“A bubble is a product of feedback from positive price changes that create a ‘new era’ ambiance in which people think increasingly that prices will go up forever…Today’s bond market…is just the opposite of a new-era ambiance. Instead, the demand for bonds is driven by an underlying angst about the slow recovery and pessimism of the future…that’s not a bubble.”
Robert Shiller, Shiller on Market Volatility¸ The Wall Street Journal, October 11-12, 2014.
Over the past several years we have used this newsletter to voice our concerns regarding the macro-economic landscape, while attempting to provide practical solutions for investors. Since our venture into financial commentary, we have questioned the veracity of consensus opinion and how it tends to be wrong, especially in regards to interest rates. Of equal importance are the factors that cause a consensus to form and whether they are benign. In essence, we question whether the consensus is truly formed through an amalgamation of individuals conducting impartial and empirical analysis, or whether these calls are simply a function of herd mentality or self-interest. In any case, negative investment consequences of incorrect consensus forecasts on the investment public are substantial; investors and their advisors deserve better.
Why is there an interest rate consensus? We know we are not arguing against straw-men. We see and hear them in financial publications, journals, research notes, newspapers, radio, television, and the internet. The question before us, therefore, is why there is a consensus and why it continues to be woefully wrong. The only real argument against low interest rates that seems to have any traction is that many market participants view rates as simply too low. This view does not take global macro-economic concerns into account, while ignoring the possibility of domestic deflation. As evidenced by recent press, deflationary concerns are becoming a renewed focal point for investors.
With falling bond yields, we continue to hear calls for a 3+% yield on the U.S. ten year. The argument for the possibility of a continuing yield under 2.5% continues to fall on deaf ears. We believe that the argument for a return to 3+% is based on one or a mix of the following: A belief in a significant upward trend in U.S. economic growth, self-interested propping of the equity markets, or short-term thinking. As we wrote almost two months ago, we concede that a continuing trend in U.S. GDP growth could bring the ten year treasury yield to 3+%. However, we are skeptical that we will see this trend anytime soon. An argument for continued growth and a 3+% yield can also imply an argument for continued multiple expansion in the equity markets. As to short-term thinking, we would like to briefly remind investors of the challenges that we face.
Massive intervention by the Federal Reserve as well as other central banks helped prop up bond prices, guiding yields downwards, while creating a race towards currency devaluation. Many focus on our current problems with Ebola and the Islamic State. We would add the following geopolitical risks that may be driving people to park their money in fixed income instruments: political-economic dysfunction calling into question the continued existence of the euro zone, a possible slowdown in China, Russian intrusion in Ukraine, the reemergence of the Dear Leader in North Korea, conflicts between the state of Israel and surrounding countries, the possibility of Iran armed with nuclear weapons, Assad’s Syria, the instability of North African countries including: Libya, Sudan, and Egypt, an intransigent domestic political situation that increasingly looks to bring about a lame duck presidency, an escalation in tensions between China and Japan, cratering economies in South America, corporate flights due to taxation, violence between Pakistan and India—two nuclear powers—in Kashmir coupled with the election of a Hindu Nationalist who is tied to the Gujarat riots of 2002, fundamental debates on energy, healthcare, taxation, and welfare policies both domestically and globally, emerging markets that are suffering from the lack of global growth, and increasing calls to address perceived economic inequality in developed markets, among others. There is no shortage of geo-political risks out there prompting a flight to quality. One could make a simple dual-sided ledger to list the possible positive and negative events surrounding the marketplace. We are inclined to believe that the negatives will outweigh any positives.
Janet Yellen must be convinced that the economy is growing above trend before raising rates. The Fed’s bond buying program is near an end. If she starts to tighten and then reverses course due to bad GDP numbers, she risks the Federal Reserves’ credibility. Moving too fast, if she is wrong, will destroy any remaining credibility that the Fed could be said to have. If growth stagnates or falls, then the economic science experiment carried out over the past six years was a failure.
Even the Fed is seeking consensus—group think—within its own organization. We decided to examine the Survey of Professional Forecasters produced by the Philadelphia Federal Reserve Bank. In the graph below, one can see that not only were most surveys of the professionals wrong, but since the Global Financial Crisis, inflation is guided upwards two to three years out in almost every survey.
(Source: Board of Governors of the Federal Reserve System/FRED, Research Department, Federal Reserve Bank of Philadelphia. Survey of Professional Forecasters)
Does anyone think the Fed is going to rush to raise their Funds rate or unwind the balance sheet? We reiterate that one of the only events that we foresee as bringing about Fed action is above trend economic growth. If growth remains sluggish, there is no need to worry about inflation. Inflation is currently low and below the Fed’s target.
