"Change is such hard work." Billy Crystal
"Change brings opportunity." Nido Qubein
Keep it short
Since my wife likes to describe my garrulous verbal communication techniques this way: "Why use 10 words when 200 ought to do", I'm going to do my best to be brief today.
This is my really short message:
1) The economy in the US is doing so much better;
2) We are not Japan (aside from current interest rate deflation (soon to be over));
3) The American consumer is the most resilient economic creature ever devised;
4) There are clearly structural headwinds globally but don't appear to be enough to keep us from printing 3%+ GDP in 2014 in the U.S.;
5) The stock and bond selloff recently was VERY needed;
Concerns are:
1) Dysfunctional political wrangling in Washington;
2) Turmoil in Egypt;
2) Political crisis in Brazil;
3) No banking union yet in EU;
4) Currency war;
5) China's credit crunch by Mark Mobius (of Franklin Templeton), assessment that it is worse than our subprime mortgage issue in the U.S.;
7) Can the Braves get to the World Series?
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Change
Change is definitely in the air - in this case, it's a good thing - we've needed a healthy bond and stock market selloff (like we saw in May and June), if we are truly going to begin to normalize with respect to interest rates and growth rates. We are in that changing dynamic right now - this swift move in bond yields is akin to what happened in June 2003.
Back in June 2003, the yield on the 10 year US Treasury moved very quickly in a matter of days and back then most economists were of the mindset that deflation was the bigger danger and that the Fed might actually consider lowering rates more. We've heard that deflation/disinflation talk from Bullard in St. Louis and we've heard some very dovish commentary recently from the Richmond and Minneapolis Fed Presidents. I used to be in that camp (for years I was in that camp). I am no longer of that mindset. And for what it's worth, Bernanke's May communication was brilliant.
Inflation clearly bottoming
I must also say, that as I analyze the work that both the Cleveland Fed and the Atlanta Fed have done (this is just a simple representation), I no longer see the Japanese-style outright deflation risks at all. This doesn't mean it can't happen here, it just means that not only do you have to squint at this point in time to see it, the data no longer support that thesis at all. Inflation doesn't appear to be a problem, per se, in either direction, but does, instead, appear to be bottoming.
Atlanta Fed Business Inflation Expectations_7-17-13 (inflation bottoming)
Wage inflation is back
The type of inflation I mentioned briefly in May is wage inflation. That's the type of inflation Bernanke has been wanting for years. This means that since the recession began, and even during the recovery, the share of profits has been very narrow. Meaning that that labor's (generally speaking-rank and file employees), share of that pie has been relatively small. With the hoarding of quality labor we're seeing and the increases in incomes broadly-based, if this continues, the consumer is going to strengthen.
We turned Japanese, now we're back to being American
I thought, if we really are Japan with respect to interest rates, we're all in big trouble. My analogy between the U.S., and Japan with respect to the balance sheet recession: comparing our household balance sheet as a nation to their corporate balance sheet has mostly run its course. We are not like Japan any more. The deleveraging in the US is mostly over. I thought it'd last longer and we'd revert closer to the historic mean with respect to debt to assets and debt to income, but it doesn't appear that we're not going to and the data are the data.
Update since May 2013
On May 2'nd I wrote that Bernanke & Co., could not get away with keeping interest rates this negative this long in the face of positive economic growth without nearly guaranteeing a period of stagflation.
On May 22'nd, Bernanke's "taper-talk" speech essentially hit a reset button that we desperately needed in financial markets. As you may know, his speech centered around the idea of scaling back bond purchases. Bonds were too expensive and stocks hadn't experienced even a 5% pullback in quite some time. Despite how it feels, overall, volatility is a good thing for financial markets. The Fed's actions have essentially drained almost all of the volatility out of the markets.
Where are interest rates headed? Bernanke offered some ideas in March of this year in his research paper (Chart source: Federal Reserve website March 1, 2013 "Long Term Interest Rates")
How do we plan with safe income now?
We have to be planning for the 10 year US Treasury to be in the 5.75%-6.25% (or higher), range by 2025. But, in all likelihood, we're going to be in the 4% range in 2017 (I traded emails with David Rosenberg this afternoon for this data point (the 2017, not the 2025 range) - I don't say that to namedrop or to pass the buck, just to let you know that other sharp minds share this view).
The Fed has been very clear and transparent about the possible trajectory of rates going forward. Now, if we plan on the high side and the economy is not strong enough then to sustain that type of rate-range, that's fine - but at least we've planned for it. This was the same type of philosophy that helped us be successful at stock and bond investing over the last several years and it's going to also be what helps us be successful risk managers (for both stocks and bonds), over the next ten years I believe. The Boy Scouts of America told us when I was one as a kid to "Be Prepared" - and that's sage advice for today.
I have wanted this environment (yields higher to be able to help folks get more reasonable yields), OB (or better), for almost two years now.
