March 15, 2021
You may be glad to know that there are no universal truths explored in this month’s letter; just boring old markets and economic thoughts:
“The greatest treason is to do the right thing for the wrong reason.” T.S. Eliot
US government bonds, despite their recent rise in yield (and many other government and corporate bonds around the globe) are currently returning a negative yield. We have discussed the challenges of producing a fixed rate of return with minimal risk to principal. We have gone further in suggesting, that if you are buying a bond with a negative yield in real terms, you are effectively agreeing to a real loss of your purchasing power in the future. In our industry, we consider the safest investment as cash or near cash. It is certainly true that $100 of cash today will be $100 of cash in a year from now, and there will be no fluctuation on that portion of your portfolio. But will that $100 get you what you want in a year from now? However, we always ask the question: What is important to you about money? What would you like money to do for you? From here we can get into many philosophical discussions, but I am going to leave that aside for now and suggest that it is used either: 1) To buy goods or services, or 2) To invest for future growth to buy goods and services in the future (or give it away to others to do the same). There are two basic outcomes that could occur:
The basket of goods and services important to you today becomes more expensive in the future; you will be worse off financially in relative terms.
The prices of companies and assets to invest in become more expensive in the future; you will be worse off financially in relative terms.
Obviously, the inverse would also be true. In relative terms, you would become better off financially if the prices of goods and services declined, or the prices of available assets to invest in declined in price relative to the value of the Dollar.
What do we know?
We know the supply of dollars is larger than any of us have seen in our lifetimes, and that the government is handing out money to companies, individuals, and the US States through increased government borrowing.
We know that savings rates are going up quickly for households and major corporations can easily borrow all the money they need.
We know that some of this money is going to be saved, some invested, and some spent.
We know that the yield on 5-year US treasuries has gone from 0.20% in yield in August to 0.84% ** today. Still a negative real return over 5 years.
We know that money supply growth according to the Federal Reserve is the highest on record.
What do I think we know?:
A lot of the new money given out has been invested in financial assets, real assets, and crypto assets; pushing up their respective prices. A survey in today’s Financial Times suggests that 1/3 of the retail investors (across all age groups) plan to put their stimulus checks into stocks.
For the past 20 years, government bonds yields generally declined when equities declined **. From mid-February to the beginning of March, the opposite occurred, the Nasdaq sold off over 10 percent, while the yield on the US 5 year jumped from .45% to over .80% **. It is possible that the jump in yields caused the Nasdaq to decline, but I am not sure.
There is a lot of talk in the media about historical valuations, bubbles, inflation, and fear of buying the top of the stock market.
I do not know how to value the US dollar anymore because real interest rates are negative. Effectively this means you get paid to borrow money. This is a perverse and counterintuitive situation compared to all of history.
Many retirees need a fixed income and are naturally concerned about losing wealth they need to live on as they age. How can this be achieved if borrowers do not have to pay a real rate of interest? Fixed income portions of their portfolios as measured by the Barclays Aggregate Bond index is down 2.83% quarter to date *.
In aggregate, little economic pain was felt across the economy during the 2020 recession because of generous unemployment assistance and assistance to companies. This creates perverse incentives where many individuals are better off financially NOT working instead of returning to work.
The pandemic from a public health crisis appears over, but considerable fear remains among the population. This should change during the remainder of the year as more people overcome their fears once vaccinated.
The government working with a more politically minded Federal Reserve is very focused on alleviating poverty and making our economic system fairer through bigger government.
What do I think?:
As we have suggested for a year, the reaction function of the Fed and the Government to offset any economic suffering continues unabated and has even accelerated. A $1.9 Trillion dollar relief bill has just passed in a strongly recovering economy. Next up: possibly infrastructure spending, but this will be more difficult politically. This money continues to be printed by the Federal Reserve with their encouragement of fiscal spending. As we continue to suggest, this will push up financial and real asset prices on a relative basis to the US dollar. I’m not sure if this means that equities are actually worth more; perhaps it could mean the dollar is worth less in relative terms? Studies that utilize historical valuations assume that history is in fact comparable. However, because the situation we are in is unprecedented; I find it difficult to make sense of most historical comparisons. I think the government and the Fed are incentivizing us to borrow money and invest.
Where to Invest?
Mainly in equities and alternatives in sectors that will benefit from higher demand and higher prices; companies that have pricing power that can pass along price increases if inflation does increase. We are very focused on protecting wealth.
