Market Perspective
Friday’s jobs report was stronger than expected on balance. It provided the opportunity, given the low volume holiday period, for speculators to push up Treasury yields to their highest level since August 1, 2011. This has been a rude shock for not just bond investors but also some high profile bond managers. Most notable in this was PIMCO’s Bill Gross, whose flagship PIMCO Total Return was caught too high in duration and with too high an exposure to TIPs. Inflation protected securities will help you if rising interest rates are accompanied by rising inflation expectations. If they are not, TIPs are a long duration, low yielding security – THE VERY WORST KIND OF BOND YOU CAN OWN. Looking back on a 1, 3, or 5 year basis, the best total return bond funds managers have been DoubleLine (DBLTX), Met West (MWTRX), and Western (WACIX).
The big picture in the bond market is that the bond bull market is over. Technically, the downtrend channel was broken. Fundamentally, Fed Chairman Bernanke signaled on May 22nd and re-iterated on June 19th that the Federal Reserve was going to be tapering back on its bond buying. They want yields to rise (in a modest way). More than that, they want to curb the bond carry trade because it isn’t helping the economy and it is potentially de-stabilizing to the financial services industry. Think of it like this: If you are a bank and the Federal Reserve has promised you low and stable rates, you could borrow money at 50 basis points at time during the past three plus years and with the proceeds buy 10 year treasury notes at 2% or 30 year notes at 3%, earning a nice spread. If you added 10 times leverage to this trade (after all, the Fed was committed to holding rates down), you could earn a return far in excess of anything you could make loaning that same money to a small business owner. As a result, the financial sector recovered from its self-inflicted injuries but Main Street continued to languish. Another negative effect of the Fed’s interest rate repression is that older people are unable to retire, or in some cases have returned to the work force, because the interest rates paid on their accumulated savings have been insufficient to meet their income needs. As older workers remain in the work force the ability of younger workers to enter the labor force is inhibited.
What we have seen in the last six weeks, is leverage in the bond market being unwound. This has created a lot of volatility and is ultimately healthy. I am concerned about outflows from bonds in the next 4 weeks or so as investors come to grips with how much they lost recently, but given the degree of this year’s economic growth (200,000 jobs per month give-or-take), 10 year yields of 2.50% to 2.80% seem appropriate.
I believe we are 18-24 months from seeing money market rates over 1%. This would be a big step towards restoring the normal signals and incentives in the market. If this happens, and the move to 3% 10 year bonds does not send the economy into recession, one will have to give Bernanke a lot of credit. The markets are saying that they now believe this transition will be successful. How else to explain the stunning decline in gold? Many believe that gold is an effective inflation hedge. The evidence from history completely refutes this notion. Gold is better thought of as a proxy for confidence in monetary authorities. The Fed and other central banks launched unprecedented efforts four plus years ago to provide liquidity to the struggling global economy. Investors reacted to the surge in monetary reserves by buying gold like crazy. They were in effect saying “This won’t work. You are creating runaway inflation”. They were wrong – creating reserves is NOT the same thing as flooding the globe with actual money. Gradually this realization has begun to sink in. Investors began to say to themselves, “If all of this QE is not going to cause inflation, then the central bankers actually know what they are doing. And if that is the case, then I don’t really need all these shiny bars and coins that do not grow and provide no income”. Jim Grant of Grant’s Interest Rate Advisor is one who believes that the Fed cannot engineer a successful transition and that inflation is inevitable and therefore gold is a wise holding. Like Bill Gross, he isn’t winning the battle right now. This just illustrates the difficulty of the current investment environment. The tide is moving against bonds and gold in the short term. If you are going to hold these assets, you need to be psychologically prepared.
The other issue roiling the market is the continued slowdown in China. The argument here is whether the economic slowdown is a controlled deceleration engineered by the Chinese authorities in order to curb speculation and depress consumer inflation (in other words, good) or it represents the bubble bursting and as such will have a profound ripple effect throughout the globe (i.e. uncontrolled and therefore bad!). Asian markets fell more than 5% in June, leaving them fairly priced if the former scenario is correct. If the Chinese economy is a burst bubble, then everything except long term treasuries is overpriced. Obviously U.S. stocks would not decline as much as emerging market stocks (which have already given back 12.4% this year), but they would still decline.
The bottom line for U.S. stocks is that they are the best asset class right now. The economy is growing (tailwind) but interest rates are rising (headwind). Valuations are full to stretched (headwind), but near term asset flows should be positive as some of the money fleeing bonds will surely wind up in equities (tailwind). The S&P 500 at 1640 is 3% from its all-time high. The Russell 2000 at 1009 has just made yet another all-time high. For me at least, it is hard to add new money at these levels.
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