Reincarnated As The Bond Market

Posted: Feb 23, 2018 2:03 PM
Reincarnated As The Bond Market

If memory serves it was former Bill Clinton advisor, James Carville, who once said when he died when he wanted to be reincarnated as the bond market in his next life, because that was where the real power was ...  (there is actually another famous quote from Carville in this week's Dividend Café, but that's just a coincidence).  Carville was not wrong (about the power of the bond market, that is; I'll leave the reincarnation stuff alone).  And as you will see throughout this week's chart-heavy Dividend Café, investors curious about the present lay of the land would be wise to understand how much that is currently going on is really a story of the bond market finding its own footing, and what that all means.

I think it is a very informative week in the Dividend Café, and a lot of attention is being paid by yours truly right now to the macroeconomic aspects impacting our portfolios.  February has been a fascinating case study in various investment principles, and we are navigating the waters of capital markets each and every day diligently and studiously.  With all that said, let's get into it ...

It's the bond market, genius

James Carville famously said in 1992, "It's the economy, stupid!"  I teach my kids not to say, "stupid," so I am not going to violate my own parental instruction.  But the "genius" here in the headline is meant to really grab your attention to the reiteration of a very obvious point right now: The bond market has taken over.  The daily moves in stocks, the primary conversation economically, and the most significant barometer of global economic realities, all can be best-traced with the bond market - the great discounter of risk, inflation, deflation, and expected growth.  The story of 2017 was that stocks said growth was coming and bonds did not believe it; the story of 2018 has so far been stocks proving growth is coming, and bonds now saying, "yeah, you're right - we hope it isn't inflationary!"  So yes, the bond market re-pricing continues, and to the extent the growth in the economy (and corporate profits) continues, we believe stocks will come out fine; and to the extent that productive growth trumps monetary inflation (which is our view), bond yields will likely find a ceiling (one of these days).

Bond market awakening

Is the U.S. bond market in a giant bubble?  It should go without saying for anyone who understands the math of bonds that if the ten-year treasury yield were to go from 2.85% to 5%, the answer would be yes, at 2.85%, bonds were in a bubble (prices of bonds go down as yields go up, and vice versa).  So essentially, whenever you hear the argument about a "bond bubble," it is basically a market call - that bond yields are about to explode higher.

So what do we make of the argument that bonds are in a "bubble"?  We have, after all, said for quite some time that there is not a great risk/reward trade-off in the bond market; we have held a modest underweight in the asset class (and still do); and most importantly, generally see the reason for bond ownership as purely related to being a diversifier and risk mitigator than a source of aggressive return.  But is that the same as saying we are in a "bubble"?

One of the things that must be said is that the vast, vast majority of so-called bond bears preaching the bubble theory have, themselves, spent virtually all of the last decade being wrong on the bond market.  It is not really a criticism, per se.  The bond market has been very easy to be wrong about in a world of interventionist monetary policy.  But it is still important from a grain of salt standpoint to recognize that the great pundits of our age are not playing off a wonderful track record.  Be that as it may, there is little basis to argue that bond yields in the treasury market are in a bubble, unless one means that current levels of yield are substantially low.  We think it is possible they will prove to be a bit low, or even fairly valued, but not substantially low.  High grade muni bond yields and corporate bond yields are more expensive in relative value, making "frothy" a better word than "bubble."

We land at the same place we started in this discussion.  Bonds are a necessary evil in a portfolio right now, unlikely to offer great returns, and potentially even exposed to some price risk if yields advance, but needed to mitigate the risk of complete stock exposure, and fundamental to the discipline of asset allocation in portfolio construction.

Is a capex boom being missed?

Until the market disruptions of early February, I had intended to write a piece on how through all of the discussion of expanding corporate profits out of tax reform, all the discussion of foreign profit repatriation, and all of the discussion of where excess cash flow may get spent in a post-tax reform world, that there was a potential market event shaping up that had the risk of being substantially missed.  The disruptions of early February took center stage, and as we write this week, the real driver of markets right now until more clarity and stability takes hold is the bond market.  But with that said, I continue to believe there is a capital expenditures boom underway that has profound implications for the market.

Why does this matter?  Spending on capex has been substantially low since the financial crisis, and represents the biggest gap in pre-crisis financial metrics that has held economic growth down.

Click here to view the chart.

Is this story connected to our theme of inflation this week?  You bet it is.  There is nothing that mutes the inflationary impact of growth like increased productivity, and there is nothing that increases productivity like capex spending!  I believe there is significant need to increase capacity, to replace old inventories and equipment, and to update various technologies and systems.  On the supply side, this is the right bet in terms of where we are in the business cycle and what we expect from tax reform (most notably from the immediate expensing aspect of it).  A capex boom is very possibly an overly optimistic prognosis, but should it happen, investors should not be surprised at the powerful force it represents for the market, not just in terms of improving top-line revenues and profit margins, but in serving as antidote to inflationary pressures.