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"(Charlie Brown), Why is everybody always picking on me?"
I'm going to pick on a couple of our longer-dated bonds. These two mature all the way out in 2030.
Most of our bonds have much shorter maturities, thus shorter duration, but let's pick on two bonds that we recently bought that have longer duration. Here's examples of two bonds and what could happen to them in an increasing rate scenario (all things being equal), looking towards the 10 year yielding 4.5%:
1) El Paso (owned by Kinder Morgan), corporate bond, 8.05% coupon, final maturity 2030. We bought the bonds at a dollar price of $104.80 which represents a 7.54% YTM. So that's 7.54% per year. IF the 10 year US Treasury went to 4.5% in 2018 (and I think it could), these bonds would trade down in price down to $95.695. That's VERY reasonable to me and 7.5% is excellent, budgetable, non-variable cash flow;
2) Princeton University (NJ), municipal bond with a $107.25 dollar price and a 4.5% coupon with a final maturity of 2030. These bonds are callable in 2017 with a Yield to Call of 2.63%, and a whopping 3.93% Yield to Maturity which implies a 6.55% taxable equivalent yield for taxpayers who live outside of New Jersey. If that doesn't get you excited, and if you're worried about the credit-worthiness of Princeton University - don't be - there are many other more important things to worry about. If the 10 year US Treasury yield moved to 4.5%, that means that the dollar price would go to $98.481.
Qualification here: These modified duration calculations are intended to be informational and helpful in terms of understanding how bonds work - when you are in a situation like we're in right now where the muni curve has disconnected from the US govie curve and it's trying to figure out what it wants to do for a living, it's not normalized (just keep that in mind). So when I say, its price will go to "X", that means all things being equal (which they aren't always, but it's a very tight estimate (as accurate as one can be)).
Both of these bonds will carry well in a rising interest rate environment due to higher coupon rates. With an 8% corporate coupon rate and a 4.5% municipal coupon rate (I'm generally targeting 5% coupon levels, but for credits like Princeton, the 4.5% example will more than suffice), as markets back and fill rather than move in a straight line, these two will trade just fine I believe.
Volatility
We're seeing notable volatility in municipal bonds - and a ton of it. The municipal bond curve is disconnecting from the US govie curve during this transition period for four main reasons:
1) May 22'nd Bernanke comments;
2) Detroit;
3) Higher interest rate expectations;
4) Redemptions;
Selling our Puerto Rico paper
We are selling all of our Puerto Rico Commonwealth exposure - when compared to all of the U.S. states, Puerto Rico ranks first in worst debt-to-GDP and worst in debt-to-Revenue. For years, it's been a great place for us to get stable, federal and state tax-free income. Detroit could ultimately serve as a template for what now appears to be a non-workable situation longer term. NOT worth the risk. The commonwealth is trying to float a few tranches of bonds to refi approximately $600M in existing debt. Many things could occur between now and then preventing that from happening or altering the pricing metrics by quite a bit. So, we took advantage of what I viewed as a more than decent (firm), selling price environment on bonds that are very risky. Do keep in mind, however, that unlike Detroit, the Constitution of Puerto Rico says that when you own bonds backed by the Commonwealth, that you are in a first lien position.
This ain't risky
5.83% beats 2.7% and it is opportunistic
5.83% (*WA state taxable equivalent yield), beats 2.7% (12 year US Treasury bond pays 2.7%)
That statement represents what a state of Washington 12 year municipal bond (with a 5% coupon which will carry well during periods of rising interest rates), guaranteed by the state of Washington yields for taxpayers in the highest Federal bracket (*assuming they are non-WA residents).
These bonds, too, will carry well in a rising interest rate environment.
"Sell, sell, sell"
I think that redemptions in bond mutual funds have only just begun. I think it gets worse before it gets better. This will put pressure on prices and will eventually open up opportunities for us to invest and grab excellent tax-free yields.
To date, since the Fed began in 2008 embarking on zero-interest-rate-policy, we've had yield spasms that only gave way to lower and lower yield levels. Those sub 2% lower levels are largely over. Since we are in this change and transition period, until we get specifics on the Fed's tapering whether it's September or after and how much they are tapering, no one knows. What I am confident of, is that we will see higher rates (as I've been thinking since August of last year), and I am confident that the low (in yield terms), was turned in on July 25'th, 2012 at a whopping 1.43%.
Based on my research, I believe that if the Fed were not buying Treasuries and Mortgage Backed Securities at the rate that they currently are (the Fed's balance sheet is currently leveraged 60 to 1), the yield on the 10 year US Treasury would be around 3.5%.
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This change is good
"This American economy is like a 12-year-old on a bike with training wheels. It doesn't need them." Dr. David Kelly - Chief Economist JP Morgan Funds - July 2013
You know, I spent some time with David Kelly (I love his Irish accent), in NY, a few years ago and I thought that he really dismissed the structural issues that (at that time), were going to lead to more intervention by the Fed and ultimately much lower bond yields. He and I disagreed on where bond yields were heading from there. But you know what? I agree with him about the current overall health of the economy in the U.S.
