investment grade sector. This combination of circumstances has helped keep high yield spreads tight to other fixed income assets, an indicator reflective of investor optimism about the economic cycle and the expectation that defaults should remain historically low.

Counter to the bullish argument, the question of broader problems potentially evolving out of the disruption currently being observed in the emerging markets should not be entirely dismissed. Emerging market economies, and for that matter many developed nations’ economies, appear to be slowing. Liquidity and lending conditions are tightening due to higher U.S. interest rates, reduction of the Federal Reserve balance sheet and rising U.S. Treasury issuance. Further, the combined effects of a stronger U.S. dollar, inflation concerns and protectionist measures being taken by the U.S., raise the overall level of uncertainty in the domestic and global economy. Although some of those concerns are peripheral to the U.S., history has proven it is a short walk to the doorstep of contagion.

High Yield Analysis

The following charts and tables provide guidance on the risk-return framework facing the high yield sector. Unless otherwise noted, data for the following charts are from Bloomberg, Barclays, Goldman Sachs and JPMorgan.

Treasury (Tsy), investment grade (IG) and high yield (HY) yields, as shown below, have been at remarkably low levels since 2011 and are now showing signs of rising in sympathy with Federal Reserve rate hikes.

The next two charts offer insight into the recent performance of high yield credit. The first illustrates total return performance by year and the second is cumulative returns since 2015. Emerging market credit is added to the second graph for further perspective.

Given the strong historical relationship with equities, the next chart highlights monthly high yield total returns and their relationship with monthly changes in equity volatility. Based on the data, a ten-point increase in the VIX index should result in a 2.50% decline in high yield returns while a ten-point decline should result in a 3.70% pick up in returns. However, with the VIX only slightly above ten and resting near historical lows, there is little reason to expect much of a pickup in returns due to falling equity volatility.

Option-adjusted spreads (OAS) reflect the difference between various credit instruments and the risk-free rate which is normally the comparable U.S. Treasury security. It not only accounts for the credit risk and interest rate risk but also factors in the optionality or risk that the issuer can call the bond at some pre-determined price. The wider (higher) the option-adjusted spread, the more risk the market attaches to the security and vice versa for tighter (lower) spreads.

The chart below shows the contrast between investment grade and high yield OAS. It also captures the price moves of the S&P 500 which are inverted on the right axis. While not at record lows, credit spreads are at very tight levels historically, which was also true in 2007 when the S&P 500 peaked.

The following chart shows the aggregate high yield index as well as a breakout of yields by credit quality. Interestingly, although yields in general are turning higher, CCC-rated bonds have been less responsive, thus the outperformance versus the other credit categories. Also note how yields on the single-B index and the aggregate high yield index have mirrored each other for the last 20+ years.

In OAS terms as shown below, spreads remain stable but the CCC’s are still trending lower (tightening – outperforming).

The continuing outperformance of the CCC-rated bonds within the high yield sector can be illustrated more specifically through the scatter chart below. Comparing the BB’s, the highest credit quality within the high yield category, with the lower-rated CCC’s reflect the significant spread tightening by the CCC’s since at least 2016.

Among the reasons for the lower quality bond outperformance may be the continuing strength of the economy which minimizes investor default concerns, as well as the reduced issuance/supply of CCC bonds relative to demand. Regardless of the reason, investors should be concerned as lower-rated bonds CCC bonds historically demonstrate much higher levels of annualized volatility, largely because they present a much higher risk of default.

A comparison of IG and HY OAS further illustrates that spread compression is not just occurring within the high yield sector but also between high yield and higher rates investment grade bonds.

The chart below combines a comparison of the spread between investment grade credit yields and those of high yield (HY minus IG yields) and the ratio of those yields (HY divided by IG yields). Both metrics are at near lows meaning HY yields are quite compressed to IG and would seem to have little room for further tightening.

The duration of a bond is a measure of price risk given a 1% (100 basis point) change in interest rates. For example, a bond with a duration of five would see the price of the bond move 5% for every 1% change in interest rates. Isolating the lowest-rated investment grade category (BBB) versus the highest-rated junk bond category shows that the BBB duration continues to migrate higher while that of the BB’s has been falling. The duration spread between the two is now near the highest levels seen since 1995.

