Wednesday, November 04, 2009

Pendulum at the Apex

We bring you this message from the markets:

“The dollar is going away as the world reserve currency. The Federal Reserve is creating another bubble. Treasury bonds are a terrible investment. We are headed for runaway inflation. Gold is going to $2,000. Interest rates will skyrocket. The 10-year U.S. Treasury bond yields only 3.5%, but who wants that? This isn’t going to last; the Chinese won’t stand for it. With the Fed printing $1 Trillion dollars, Fed Funds at 0% and the budget deficit running over $1 Trillion for the next 3 years, we’re not just looking at inflation; we’re looking at hyper-inflation and double digit interest rates. Buy stocks!”

Of course, this is just a rather cynical summary of the somewhat contradictory picture we have seen financial markets craftily drawing up since the gut wrenching lows of March 2009. It is a marketplace with no diversification, little regard for risk-aversion, and a preponderance of highly correlated asset returns. Indeed, with gold recently breaking to new highs, the dollar under consistent pressure, and the Dow inexorably climbing from 6,500 to 10,000 you can actually see some confirmation of these proclamations.

It’s hard to dispute such prognostications. They seem as clear as the housing and tech bubbles look now in hindsight. They seem inevitable. Or do they?

Of course, we don't know what the future holds. There is no crystal ball and nothing in life is certain. If nothing else, the stock market has clearly demonstrated at least that over the past 10 years of negative returns. What is interesting and perhaps more rewarding is to look at the realities of today, not just the expectations and perceptions the markets have of tomorrow. Today there are some important potential inflection points that may reverse trends that have been at work for several decades. The typical Pavlovian response in markets to take risk in the presence of easy money, big government spending, and a declining dollar might be, at the very least, somewhat premature.

It is really astounding that our economy is hardly motivated with interest rates at all time lows. Indeed on many fronts it is not “rates” that are important. Instead, it is the “levels”. The levels of debt are so high and onerous that even historically low interest rates can’t seem to induce further borrowing and consumption. The level of capacity in the economy may be too great to provide significant rates of return on marginal capital investment. The potential rate of growth in GDP is too weak to impact the level of employment. Yes, the recent GDP report showed annualized growth of 3.5% in the 3rd quarter. However, nearly half of that growth came from auto sales. Will auto sales be sustainable, post Cash for Clunkers, or without government backing for GMAC and Ford Credit to provide auto financing? Another 16% of recent GDP growth came from residential construction, which is only 3% of our overall economy these days. Will the first- time homebuyer tax credit result in sustainable housing construction? If the levels in the economy are misaligned, then the rates of change and return may prove illusory.

The U.S. economy has been expanding for many years, certainly creating wealth along the way, but also propelling our growth with artificially low interest rates and increased leverage when times got tough. It has worked, and the expectation is that it will work again. Many fear it may only work too well and create runaway inflation and unfunded fiscal deficits. But it’s the status quo. Yet, there is an opposite force starting to assert itself, which might give us an indication of the returns we can expect on our investments in the years ahead.

Figure 1. (Click the chart for a larger image.)

An object in motion tends to stay in motion unless acted upon by an opposite force.

This paraphrases what most of us remember from high school physics of Newton’s First Law of Motion, which is also known as Newton’s Law of Inertia, and it actually applies to what we might expect from the economy and asset values for years to come. As the chart above indicates, we may begin to see it in the relationship of increased savings and ownership of risk-free U.S. Treasury bonds. According to Federal Reserve data, the household and non-financial business sectors combined are on track in 2009 to see a reduction in year-end debt levels for the first time since data from the Federal Reserve started in 1946. The average rate of growth in debt levels over that period of time is close to 10% annually. This marks an historic change in behavior. Furthermore, the savings rate has broken a 35 year downtrend that reached a low near 0% in 2005. From the late 1940s to the early 1990s the savings rate was between 6% and 12%, consistently averaging just above 8%. By the middle of this year, for the first time in the past 10 years, the savings rate increased to 5%. If we continue this trend reversal, it is certainly possible an 8% or even 12% savings rate can be achieved. So, what does this mean?