What is very concerning, however, is the degree to which the markets STILL believe that the Fed is going to be zero-bound forever. I used to think 10 years. I don't think that any more. I began to change my mindset the middle of last year (around the August time-frame).
I've worked in this business for 17 years of the 30 year bull market and so me and most of my peers experientially know nothing (firsth-hand), but falling rates. So you have to research and think and ask questions of experts about periods of rising rates. Isn't that like everything in life? If you have no personal experience, don't you have to investigate and research?
1981 and 1994 were two years where if you didn't have a strategy as to how to invest in bonds and if you weren't preparing for higher rates and if you didn't have realistic pricing volatility expectations, you most likely felt like you were looking directly into the sun and your face was melting off.
Too dependent on the government to fix things?
It is my opinion that when investors sell with a severe-panic-sell response because of even the notion of the Fed reducing the pressure they're exerting to mash down interest rates artificially, then this template for government policy has gone awry. The market's over-dependence and utter reliance on the heavy hand of government, should cause all capitalists (regardless of political affiliation), to be a bit concerned.
As an investor, you might also just buckle up and prepare for some more volatility. The Fed's efforts thus far have largely removed volatility from the equation. This additional volatility may not appear right away and there may not even be severe volatility around the September FOMC meeting timeframe. Please know, though, that my read on the situation is that the bond market believes that QE is over by the end of 2014 and the bond market usually gets it right. One-two percent on the Fed Funds rate, though - that's a different story altogether. That could be around for quite some time. Like ten years "some time", kind of time...
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Stock market cyclical bull market update
[The 17 bull markets since 1921 have averaged 49 months in terms of duration. This one is already 53 months old. And the average bull market in terms of intensity is 153%, and the current rally has just about matched that performance]. (Source: Wall Street Journal 7-13)
Bob Farrell, former legendary Merrill Lynch analyst used to say, "The public buys the most at the top and the least at the bottom."
We are still buying stocks
This is still not (at all), an anti-stock stance, for most clients whose income now and income later needs are met, we own quite a few stocks and are adding to positions at a steady pace when it makes sense to do so. It just helps to remember what the average bull market runs are.
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A few personal questions
Please mull these over:
1) Do you think there will be another significant global market correction at some point within the next five years?
2) Do you think that it is even possible that it could be as bad or worse than 2008?
3) Do you want what happened to your portfolios to happen to you again this time or would you prefer a better outcome?
4) How much budgetable, projectable income will you need to live comfortably in your world as you know it just ten years from now?
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Reviewing our objectives
To reiterate our broad retirement plan goals:
1) Secure Income Now with dividends from equities, ETF's and mutual funds and, yes, definitely bonds being mindful of pending changes to monetary policy;
2) Secure Income Later with low-cost, private pensions (through guaranteed income strategies guaranteed by insurance companies);
3) Dollar cost average in the capital appreciation space being careful to avoid big mistakes in equities over the next three years.
4) Evaluate the need for Long Term Care insurance;
5) Be strategic in income tax and basis planning;
6) Be aware of the potential future issues around multi-jurisdictional trustees & beneficiaries and be proactive about ways to coordinate care of aged loved ones;
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My job
In closing, let me remind clients and make myself clear with folks who are yet to be clients:
I don't believe that my job is to make clients rich. I work to prevent them from ever being poor. My role is to help clients to keep from making big mistakes.
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In the gap out west
Squat down for a picture in the gap (at the inflection point)
My former roommate from freshman year in college and I both turned 40 this year and so we purposed to climb Mt. Rainier, WA. We trained, purchased gear, planned and strategized and hired the best guides. The first day we climbed 4600 feet in elevation with 35 mph winds, sideways precipitation, posthole digging through 3 feet of snow with very little visability. It was SO much fun! Sounds crazy to some, but it was great. We put in the hard work on our first day. And do you know what? By the third day, it was sunny, clear and beautiful. Our guides were very concerned about the snow, though, above 12,200 ft., in elevation, and thus, we didn't get to go all the way to the summit on that trip - and to some, the trip was a failed summit attempt. But do you know what? It was very successful! Alpine mountaineering at that elevation (and in those conditions), is really super (and great exercise), and beyond that, making it back in one piece to my wife and kids (and to help you), was very successful indeed!
Thank you for permitting me to share my experience on Mt. Rainier with you in what I hope you receive as a non-self-promotional type of deal.
Thank you for your business - I have a great job and people like you make it possible.
I hope that you and yours are having a wonderful 2013 thus far. Talk with you soon!
Enjoy the May 2013 KAL cartoon from the Economist with President Obama and China Premier Xi
Yours,
Jack
The next edition of Insights (not including Special Updates), will be in January 2014.