Upon further examination

I believe what I wrote earlier in the month about the "technical factors" in the factor that led to that particularly high volatility week was exactly correct, and that the small spark of a wage growth number led to a chain of events that put markets in a panic attack (and that the heavy volume of "weak hands" holders of ETF's and mutual funds put selling pressure on markets that led to cascading effects in prices as computer-driven buyers removed their bids).  Simple enough.  But I will add to the story that the role the "short volatility" trade played in exacerbating all of it is likely as high as many have written.  There have been some decent stories in the press (and not decent ones) about this whole phenomena, but the side effects to a horrifically large and reckless trade (mostly through inverted and leveraged exchange traded product owned by very, very unsophisticated investors) being unwound were all kerosene on the fire of a panic attack.  Worse, it was entirely avoidable by investors following this simple mantra (or the advisors who guide them) - "Don't buy stupid stuff that serves no purpose in your portfolio."

Inflation in the eye of the beholder purchaser

Why can inflation be so debated and difficult to measure?  Because inflation is, by definition, the phenomena of aggregate price increases across an economy.  The last 15 years have seen such incredible dispersion in price inflation, largely led by the areas of the economy most subsidized by the government (college tuition, health care).  Varying price movements from apparel to food and beverage, etc. have created a lot of dispersion, confusion, and disagreement about inflationary realities.  And furthermore, let's just politely say that many do not believe the "housing numbers" reflected in government CPI data.

Click here to view the chart.

Across the pond

As investors in the UK equity markets and believers in the British bottom-up story post-Brexit, what are we to make of their tightening monetary conditions, even as the whole world obsesses over the U.S. Fed's plans for monetary policy?  The reality is that we see a tighter monetary environment in the UK as very different than many pundits do.  First of all, the big fear when interest rates move higher is always that more and more income gets spent on people's housing payments, given the fact that across the world people seem to be obsessed with short-term adjustable rates (largely because they have been conditioned to believe that interest rates cannot go higher).  71% of Brits had adjustable rate mortgages in 2012; but only 39% do now!  That massive move towards fixing one's housing liability is a huge, huge economic insulation.  Secondly, we are seeing a substantially improved financial sector in Britain, as increased rates are leading to better margins, better financial products for consumers, and better profit margins.  Finally, wages are picking up (bucking the expectations of Brexit bears), and there has been material pick-up in the sterling pound as well.  Political and trade uncertainties persist, but we remain in a long-term sense, bullish on Brexit, and bullish UK (especially relative to European Union counterparts).

Be careful about what is supposed to be obvious

Stocks struggle when interest rates rise, right?  This is the consensus view.  This is the status quo.  We all know this, right?  Well, actually, no.  It is dead wrong.  Stocks can drop when rates rise, but they can do the opposite too.  The historical non-correlation is somewhat indisputable.  Note the following, and be stunned.

Click here to view the chart.

So what do we know about stocks and rising rates?

What we do know is that in the periods most defined by a rising rate cycle, dividends make up a larger percentage of the total return of stocks.  This should be somewhat intuitive, for during period of falling rates, in theory, P/E ratios expand, giving more favor to non-dividend paying growth stocks.  But with rates rising, the competitive fight for yield makes dividend growers more attractive, and a larger percentage of the return to be had in equities will come from their dividend yield.

Click here to view the chart.

Chart of the Week

When we talk in the Dividend Cafe about the "secular bull market" in bonds, a bull market of over 30 years in length, you will note two things from this week's Chart of the Week:

(1) The secular and long-term nature of the bond bull market is indisputable, as bond yields have stayed in a declining trend, led by contained inflation and a different paradigm in monetary policy

(2) And yet, one can see as clear as can be a repeated gyration in yields within this secular trend (sometimes violent gyrations).  A 30-year bull market in bonds has not meant a straight line down in yields (which means a straight line up in bond prices),  Rather, it has been a staggered move down.

Some believe that the bond market is about to see the 10-year yield move above its trendline.  Our view is that such charting and technical analysis is reasonably worthless to a real investor in any practical sense.  What we believe is this: Bond yields are higher now than they were in the doldrums of post-crisis recovery; they are likely to stay as such, if we are lucky; and economic fundamentals do not suggest dramatically higher bond yields than what we have now.  Higher?  Very possible.  Much, much higher?  We don't think so.  Why?  Global growth has picked up (hence higher rates), but global growth is still constrained by debt-deflationary realities enough that rates have a ceiling, in our analysis.

Click here to view the chart.

Quote of the Week

"People who rely heavily on forecasts seem to think there’s only one possibility, meaning risk can be eliminated if they just figure out which one it is. The rest of us know many possibilities exist today, and it’s not knowable which of them will occur. Further, things are subject to change, meaning there will be new possibilities tomorrow.This uncertainty as to which of the possibilities will occur is the source of risk in investing.”

-- Howard Marks

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It was a chart-heavy week here at the Dividend Café, but hopefully, you found it all substantive and meaty as well.  I love this present level of engagement in the global economy and capital markets.  I find my morning reading right now particularly invigorating, and I am eager to make the right decisions about what to do (and not do) on behalf of client allocations, and am very pleased with what we have been doing this year.  A stock can surprise you in a good way (as Cisco did last week), or can surprise you in a bad way (as Wal-mart did this week), but ultimately this little thing we do on an almost obsessive basis is what we believe truly moves the needle in client outcomes - a deep study of the underlying forces behind capital markets - foundational realities ("first things") - that drive financial markets.  Our obsession with being the most researched investment and wealth management firm we can be, coupled with the daily awareness that driving our client's behavioral responses to investment markets, is our unique value proposition that we refuse to abandon.  It is to that end, that we work.

David L. Bahnsen writes at the Dividend Café.