Where to be cautious now: Fixed income. Early in the pandemic, buying higher yielding corporate fixed income product made sense when the bonds became cheap. We believed in extending out to lesser quality credit bonds made sense as we expected the Fed to assume the credit risk in one form or another. Prices of most of the bonds rose (yields fell considerably from the spring of 2020). But now, government bonds have been rising in yield. We are also in the perverse situation where cumulative corporate borrowing in 2020 rose approximately $400 billion! To put that in perspective, corporate borrowing after the 2008 recession declined by more than $400 billion. This is not lost on Warren Buffet in his recent annual shareholder letter where he suggests that fixed income investors worldwide face a bleak future. I agree because if you are buying Moody’s rated Baa Corporate Bond yielding approximately 3.7% (one level above a junk bond), your upside is limited to that rate of return. These bonds may be safe for a while, but they can only ever pay the 3.7% per year (bounded upside with considerable downside). Fixed income portfolio managers may say: we will hold these bonds to maturity, so you are safe even if they rise in yield. You will get that 3.7% unless they default. Well, most of these bonds are not particularly liquid, and if the Fed cannot or will not come to the rescue on the next downturn, you may find this strategy is riskier than originally considered.
I suggest that we are in an inherently unstable economic condition, and it requires a good deal of open-mindedness and flexibility. This is a huge monetary experiment that has never taken place in modern history, and we need to adapt to new information as it presents itself. There are no “experts” because nobody has this experience (well put by our old head of economics at a prominent fund, thanks JR); it is important to understand what you do not know!
We do not know what the consequences will be, but we do know there will be consequences.
Conditions currently exist for free money, more government spending, strong economic growth, I suggest finding yield in equities that pay dividends in companies that are protected against price increases (energy, utilities, real estate, banks, mining, tech quasi monopolies). We need to protect our wealth by NOT limiting (as in fixed income) our upside to price appreciation in this environment. If these conditions change, we must be able to change with it. Flexibility means having relatively liquid investments as a percentage of your portfolio to be able to change when conditions change. Thought should be given to the illiquidity of corporate credit, funds with lock up periods, and crypto if it is a significant portion of your wealth.
The recent rise in government fixed income yields may or may not be a problem, but it is something we are watching closely. As we have pointed out, real yields are still negative, and ability to borrow does not seem to be meaningfully impacted yet, but this could change. The rate of change in yields is also important.
If the Fed loses control of rates (and at present this is not clear to me) because of higher inflation, one of two things is likely to occur: 1) Yields on all bonds will go materially higher, and equities will become vulnerable, or 2) The Fed will be able to control the yield curve by capping longer term rates, and the dollar is likely to suffer significantly. This suffering may take place in the form of higher real and financial assets as governments around the world are following similar paths to the Fed.
The biggest issue I see is if the Fed loses credibility and control of the situation. I think this is a reasonable probability eventually; it could happen all at once or slowly over time. Investors in fixed income should eventually realize that the Fed is monetizing their debt. Ask yourself, how could the government pay back all this debt, and continue to provide essential services to the population if interest costs on the debt doubled? Tripled? We are moving towards more government (more government spending) reliance currently, and this trend looks set to continue. Tax increases could happen, but the appetite looks low when money is free and without consequence. Despite discussion of tax increases, fiscal restraint by politicians appears to be waning on both sides of the political spectrum.
Once again, this brings us back to our case for equities and alternatives instead of fixed income to protect your wealth and your purchasing power. With equities obviously comes more volatility in portfolios.
It seems to me that Investors must decide for themselves what risk to tolerate: Erosion of purchasing power or increased portfolio volatility. Unless prices for goods, services, and assets stabilize or decline, remaining in cash or near cash is not without consequences in the current economic climate.
In summary, and as we have pointed out in previous letters, there will be significant consequences to the economic and social policies we have adopted during the pandemic. There really is no free lunch; the next crisis will eventually come (it always does). I leave you with one question: Given our current policies, (as well intentioned and morally justifiable as they are) are we building resiliency in individuals and society to cope and adapt to future crises?
As always, I very much welcome your thoughts and feedback.
Joseph Cardello, Principal August Wealth Advisors, LLC The Loft, 101 Franklin Street, Suite A
Westport, CT 06880
Direct (916) 461-9451 toll free (800) 985-9477 firstname.lastname@example.org
Investment advice offered through Stratos Wealth Advisors, LLC, a registered investment advisor; DBA August Wealth Advisors. Trading instructions sent via email, fax or voicemail will not be honored. There is no assurance that these messages can be retrieved on a timely basis, nor is there any sure method of confirming the customers identity. The information contained in this email message is being transmitted to and is intended for the use of only the individual(s) to whom it is addressed. If the reader of this message is not the intended recipient, you are hereby advised that any dissemination, distribution or copying of this message is strictly prohibited. If you have received this message in error, please immediately delete. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful. No reader should make any investment decision without first consulting his or her own personal financial advisor and conducting his or her own research and due diligence. Investing in the bond market is subject to risks, including market, interest rate, issuer credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies is impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. ** As reported in the Financial Times.