Another useful metric to gauge relative value is yield per unit of duration. This is conceptually similar to the Sharpe Ratio. Overall investment grade credit issuance generally has a longer duration as higher quality issuers can more easily and cost effectively issue bonds with longer maturities. The long-term average (since 1989) duration for IG is 6.1 years and the average yield is 5.82% which means the average yield per unit of duration is 0.95. For high yield, the long-term average duration is 4.4 years and the average yield is 8.98% for a yield per unit of duration of 2.04.

As the table below demonstrates, current yield levels offer much less return per unit of duration risk for both IG and HY than the average. The combination of rising rates and shorter duration in HY, which helps limit the exposure of higher interest rates, may help explain why junk bonds appear more attractive using this measure relative to IG. The chart below the table offers historical context of this relationship.

As mentioned, supply and demand dynamics play an important role in relative performance as the next chart highlights. Currently, IG issuance is much heavier than HY issuance, a divergence that accelerated in 2015. The shaded area in the chart is the ratio of the notional amount of high yield bonds outstanding relative to investment grade. At 53.3% of IG outstanding, high yield supply is at the lowest relative level since 1995.

Summary

At this point in the business cycle, credit cycle and emotional cycle, the low yields and tight credit spreads in the high-yield corporate sector point toward a definitive asymmetry in risk. More bluntly, given the higher probabilities of default in high yield bonds, investors are taking on a lot of risk and are not being properly compensated for it. This can certainly continue as investing is the only business where otherwise sane individuals pile into the store to pay ever higher prices and flee as prices collapse. The current dynamics reinforce that behavior and will further ensure the alternative scenario when prices commence lower.

More importantly, the charts in this series argue that all measures of value across the full credit spectrum in absolute terms appear quite rich. Yield levels remain very low and credit spreads very tight.

This analysis argues that if an investor is going to take their chances and remain invested in corporate credit, they should do so in an “up-in-credit” manner. For example, own the double-B credits as opposed to the single-B’s and triple-C’s. Likewise, in the investment grade sector, own the double-A and single-A credit bonds as opposed to the triple-B bonds. The “give-up” in yield for moving up in credit is minimal and the added protection of better quality securities is prudent especially at this late stage in the cycle.

Without regard for how long it takes for spreads to normalize, risk management is very forgiving when valuations reach these levels. As a reminder, the diligent and patient investor is the rewarded investor who avoids large losses and continually compounds wealth.

Wicksell’s Elegant Model

“It’s unbelievable how much you don’t know about the game you’ve been playing all your life.” Mickey Mantle

The word discipline has two closely related applications. Discipline may refer to the instruction and nurturing of an individual. It can also carry the connotation of censure or punishment. The purpose of discipline, in either case, is to sustain integrity or aim toward improvement. Although difficult and often painful in the moment, discipline frequently holds long-lasting benefits. Conversely, a person or entity living without discipline is likely following a path of self-destruction.

The same holds true for an economic system. After all, economics is simply the study of the collective decision-making of individuals with regard to their resources. Where capital is involved, discipline is either applied or neglected through the mechanism of interest rates. To apply a simple analogy, in those places where water is plentiful, cheap, and readily available through pipes and faucets, it is largely taken for granted. It is used for the basic necessities of bathing and drinking but also to wash our cars and dogs. In countries where clean water is not easily accessible, it is regarded as a precious resource and decidedly not taken for granted or wasted for sub-optimal uses.

In much the same way, when capital is easily accessible and cheap, how it is used will more often be sub-optimal. If I can borrow at 2% and there appear to be many investments that will return more than that, I am less likely to put forth the same energy to find the best opportunity. Indeed, at that low cost, I may not even use borrowed money for a productive purpose but rather for a vacation or bigger house, the monetary equivalent of using water to hose off the patio. Less rigor is applied when rates are low, thus raising the likelihood of misallocating capital.

