To My Clients, Friends & Observers:
Our fixed income strategy extends maturities as rates rise and shortens them as rates fall. Consequently we have been reinvesting at ever shorter maturities for many years now. It’s not necessary to speculate as to the duration of low interest rates to position portfolios appropriately. Examine the following chart of the yield of the five year U.S. Treasury note.
It’s one perspective of U.S. monetary policy since 1962. Since the great bull market in bonds began in 1981 the chart shows a fairly consistent pattern of lower highs and lower lows. By inspection it also shows the average debt service of U.S. direct 5-year debt has been approximately 6% for the 50 year period. Historically, for all maturities, the average aggregate cost of U.S. debt has been approximately 5.5%. According to the U.S. Treasury, debt service on $16 trillion in 2012 was $360 billion at a rate of 2.24%. At a historical average rate of 5.5% the debt service would be over $700 billion. U.S. debt is forecast to increase over $1 trillion a year for the next two years. This will have to be financed. Total revenue from taxes was $2.5 trillion in 2012. The interest rates of direct debt service have been declining fairly steadily:
Year Interest rate
This does not address indirect, though guaranteed, debt or other unfunded, but guaranteed, federal obligations. Examine the ten year benchmark U.S. Treasury.
Interest rates have risen this year and we have extended maturities to 2 and 3 years in certain portfolios. However, the falling peak on the right may be forming a head and shoulders pattern, which suggests a possible yield between 1.5% and 2% in a year or two. Both charts clearly show treasuries trading in a still-declining channel. Fiscal conditions dictate that interest rates must be suppressed for as long as possible to prevent or postpone an eventual default. The Federal Reserve has warned for years that there is only so much that monetary policy can do, that fiscal policy must address the debt. Perhaps the latest Washington circus has glaringly illustrated just how bad U.S. finances really are. Let us have the audacity to hope so.
While there is ample evidence that interest rates should stay low for quite some time, rates may rise anyway if lenders refuse to buy Treasury bonds at these rates. The Fed and the Treasury are truly painted into a corner. The only way out of this fix is fiscal restraint and strong economic growth, which we do not have, and which we are encouraged to believe is “somewhere over the rainbow.” The last four quarters, GDP has grown 1.9% and the “recovery” is long in the tooth. The worst case scenario is a relatively worthless dollar and the dollar has been steadily falling against a basket of currencies, especially the euro. This reflects declining confidence in the dollar. Our groceries – and our stocks - are denominated in dollars.
The following chart shows how various sectors of the stock market have reacted to rising 10-year T-note yields since 1970. Note that these are “averages.” They generally reflect the speed with which different sectors can pass along price increases. The two worst are financials and utilities; financials because they are stuck with loans at lower rates and utilities because they require regulatory hearings for rate hikes and subsequent dividend increases to catch up to market rates.
The negative total returns don’t put me off either sector presently. Rates eventually stabilize. Financials and utilities eventually normalize. If I own them for their dividends, which increase annually, temporary declines in share prices are insignificant. There are great dividend opportunities in the market today.
New portfolios, recently constructed, are overweight in utilities, non-money-center financials and energy, and fairly represented in manufacturing and tech. The portfolio P/E is under 14 and the dividend yield is just under 4%. They include some Australian securities for their good fundamentals as well as their strengthening currency. The P/E ratio of the S&P 500 Index is 19.2, the dividend yield, 1.9%.
I look at the left side of the first chart above, the period from 1962 to 1981, years of monetary expansion. Since 1935, Keynesian economics had become gospel. The predominant college economics textbook was (Paul) Samuelson. As late as 1980, when I got my MBA, there were lettered people in academia and government who actually extolled “rolling over” the federal debt - ad infinitum - as policy. Inflation was not understood for the decay it was causing. Inflation became stagflation.
In 1979 Paul Volker became Fed chairman and reversed the inflationary, Keynesian policies of Arthur Burns, instituting the Swiss-pedigreed economics of Milton Friedman and the Chicago School, i.e., let interest rates rise and restrict money supply growth to slightly more than real GDP growth. Almost immediately a sharp recession ensued. In 1980 Ronald Reagan was elected president and instituted fiscal policies designed to expand the supply of goods and services, reducing inflationary pressure. To their credit, neither Reagan, a republican, nor Volker, a democrat, blamed each other for the recession. In fact theirs was a complimentary marriage of sound monetary and fiscal policies. The recession was broken in 1981 as the chart shows. Presently, we might take notice of Great Britain, which has the fastest growing economy in Europe, after suffering three years of austerity under the Cameron government.
Today the Keynesians are back in the driver’s seat and they may be around for a while. Janet Yellen will likely be the next Fed chair. Ideas and philosophies have consequences. Where will they take us?
Dennis M. O’Connor