A strategy to built on the rather basic assumption, that as the economy gets better after the latest recession, interest rates, now at historic lows at the short-end of the curve and near cyclical lows at the long-end, will rise. We have a couple of reasonable reasons for believing that rates will rise.
First, they already are rising at the long-end. The low for the 30-year Treasury bond was over a year ago at essentially 3%, now it is 4.5%. Since the Fed does not dictate to the long market what rates should be, this is where the market for funds, supply and demand, put the rate. In the next several months, we expect demand for funds to increase as the Treasury sells bigger and bigger offerings of bonds to raise the funds for various and sundry Federal programs, while corporations take the opportunity to grow their balance sheets by borrowing fairly cheaply and buying higher returning stuff (like competitors or products or facilities), and the housing market slowly emerges from a few years of hibernation.
While demand increases, supply will likely decrease as several Fed programs to provide liquidity to specific markets end. The Fed is force-feeding the mortgage-backed securities market, Treasury and Agency notes and commercial paper. All of these specific programs will end by July, some could be extended, but probably not expanded. As these programs unwind (by borrowers paying-off the debt to the Fed) the Fed’s balance sheet will slowly shrink. This in effect reduces one of the biggest sources of supply of funds to the market.
The other big sources of funds have been individuals in their preference for bonds over stocks and institutions. We’ve commented before that the individual’s appetite for bonds is silly but it goes on for now. At some point, individuals will decide that stocks are a better deal and they will shift. Don’t ask me when, but it will happen. At the same time, institutions are already moving away from debt toward other investments. Anecdotally, venture capital, private equity and mezzanine finance are all attracting relatively more money than they had been. Pension plans have begun to refocus on higher risk areas of investment after moving to reduce risk in 2008 and 2009. Foreign investors might follow a similar path except for foreign central banks, which are pretty much stuck buying bonds. But even these customers don’t have to buy our bonds. If we see protracted dollar weakness, they might go somewhere else, say Aussie dollars or Chinese Yuan or Japanese Yen. Commercial banks will begin to slowly reduce their bond investments and make actual loans, but that might take a while.
So, we see this as one change that will create a higher interest rate environment. The other is inflation or fears thereof. We have seen few immediate signs of inflation so far in this recovery. There have been short-lived spurts in commodity based inflation. But, under-utilization of both labor and capital will keep a lid on inflation in the short-run. But, both will probably tighten-up someday. The monetary backdrop that was created to spark a rebound in the economy is also the backdrop that encourages inflation. We have a lot of extra money floating around in the system and that money will ultimately go to generate more growth but there is too much money to do just that.
There is a third reason rates will go up, once rates are at zero, they can’t go any lower.
So, what is the plan as all this plays out? First, we hedge this risk in the most bond-dependent portfolios. This buys us time because if rates move more quickly than we kind of expect, we won’t be hurt too badly. If all this change takes a long time, we’ll still have our high yield exposure, our convertible exposure our investment grade corporate exposure and all of those have decent yields and good prospects. So, if a year from now rates haven’t gone up very much or not at all, most of our bond positions will do just fine and we’ll be able to absorb the loss on a small hunk of the portfolio. It won’t be optimal, but it won’t be a tragedy either. If rates do go up in the next six months, we’ll thank our lucky stars that we’ve taken this precaution. If rates go up a lot in the next year, we’ll wish we’d have done a lot more.
So, the hedge buys us time to enjoy a continued narrowing of spreads in corporate bonds, especially high yield bonds. (By the way, not last week but the week before, set a new record in high yield issuance as many below investment grade companies decided to take advantage of a good market for high yield and refinance higher coupon debt.) We doubt that spreads will reach the all-time lows that prevailed just 18 months ago. We will not likely ever see high yield debt selling for 350 basis points over comparable Treasury yields again. But, when you’re 800 over, there’s still a decent chance to get back to 500 over. That is a pretty good return for bonds.
So, when those spreads have come about as far in as they are likely to, what then? Then the game in risk taking is over. We’ll shift back towards low risk and wait for our next chance to take risks again, after the next downturn in the economy and repricing of risk. In the interim, we want to measure our duration risk and see if we are ahead to stay intermediate or whether we should reduce duration. Luckily, in bond land there are options available to do just that. The odds favor us shifting to floating rate again before this cycle is over. In floating rate (also known as bank loans or short junk) you get a decent credit spread but you don’t have to take duration risk. Floating rate is enjoying the same spread tightening that high yield is having, but without the duration impact.
We are seeing the worst of the defaults and other credit events right now, or maybe three months ago. Defaults hit an annual rate of 13% in the second quarter and slumped to 9% at an annual rate in the third quarter. We expect there was some more modest improvement in the fourth quarter. As credit conditions continue to improve, spreads will continue to tighten. That could take several more years, but it always improves during expansions.
We will have different choices in government bonds. All the inflation-linked bond funds focus on the government inflation-linked bonds. So TIPS are the basic tool to float up with inflation while other bonds have to suffer with inflation. Today, TIPS don’t provide enough inflation protection to worry about. We probably won’t see enough inflation to cover the 150 basis point inflation premium in TIPS (the spread between the straight yield on say ten-year Treasuries and 10-year TIPS). If TIPS owners get tired of waiting and begin to move back into conventional bonds, we might get a much better entry point in a couple of years. If nothing else, the closer we are to the onset of inflation, the less time we have to wait for that inflation element to start contributing to our returns.