Happy Talk

In November 2010, The Washington Post published an article by then Federal Reserve (Fed) Chairman Ben Bernanke entitled What the Fed did and why: supporting the recovery and sustaining price stability. In the article, Bernanke made a case for expanding on extraordinary policies due to still high unemployment and “too low” inflation. In summary, he stated that “Easier financial conditions will promote economic growth. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”

To minimize concerns about the side effects or consequences of these policies he went on, “Although asset purchases are relatively unfamiliar as a tool of monetary policy, some concerns about this approach are overstated.” In his concluding comments he added, “We have made all necessary preparations, and we are confident that we have the tools to unwind these policies at the appropriate time.” During her tenure as Fed Chair, Janet Yellen reiterated those sentiments.

Taken in whole or in part, Bernanke’s comments then and now are both inconsistent and contradictory. Leaving the absurd counterfactuals often invoked aside, if asset purchases were in 2010 “unfamiliar as a tool of monetary policy,” then what was the basis for knowing concerns to be “overstated”? Furthermore, what might be the longer-term effects of the radical conditions under which the economy has been operating since 2009? What was the basis of policy-makers’ arguments that extraordinary policies will not breed unseen instabilities and risks? Finally, there is no argument that the Fed has “the tools to unwind these policies,” there is only the question of what the implications might be when they do.

In the same way that no society, domestic or global, has ever engaged in the kinds of extraordinary monetary policies enacted since the Great Financial Crisis (GFC), neither has any society ever tried to extract itself from them. These truths mandate that the uncertainty about the future path of the U.S. economy is far more acute than advertised.

Even though policy-makers themselves offered no evidence of having humbly and thoroughly thought through the implications of post-GFC policies, there is significant research and analysis from which we can draw to consider their implications apart from the happy talk being offered by those who bear no accountability. Looking back on the past 60+ years and observing the early stages of efforts to “unwind” extraordinary policies offers a clearer lens for assessing these questions and deriving better answers.

The Ghost of Irving Fisher

Irving Fisher is probably best known by passive observers as the economist whose ill-timed declaration that “stock prices have reached a permanently high plateau” came just weeks before the 1929 stock market crash. He remained bullish and was broke within four weeks as the Dow Jones Industrial Average fell by 50%. Likewise, his reputation suffered a similar fate.

Somewhat counter-intuitively, that experience led to one of his most important works, The Debt-Deflation Theory of Great Depressions. In that paper, Fisher argues that overly liberal credit policies encourage Americans to take on too much debt, just as he had done to invest more heavily in stocks. More importantly, however, is the point he makes regarding the relationship between debt, assets and cash flow. He suggests that if a large amount of debt is backed by assets as opposed to cash flow, then a decline in the value of those assets would initiate a deflationary spiral.

Both of those circumstances – too much debt and debt backed by assets as opposed to cash flow – certainly hold true in 2018 much as they did in 2007 and 1929. The re-emergence of this unstable environment has been nurtured by a Federal Reserve that seems to have had it mind all along.

Even though Irving Fisher was proven right in the modern-day GFC, the Fed has ever since been trying to feed the U.S. economy at no cost even though extended periods of cheap money typically carry an expensive price tag. Just because the stock market does not yet reflect negative implications does not mean that there will be no consequences. The basic economic laws of cause and effect have always supported the well-known rule that there is no such thing as a free lunch.

Cheap Money or Expensive Habit?

Interest rates are the price of money, what a lender will receive and what a borrower will pay. To measure whether the price of money is cheap or expensive on a macro level we analyze interest rates on 3-month Treasury Bills deflated by the annualized consumer price index (CPI).  Using data back to 1954, the average real rate on 3-month T-Bills is +0.855% as illustrated by the dotted line on the chart below.

When the real rate falls below 0.20%, 0.65% below the long-term average, we consider that to be far enough away from the average to be improperly low. The shaded areas on the chart denote those periods where the real 3-month T-Bill rate is 0.20% or below.

Of note, there are two significant timeframes when real rates were abnormally low. The first was from 1973 to 1980 and the second is the better part of the last 18 years. The shaded areas indicating abnormally low real interest rates will appear on the charts that follow.

The chart below highlights real GDP growth. The post-war average real growth rate of the U.S. economy has been 3.20%. Based on a seven-year moving average of real economic growth as a proxy for the structural growth rate in the economy, there are two distinct periods of precipitous decline. First from 1968 to 1983 when the 7-year average growth rate fell from 5.4% to 2.4% and then again from 2000 to 2013 when it dropped from 4.1% to 0.9%. Interestingly, and probably not coincidentally, both of these periods align with time frames when U.S. real interest rates were abnormally low.

Revisiting the words of Ben Bernanke, “Easier financial conditions will promote economic growth.” That does not appear to be what has happened in the U.S. economy since his actions to reduce real rates well below zero. Although the 7-year average growth rate has in recent years risen from the 2013 lows, it remains below any point in time since at least 1954.

Similar to GDP growth in periods of low rates, the trend in productivity, shown in the chart below, also deteriorates. This evidence suggests something contrary to the Fed’s claims.

Despite what the central bankers tell us, there is a more convincing argument that cheap money is destructive to the economy and thus the wealth of the nation. This concept no doubt will run counter to what most investors think, so it is time to enlist the work of yet another influential economist.

Wicksell’s Elegant Model

Knut Wicksell was a 19th-century Swedish economist who took an elegantly simple approach to explain the interaction of interest rates and economic cycles. His model states that there are two interest rates in an economy.

First, there is the “natural rate” which reflects the structural growth rate of the economy (which is also reflective of the growth rate of corporate earnings). The natural rate is the combined growth of the working age population and the growth in productivity. The chart of the 7-year moving average of GDP growth above serves as a reasonable proxy for the structural economic growth rate.

Second, Wicksell holds that there is the “market rate” or the cost of money in the economy as determined by supply and demand. Although it is difficult to measure these terms with precision, they are generally accurate. As John Maynard Keynes once said, “It is better to be roughly right than precisely wrong.”

According to Wicksell, when the market rate is below the natural rate, there is an incentive to borrow and reinvest in an economy at the higher natural rate. This normally leads to an economic boom until demand drives up the market rate and eventually chokes off demand. When the market rate exceeds the natural rate, borrowing slows along with economic activity eventually leading to a recession, and the market rate again falls back below the natural rate. Wicksell viewed the divergences between the natural rate and the market rate as the mechanism by which the economic cycle is determined. If a divergence between the natural rate and the market rate is abnormally sustained, it causes a severe misallocation of capital.

If the market rate rises above the natural rate of interest, then no smart businessman would be willing to borrow at 5% to invest in a project with an expected return of only 2%. Furthermore, no wise lender would approve it. In this environment, only those with projects promising higher marginal returns would receive capital. On the other hand, if market rates of interest are held abnormally below the natural rate then capital allocation decisions are not made on the basis of marginal efficiency but according to the average return on invested capital. This explains why, in those periods, more speculative assets such as stocks and real estate boom.

To further refine what Wicksell meant, consider the poor growth rate of the U.S. economy. Despite its longevity, the post-GFC expansion is the weakest recovery on record. As the charts above reflect, the market rate has been below the natural rate of the economy for most of the time since 2001. Wicksell’s theory explains that healthy, organic growth in an economy transpires when only those who are deserving of capital obtain it. In other words, those who can invest and achieve a return on capital higher than that of the natural rate have access to it. If undeserving investors gain access to capital, then those who most deserve it are crowded out. This is the misallocation of capital between those who deserve it and put it to productive uses and those who do not. The result is that the structural growth rate of the economy will decline because capital is not efficiently distributed and employed for highest and best use.

Per Wicksell, optimal policy should aim at keeping the natural rate and the market rate as closely aligned as possible to prevent misallocation. But when short-term market rates are below the natural rate, intelligent investors respond appropriately. They borrow heavily at the low rate and buy existing assets with somewhat predictable returns and shorter time horizons. Financial assets skyrocket in value while long-term, cash-flow driven investments with riskier prospects languish. The bottom line: existing assets rise in value but few new assets are added to the capital stock, which is decidedly bad for productivity and the structural growth of the economy.