Consider for a moment that credit is tight, the household sector is at record levels of indebtedness at 180% of GDP, and real unemployment (including those who have given up looking for jobs and those reduced to part-time) is frighteningly high at around 17%. Of course people are saving. They need to save in order to protect their personal balance sheets, amid job insecurity, stifling debt levels and the specter of higher taxes. The same goes for corporations and banks, where funding and returns on capital have become more uncertain. Again, given the levels of debt, not the rates, people have little choice but to save and sit on cash. Hence, there is an underlying demand for U.S. dollars and safe, liquid U.S. dollar assets. Only dollars can repay dollar-denominated debt, of which there is 30 times more than actual dollars available. That’s why the dollar appreciated over 25% when the initial and most violent wave of deleveraging occurred in late 2008 and early 2009. It’s also why the Federal Reserve continues to be so aggressive. They understand how scarce dollars are, relative to the amount of debt in the system and the potential for further deleveraging.

Bear with me and consider the numbers to see how this is playing out. It could mark a material change in how we, as a nation, save and invest.

The U.S. has aggregate borrowings of close to $55 Trillion. U.S. Treasury debt owned by the public is just over $7.1 Trillion (and there is another $4.4 Trillion of intergovernmental holdings owned by agencies such as Social Security). In the first quarter of 2009 alone, household ownership of U.S. Treasury bonds increased by an astounding 140%. This represents an increase of $336 billion. We have never seen a quarter-to-quarter increase greater than 30% (occurred in 2004) going back to 1951, as far back as this data goes from the Federal Reserve. Add to this that during the first two quarters of 2009, money- market mutual funds, which many households have ownership in through 401ks or brokerage accounts and is not included in the household data, increased Treasury holdings by almost $400 Billion, an increase of 324%. Certainly much of this results from general risk-aversion. Very similarly, FalkerInvestments transferred client money market assets into a U.S. Treasury money market fund, in late 2007, to avoid risks we could see developing in the asset-backed commercial paper market. When taken together, there is over $700 Billion of additional funds that have been invested in Treasury bonds from these sources over the last two years. They have absorbed 30% of additional publicly held Treasury issues since 2007, yet only account for a combined 15% of all Treasury ownership. Further, consider that the household sector alone only accounts for 8% of all publicly held Treasury debt today, having hit a low of 4% at the end of 2008. As recently as the year 2000, the household sector owned 21% of publicly held Treasury debt and was consistently between 20-30% going back to 1951. At the 20% level today, the household sector would own roughly $1.4 Trillion of the $7.1 trillion of Treasury bonds outstanding. Indeed, we may see those ownership levels again. With disposable personal income today at $10.9 Trillion, if the savings rate reached 12% there would be at least $1.3 Trillion available for investment annually, without considering growth in income. That is almost $1 Trillion more than we are saving today. Certainly, the savings will be spread around, but as households continue feeling the pressure of debt and unemployment, it is very likely that Treasury debt will see a significant continued source of demand, as it is the only legitimate risk-free investment available. You can debate that in the long-run, but for now the U.S. is a long way from any risk of default. When people save against the financial pressures that are mounting, they invest for more certain return and do not speculate. Given the data, we could well be in the early stages of a trend reversal.

Taking a quick tangent from this, everyone seems to be worried about China selling Treasury holdings and their continued willingness to fund our deficits. Mainland China and Hong Kong combined represent the largest foreign investor in U.S. debt with $921 billion of publicly held Treasuries. But also understand that they have their currency pegged to the U.S. dollar, so they have to keep buying dollar assets, favoring Treasuries because they are risk-free. If they don’t keep buying, the Chinese yuan will appreciate, making their exports more expensive and threaten all the capacity they are adding through their own massive stimulus measures. With our trade deficit shrinking, as consumers revert to saving instead of spending money, China’s trade surplus will also shrink, leaving them fewer dollars with which to buy Treasuries. Yet, when considering the numbers from above, it is distinctly possible we don’t need China to buy more of our debt. We could fund our own budget deficits with domestic savings. The whole China concern of today may well be flawed and it is really they who face the more difficult adjustment. If we aren’t willing to underwrite Chinese trade surpluses, as we have for so many years with debt-fueled consumption, they are left with fewer resources to keep their currency and exports cheap, and will have to seek other ways to keep their 1.3 Billion people happy.