The important thing to remember is that we have choices and we will use those choices to take or mitigate risk across the cycle. Unlike stock funds, which are pretty much the same, there are distinct differences in bond funds. In bonds, credit defines the asset classes and duration defines the ‘style’. These are not really subject to a lot of interpretation. Bond funds don’t usually move from one style box to another.
Producer Prices rose by a mere 0.2% in December while core prices were unchanged. This was in line with expectations of a small gain. Food prices were higher while energy prices fell slightly for the month. For all of 2009, producer prices rose 4.4% while the core version of the index rose 1.5%.
Housing starts were lower by 4% in December ending the year at a 557,000 annual rate. The comparable number of November was 580,000. Some of the decline can be blamed on bad weather in much of the Northeast and Great Lakes regions that came early last year but also the ongoing glut of new homes for sale was a detriment to builders. Also, the rising tide of foreclosed properties makes it hard to sell new homes at reasonable prices.
Leading indicators rose a further 1.1% in December. The leading indicators are supposed to indicate the direction of economic activity six months or more in the future. So, this gives us something of an all clear into the middle of 2010. The coincident indicators also rose by 0.1%. These indicators are the same ones the National Bureau of Economic Research uses to time business cycles. The coincident indicators have been climbing since the summer.
So, healthcare is again up in the air since the highly unpopular bill has gotten its 41st opponent. At the same time, financial re-regulation is now a front-burner issue. And, Dr. Bernanke is facing a stiff challenge to his reappointment as Fed Chief. The activist administration keeps coming up with ways to change the status quo. Wall Street doesn’t like change. We’ve seen volatility come back with a vengeance. Last week was the worst week for the markets since the bottom back in March 2009. As we somewhat (but not entirely forcefully enough) foreshadowed that once the bulk of investors got bullish, the easy money had been made. The steady decline in volatility and attendant risk measures since the bottom had made everyone a lot more comfortable owning stocks and so any disturbance to that comfort lead to negative reactions.
This is a good thing for investors in the long run. We’d much rather have to scratch and claw for every eighth and quarter than have it fall in our laps (though having it fall in our laps was fun while it lasted). Stocks are still relatively cheap, except for the small caps. We were rather confused when small caps actually held up better during last week’s collapse in share prices. We can only guess that this is a play on ‘the market’ rather than individual stocks. The large caps are the cheapest area in the market and are still the best deal in town as far as we can see. So, last week we bid up expensive bonds and sold cheap stocks. That doesn’t sound like a well reasoned approach to investing.
The really big news last week came out of China. The instigator for the global dip was a rumor out of China that the government there was taking steps to limit growth in credit in hopes of slowing growth in inflation. The Chinese economy has seen a huge increase in housing prices. Also, food prices and fuel prices have risen. Wages have not kept pace, but are also increasing. For China to avoid an inflationary episode which could undo so much of what they have built, the Chinese monetary authorities are trying to head-off an inflationary spiral. By limiting credit, they will release some of the upward pressure on home prices. Why didn’t we think of that say seven years ago?
If China slows down, that will likely have an impact on their near-neighbors like Taiwan, Korea, Japan, Singapore and ultimately on the global economic rebound. How much is a matter of debate. We would argue that Chinese supply is equally as important as Chinese demand in this equation and Chinese supply will not be materially impacted by a slowdown in local Chinese demand for housing. That is a minority opinion these days, but then we’re not especially prone to exaggeration like so many other folks.
One thing a lot of people keep forgetting about China is that it is still a totalitarian society. If the central government wants to show that housing is quieting down, that’s what the statistics will say. It is widely assumed that much of China’s fabulous economic resurgence in the past twenty years is largely a statistical chimera in the first place. From what close observers of China’s economy can see, the inflation statistics are under-reporting inflation while many of the labor statistics under-report the amount of unemployment. Actual economic growth is probably over-reported on a systematic basis. So, if you don’t want to believe the statistics that is okay. What we may be seeing is a reluctant response from the government to a housing bubble that has gone on too long to be ignored. Stay tuned and we will try to report any significant information that we can glean on this topic.
US stocks were lower across the board as alluded to above. Most foreign markets were also down.
While stocks were having a wild time, so too were bonds. In reaction to the fear that swept through the markets last week, bonds largely rallied. The exception to that rule was the high yield area, which showed once again that it has a lot in common with the common stocks of companies. Most high grade areas were higher on the week. Luckily for us, we are starting our inverse government bond trade this week, from higher prices and lower yields than were available before.
Foreign bonds were also generally higher. The exceptions to this rule were some emerging markets. Despite China’s troubles, most emerging markets continue to grow very quickly and show persistent improvement. The major developed markets all saw higher prices.
Real estate securities were also down nearly everywhere. Foreign markets seemed to be down more than in the US, but that is damning by faint praise.
Commodity markets tended to follow energy prices down. Precious metals, industrial metals and most agricultural commodities were lower.
Karl Schroeder, RFC
Investment Advisor Representative
Schroeder Financial Services, Inc.