Summary

As central bankers continue to espouse policies leading to market rates well-below the natural rate, then, contrary to their claims, structural economic growth will fail to accelerate and will actually continue to contract. The irony is that the experimental policies, such as those prescribed by Bernanke and Yellen, are complicit in constraining the growth the economy desperately needs. As growth languishes, central bankers are likely to keep interest rates too low which will itself lead to still lower structural growth rates. Eventually, and almost mercifully, structural growth will fall below zero. The misallocated capital in the system will lead to defaults by those who should never have been allocated capital in the first place. The magnitude and trauma of the ensuing financial crisis will be determined by the length of time it takes for the economy to finally reach that flashpoint.

As discussed in the introduction, intentionally low-interest rates as directed by the Fed is reflective of negligent monetary policy which encourages the sub-optimal use of debt. Given the longevity of this neglect, the activities of the market have developed a muscle memory response to low rates. Adjusting to a new environment, one that imposes discipline through higher rates will logically be an agonizing process. Although painful, the U.S. economy is resilient enough to recover. The bigger question is do we have Volcker-esque leadership that is willing to impose the proper discipline as opposed to continuing down a path of self-destruction? In the words of Warren Buffett, chains of habit are too light to be felt until they are too heavy to be broken.

 

Allocating on Blind Faith – RIA Pro

“Successful investing is about managing risk, not avoiding it.” – Benjamin Graham

Almost all passive investment strategies are based on the assumption that younger investors should hold more equities as a percentage of their total portfolio. Likewise, as they age and get closer to retirement, the allocation to fixed income assets should grow while equity holdings shrink. Target Date Funds (TDF’s), which base asset allocation solely on a specific future date, are the poster child for this strategy and demonstrate the current epitome of blind faith in passive strategies.

If such a strategy were effective, investing would be simple and we could all meet our retirement goals. Unfortunately, our investment lifespans never line up with valuation peaks and troughs. As such, any strategy that ignores expected returns and the risks associated with asset prices at each point along the investment horizon is destined for failure.

In this piece, we focus on an important graph and its construction. We illustrate that there are times, regardless of whether you are 75 or 25, that you should heavily invest in stocks and other times when bonds should take priority over stocks.

We offer a special thank you to Brett Freeze for help sourcing and compiling the data used in the graphs and tables below.

Missing the Target

Target Date Funds (TDF’s) are mutual funds that determine asset allocation and particular investments based solely on a target date. These funds are very popular offerings in retirement plans and 529 College Savings Plans due to the known date when someone wishes to retire or send a child to college.

When TDFs are newly created, with plenty of time until the target date, they allocate assets heavily towards the equity markets. As time progresses, they gradually reallocate towards government bonds and other highly-rated fixed income products.

The following charts show how Vanguard’s TDF allocations transition as the amount of time remaining until the target date declines.

The problem with these funds is that the asset allocations employed are solely a function of a specified future date, giving no consideration to the price paid for those assets. More simply, these funds completely ignore the most basic rule of investing, buy low and sell high.

Expected Returns 

To effectively explain a practical method for allocating between stocks and bonds, we have created a rather complex graph. Rather than present it now and try to explain the myriad of data points represented by the various symbols and lines, we think it is best to walk you through the construction of the graph. Viewing the various components of the graph in isolation will make it easier to interpret and shine a light on the expected outcomes for stocks and bonds.

Valuations

The following three graphs are scatter plots of popular equity market valuations and their associated returns. Specifically, the green, orange, and purple markers represent the intersection of a quarterly valuation level and the subsequent 10-year annualized total return. Instead of using the specific valuation data in the x-axis, we use each data point’s standard deviation from the mean. This allows us to more effectively compare the values of the three metrics together.

On each graph you will see a downward slanted line, which is the regression trend line of the markers (dots/diamonds). Each graph also has a vertical line representing the current valuation level. The intersection of these two lines is the expected return for the next ten years. The three graphs and the compilation of them shown last is based on nearly 75 years of data.

