Less than Zero
In the late 1980’s Brett Easton Ellis published “Less Than Zero”, a nihilistic tale about the excesses of that time set amongst the young and privileged of Southern California. Fast forward 30 years and today’s topic (on the heels of “TARP”, “QE” and other government intervention that some might consider excessive) is the remarkable emergence of investors who are willing to buy bonds that will pay zero, or even negative rates of interest.
Over one-third of today’s developed market government bonds promise no investment return, according to Citibank. This phenomenon shatters the long-held belief that investors should demand interest as the price for the use of their money. Of course, many things have changed since the “Great Recession” of 2008 -2009, but this latest chapter in the slow economic recovery is causing a bit of angst among politicians and economists.
As of today, the U.S. Treasury market is not afflicted with this anomaly. However, investors looking for “safe” investments in Germany, Japan and Switzerland accept negative returns in exchange for the perceived safety of government bonds. This complicates the work of our Federal Reserve, which seems set on "normalizing" (i.e. raising) U.S. interest rates.
The Fed, having largely succeeded at stabilizing the economy, has been considering how to unwind the extraordinary policies of the past few years. If it raises rates too early, it may undo some of the benefits (low rates, higher asset prices) of the policies it has pursued for the past seven years. If it waits too long, inflation may perk up unexpectedly forcing it to raise rates quickly, potentially triggering a recession. If we raise rates while others are printing money, the subsequent rise of the U.S. dollar may make our goods less competitive in international markets.
Amid all this uncertainty, investors in U.S. stock and bond markets have done well. The S&P 500 was positive by about 3.3% in the third quarter, and the index sits just a few points shy of an all-time high. Bond performance was essentially flat in 2016. In our view, stocks are fully valued and offer modest long-term return potential. Earnings growth on the S&P has been non-existent for over a year. To sustain today's current high prices, at least a small rebound in earnings is needed. Fortunately, earnings seem set to rebound modestly (5% to 7%) from current levels. This should provide some support for a fully valued market.
We believe U.S. interest rates are in the process of bottoming out. While rate increases may be gradual, we believe the path of least resistance is up. This year Treasury Inflation Protected Securities or TIPs, have significantly outperformed conventional bonds. To us this means inflation pressures, however slight, are building. A whiff of inflation might be good for the economy, but will be a headwind for long term investment grade bonds.
Even though value is wearing thin in U.S. stock markets we believe portfolios should remain close to targeted allocation for U.S. stocks, preferring higher quality issues compared to the index. Value is more compelling in international markets (Europe, Asia, Emerging Markets) but some caution is warranted due to the central bank policies mentioned above. Bond portfolios should be positioned in short to intermediate term maturity in order to account for the slowly rising rate environment.
We look forward to meeting with you and we continue to appreciate the trust you have placed in our firm.
The Altavista Investment Team – Fall 2016