Bernanke started Quantitative Easing (QE) as a student of the Depression. QE is winding down, and we are looking into the guise of possible deflation—the very thing we were looking to avoid. We ask ourselves what tools the Fed has—other than another a renewal of current QE or another QE program—to fight any deflationary specters. Mario Draghi’s toolbox looks like it was either built by Fisher Price or a mad scientist. His ability to stand as a vocal policy leader is quickly fading as the Germans continue to challenge ECB action. We do not think we should expect any positive news coming out of Europe in the near future. What does this mean for European growth? More importantly for those of us with a U.S. home bias, what does this mean for growth in the United States?
Low inflation gives Yellen more room to deliberate and speak rather than act. The economy could be stronger than anticipated. The U.S. economy is resilient and large, but we do worry. There are many headwinds that could prove ruinous to the Fed taking action.
In addition to our inability to understand how the professional forecasters can be wrong, we wonder why in most instances interest rate and inflation forecasts are coming from money managers that primarily run equity portfolios. While some of our best friends are equity guys, we struggle to understand why they continue to forecast these metrics.
As a possible counterargument to our contention that a continued call for rising rates is a self-interested call to propagate the upward price action of the equity markets, we offer the following: if the equity markets are rising every time the Fed looks more dovish and defers rate increases, what does this mean for the equity markets if yields do go to 3% or higher? It seems any suggestion of rising rates portends a negative outlook for equities. Inflation is a bigger enemy to bonds than economic growth. In addition, inflation does not necessarily need to come from trending economic growth. It can come through changes in growth e.g. a tightening in the labor market.
If we head closer to full employment as is trending, i.e. an unemployment rate of 5%, then we worry about the conflicts of the Fed’s dual mandate structure. The first mandate for the U.S. Fed is price stability/stable inflation. Many have argued that pricing is artificial, largely due to Fed action. Is the Fed ignoring the first mandate to meet the second mandate (full employment)? In other words, is the Fed creating a bubble to fight another bubble?
We continue to argue that there are many factors contributing to low government bond yields. If one believes that the AA+ rated United States sovereign bond yields cannot go lower, we would like to point to the AAA rated German bund. The German bund continues to yield less than 1%; this yield has been at least 100 basis points below the U.S. ten year for some time. We also remind investors that the U.S. ten year yield hit 1.43% on July 25, 2012.
We believe there is ample reason that the street gives little credibility whatsoever to the concept of falling rates. One can make the argument that it is not in the interest of the street to project falling interest rates. Falling interest rates imply stagnating or falling growth. Falling growth cannot support a market where fundamentals are largely divorced from historic norms. As we try to understand the interest rate consensus, we believe this theory has some traction. While we are not entrenched contrarians, our pragmatic approach to investing causes us to be skeptical of consensus thought. There is comfort found in following consensus opinion, though this solace provides no opportunity to discover value. Agreeing with market consensus leads to market returns at best.
What should investors do with this information?
We suggest purchasing select high quality large capitalization equities with a wide economic moat that have not been propelled upwards by momentum buyers. With momentum investment strategies and the equity indexes themselves vulnerable to P/E multiple contraction, we believe individual stock-picking based on sound fundamental analysis may come back into favor. We plan to offer solutions based on fundamental investment principles in the coming weeks.
In the meantime, hedge funds and funds of funds are an option for those who can meet the qualifications of an accredited investor or for those who are looking to approach these vehicles through tradable funds. With the prospects of further downward pressure on the euro and yen, we suggest there will be opportunities to take short positions in these currencies.
If one is uncomfortable with shorting foreign exchange, the converse play in G3 currencies is going long the U.S. dollar, i.e. purchasing dollar-denominated assets. We believe the U.S. dollar will demonstrate relative strength against currencies that seem to be depreciating faster. Finally, low duration and unconstrained bond funds can be havens of safety to park assets during this time of interest rate and market uncertainty.
We’ve been seeing a lot of corn mazes leading up to Halloween. We find this an interesting allegory to our argument on the consensus and interest rates. If one follows the group in the maze, one can be assured of not being left alone. However, the chances of getting out of the maze before the group is nil. It is only if you make a different turn in the maze than the group that you have any possibility to get ahead of the herd. There is always the chance that herd avoidance will lead one to be the crying child lost in the middle of the maze. This is why it is helpful to step back and perhaps even survey the maze from a higher level, before rushing in with the group. Remember, not all bonds are created equal.
Good Fortune!