1. Market Cap to GDP

This valuation compares the market capitalization of the broad market to nominal GDP. Given that corporate earnings are almost entirely a function of economic growth, this ratio provides guidance on whether total market capitalization is appropriate versus GDP. Warren Buffet said this ratio “is probably the best single measure of where valuations stand at any given moment.”

The R-squared measuring correlation stands at 0.69, meaning that 69% of ten-year forward returns can be explained by the current valuation. The ten-year annualized expected total return is -1.42% as shown by the circle surrounding the intersection of the current valuation and trend line. Also note that with the exception of one quarterly instance, anytime the ratio was greater than two standard deviations above the average, the following ten years posted a negative return.

2. Tobin’s Q Ratio

James Tobin created this ratio to show the market value of all companies versus the replacement value of all those companies’ assets. When the measure is 1.0 or greater, it means the aggregate value of stocks is greater than the aggregate value of their assets.

The R-squared is 0.67, and the ten-year expected total annualized return is +2.92%.

3. Robert Shiller’s CAPE

– Cyclically Adjusted Price-to-Earnings ratio (CAPE) is our preferred method of calculating the widely popular price-to-earnings (P/E) ratio. Unlike most P/E measures which use earnings from 12 months prior or forward estimates in the denominator, this method uses an average of the last ten years of earnings. The benefit versus the shorter time frames is that it factors in longer-term earnings trends and complete economic cycles. P/E calculations using 12-months of data are exposed to short-term deviations from the earnings trend and ignore the cyclicality of economic activity.

The R-squared is 0.62, and the ten-year expected total annualized return is +3.49%.

Now we compile the data from the three graphs to get a broad picture of what these valuations portend.

We find it fascinating that the trend lines and data points for three different valuation methods are so closely aligned. While each valuation measure points to a different expected return, the broad message is clear that higher valuations imply weaker future returns and vice versa. More importantly, the current valuation levels all point to poor expected returns. Factor in inflation and the returns for all three measures are likely at or below zero.

Fixed Income Alternatives

Having seen return expectations for stocks, we now shift focus to consider the potential return on other asset classes. While there are many alternative assets in which one can invest, we chose to simplify this analysis and compare equities to the yields of liquid, high-quality fixed-income securities. The primary reason is that the U.S. Treasury note and investment-grade bonds we use are easy to acquire and guarantee a fixed ten-year return barring a default. Default risk for the bonds we selected for this analysis is very low.

The following graph combines the guaranteed yields of the bonds we selected (barring default) as compared to the equity outcomes shown above. The red dotted line in the graph represents the current yield on a risk-free ten–year U.S. Treasury (2.95%), while the aqua shaded area provides a range of yields for the corporate bonds. Beneath the graph is details of the corporate bonds selected for this analysis.

The following table compares the expected returns for equities, Treasury note, and the selected corporate bonds.

Summary

We only presented three measures of valuation in this analysis. We did not cherry pick valuations as evidenced by the table below showing our three indicators as well as five others.

For an investor who elects to continue to chase the stock market higher, do so with the understanding that the market is well overdue for a serious drawdown. If you are a passive investor and do not track day to day price changes or follow technical studies, we recommend you take this analysis seriously and formulate a plan to manage risk. 

However, doing so requires some work and effort which runs counter to current investment norms. Passive investing is “easy” and requires no effort. Plus, the fees are low. In contrast, identifying times when the market is cheap or expensive requires some work and usually cuts against popular opinion. The evidence of historical data is clear; we are all but guaranteed to achieve a better return on bonds than stocks for the next ten years.  The only question we all must answer is when should we stop following the equity herd and start following the long lesson of the history books? Despite the insistence of many popular investors and the financial media, this time is not different.

As Benjamin Graham notes in his classic book The Intelligent Investor, “Successful investing is about managing risk, not avoiding it.” Ultimately, risk is most effectively managed by being discriminating about the price paid for an asset. Target date funds and many other passive strategies intentionally disregard his advice.