Many people would dismiss all this as conjecture, especially those counting on runaway inflation and skyrocketing interest rates, but there is a message here. It is hard to imagine a world so different from what we have become used to. The imbalances in the global economy have been building for a long time and we have now experienced an awakening, with two collapses of asset prices in seven years. It is entirely possible that the opposing force of over-indebtedness will reverse the economic course of the last several decades. It is showing up in the numbers, while the markets, aside from the Treasury market, might not see it yet.

As this relates to our investment strategy, we may have to be willing to accept investment returns over the next several years that are potentially lower than the long-term average. Certainly, the last 10 years have already been well below average. In the midst of deleveraging and increased savings, risk-taking may not be well rewarded and, indeed, risk-aversion will continue to be the surprising beneficiary. Using the changing character of household savings and Treasury ownership as an indication of risk tolerance going forward, we can infer that high-quality investments with a greater certainty for return, both on and of principle, will likely be favored over investments that offer potentially higher rates of return. This is called saving and investing, not borrowing and speculating.

We don’t see such developments as disastrous or necessarily portending another crash. One could argue that it sows the seeds of more balance and stability in the absence of any significant geo-economic or geo-political interference (i.e. trade protectionism and global terrorism, two destabilizing forces that make life all the more uncertain). Economic growth will slow considerably, in part due to Keynes’ paradox of thrift. The Fed’s position on interest rates and monetary policy is likely a symptom of what ails us, not necessarily a catalyst for further imbalances. We would rather see growth in equity prices moderate and have interest rates remain stable. If stocks continue to fly upward, it may likely be on the back of speculation, not on sound value investing. If interest rates begin to move higher as more people are convinced of future inflation and unfunded deficits, then the indebted household and real estate sectors may likely crumple under the pressure.

We need to see moderation and we are investing along those lines. We are not interested in the risk trade or one that assumes the status quo. We are not willing to chase the stock market higher by adding high-beta, speculative growth stocks to our portfolios. We are looking for consistent, more predictable, returns from the stocks and bonds of high-quality companies, and favor a portfolio profile that outperforms markets by being risk-averse, which is characteristic of our past returns.

As always, we own only companies that demonstrate consistent internal rates of return that exceed the cost of capital. That is an irrefutable measure of quality. We are increasingly focused on those companies with the stocks and bonds that offer strong cash flow yields to the investor. Before the markets reached the bottom this year, we allocated up to 25% of our model portfolios to investment-grade bonds with an average annual yield to maturity of 7.5%. We have trimmed several equity positions as they have recovered and started to add more concentration to stocks with dividends in excess of 3%. Our stock holdings represent close to 60% in our model portfolios with any remaining cash immune from market risk and awaiting opportunity in the U.S. Treasury Money Market Fund. For our clients with dedicated bond portfolios, we continue to invest at the best investment-grade bond rates available on the yield curve, favoring maturities under 5 years. If we see long-term rates rise, we will slide our maturities out further on the curve

Again, no one knows what the future holds. The markets, however, seem on the verge of certainty about the future. I would agree that things are better today; we did not go completely over the edge. The market rise is fairly well justified to this point and, frankly, a relief to those of us with stock investments. This may not be “the” moment and maybe the lesson has yet to be learned. But with households losing almost $12 Trillion in financial and housing asset values in two years, representing the biggest percentage drop since the Great Depression, I’m not sure the system can withstand a more obvious lesson. With such deep losses in assets dear to the American household, the widespread public outcry over bailouts, deficits and taxes, combined with the changing nature of savings and investment, there is good reason to believe we are finally changing course.

As always, we welcome your questions and comments. So we can respond directly to anything you might want to offer or ask, rather than sending a comment through this blog, please send an email to .

Peter J. Falker, CFA

November 4, 2009

No comments: