Interest Rates Rising – the sequel

Mal Spooner is a veteran fund manager and currently teaches at the Humber College School of Business.
Mal Spooner is a veteran fund manager and currently teaches at the Humber College School of Business.

No doubt you’ve noticed about half the industry pundits cautioning that the US Federal Reserve is closer to ‘tightening’ monetary policy.  What this implies for us regular folk is that they will introduce monetary measures that will allow interest rates to rise.  We have enjoyed a very long period of inflation and interest rate stability following the financial crisis (a crisis almost forgotten by many).  Despite a recent slowdown in come economic indicators, efforts by governments around to world to jumpstart an economic recovery did bear some fruit.  The rebound in profitability, employment and growth has been particularly robust in the United States.  Both Europe and China are now making efforts to replicate this success by bolstering liquidity in their financial systems as the US did.

So what’s to worry about?  Savvy investors will have already noticed that interest rates in the world’s strongest economy have already begun to rise, even before the FED has taken any action.  This is what markets do – they anticipate rather than react.  Some forecasters predict that although interest rates are bound to trend upward eventually, there’s no need to panic just yet.  They suggest that there’s enough uncertainty (financial distress in Europe, fallout from falling energy prices, Russia’s military ambitions, slow growth in China) to postpone the threat of rising rates far into the future.

Yield Curves 2015-05-02_15-28-30

What they are ignoring is that the bond markets will anticipate the future, and indeed bond investors out there have already begun to create rising interest rates for longer term fixed-income securities.  The graph illustrates that U.S. yield curves have shifted upward.  The curve shows market yields for US Treasury bonds for various maturities back in February compared to rates more recently.  So what’s the issue?  If investors hang on to their bonds while rates are rising, the market value of those bonds declines.  This often comes as a surprise to people who own bonds to avoid risk.  But professional bond traders and portfolio managers are acutely aware of this phenomenon.  So they begin to sell their bonds (the longer term-to-maturity bonds pose the most risk of declining in value) in order to protect themselves against a future rise in the general level of interest rates.  More sellers than buyers of the bonds pushes down the market price of the bonds, which causes the yields on those same bonds to increase.

Many money managers (including me) have learned  that despite how dramatically the world seems to change, in many respects history does repeat itself.  For example, while writing my CFA exams back in the mid-1980’s, I was provided with sample exams for studying, but they were from the most recent years.  I figured it was unlikely that questions on these sample exams would be used again so soon, and managed to do some digging in order to find much older previous exams.  I reasoned there are only so many questions they could ask, and perhaps older exam questions might be recycled.  I was right! In fact several of the questions on the exam I finally wrote were exactly the same as the ones I’d studied from the old examination papers.

In my experience recent history is not useful at all when devising investment strategy or trying to anticipate the future, but often a consideration of historical events further back in time – especially if trends in important economic drivers are similar – can be very helpful indeed.

The consensus is that interest rates will rise eventually.  But it is human nature to stubbornly hang on to the status quo, and only reluctantly (and belatedly) make adjustments to change.  What if what’s in store for us looks like this:  Consistently increasing interest rates and inflation over the next decade?  This has happened many times before (see graph of rising 10-year Treasury bond yields from 1960-1970).

US Treasury Yields 1960 - 1970

Before you rant that things today are nothing like they were then (and I do agree for the most part) consider the following: Is the boy band One Direction so different today compared to The Monkeys then?  And wasn’t the Cold War simply Russia testing the fortitudes of Europe and America just like the country is doing today?  Weren’t nuclear capabilities (today it’s Iran and North Korea) always in the news?

Yes there have been quantum leaps in applied technology, brand new industry leaders in brand new industries.  China’s influence economically was a small fraction of what it is today.  So where is the commonality? The potential for rising interest rates coming out of a recession.  The US government began raising rates in 1959, which caused a recession that lasted about 10 months from 1960 – 1961.  From that point until 1969 the US economy did well despite rising interest rates and international crises.  But which asset classes did well in the environment?

Growth of $100 - 1960 to 1970

Could the disappointing 1st quarter economic data be hinting that we might also be entering a similar transitioning period?  Inflation is bad only for those unable to pass higher prices along to customers.  If the economy is strong and growing then real estate and stock markets provide better returns.  Since the cumulative rate of inflation between 1960 and 1970 was about 31%, investors essentially lost money in constant dollars (returns below the rate of price inflation) by being invested in the bond market.  They would have done better by simply rolling over short-term T-Bills.  An average house in the US cost about $12,700 in 1960 and by 1970 cost $23,450 – beating inflation handsomely.

Do I believe we will see a repeat of the 60’s in terms of financial developments?  Yes and no!  There will be important similarities – especially in terms of stock markets likely performing well enough and the poor prospects for the bond market. There will be differences too.  The outlook for real estate is clouded by the high level of indebtedness that has been encouraged by extremely depressed interest rates over the past few years.  Higher rates mean higher mortgage payments which might serve to put a lid on real estate pricing, or cause prices to fall significantly for a period of time before recovering.

Companies that have substantially financed their acquisition binges with low-cost debt will soon find that unless they can pass along inflation to their customers their profit margins will be squeezed.  Who will benefit?  Commodity producers have had to significantly reduce their indebtedness – commodity prices tend to stagnate when inflation is low, and even decline when economies are growing slowly.  In a global context, these companies have had a rough time of it.  It is quite possible that their fortunes are about to improve.  If Europe and China begin to enjoy a rebound then demand will grow and producers will have more pricing power – perhaps even enjoying price increases above the rate of inflation.

Do I believe any of this retrospection will prove useful?  I hope so.  The first signs that a different environment is emerging are usually evident pretty quickly.  If there were a zero chance of inflation creeping back then why are some key commodity prices showing signs of strength now?

recent aluminum price recent copper price data

If we begin to see inflationary pressures in the US before Europe and Asia, then the $US will depreciate relative to their currencies.  In other words, what might or might not be different this time is which countries benefit and which countries struggle. Globalization has indeed made the world economy much more difficult to come to grips with.  Nevertheless, there are some trends that seem to be recurring over the years.

There will be recessions and growth spurts.  In recessions and periods of slower growth, some formerly stronger industries and companies begin to lose steam as a paradigm shift takes place, but then other industries and companies gather momentum if the new reality is helping their cause.  This is why I’ve biased my own TFSA with commodity-biased mutual funds (resource industries, including energy) and a European tilt.  You guessed it – no bonds.

Any success I enjoyed while I was a money manager in terms of performance was because exercises like this one help me avoid following the mainstream (buying into things that have already done well) and identifying things that will do well.

 

 

 

 

 

 

 

You are energy efficient!

If you listen to extreme environmentalists, you’d think the entire human race was oblivious to the fact that many of the resources we use are non-renewable, and that our fate is to irresponsibly destroy the planet.

Well I have some good news. According to the U.S. Energy Information Adminstration’s (EIA) most recent Residential Energy Consumption Survey (RECS), U.S. homes built in 2000 and later consume only 2% more energy on average than homes built prior to 2000, despite being on average 30% larger.

I recall the brouhaha created when in 1972 (yes, I’m that old) when the Club of Rome (a distinguished think-tank) published a study called Limits to Growth. Many folks have since criticized the work, and still others have tried to defend it (by re-interpreting the study “using modern language” or some other sleight of hand). The prediction was that humanity’s pursuit of constant growth and consumption of resources (energy, food, trees etc.) would use up the planet within 100 years. Yes, Limits to Growth did suggest that if mankind undertook to minimize greed, control population growth and take advantage of technology that things might not turn out so bad, but it was unequivocally pessimistic about this possibility. Quite a stir was caused by the publication.

We had another panic more recently: The Association for the Study of Peak Oil and Gas (ASPO) suggested regular conventional oil reached an all time peak in 2005. The ‘theory’ was that we’ve used up half of the oil the earth has to offer, and so it’s all downhill from now on.

So how can it be that suddenly the U.S. is expected to be almost energy self-sufficient?

“The United States, which currently imports around 20 per cent of its total energy needs, becomes all but self-sufficient in net terms — a dramatic reversal of the trend seen in most other energy-importing countries,” the Paris-based International Energy Agency said in its World Energy Outlook released Monday Nov. 12, 2012.

What these ‘studies’ and occasional panics fail to take into account is the greatest innovation ever – CAPITALISM! Shortages and surpluses are corrected by economics. The laws of supply and demand and the unencumbered adjustments in pricing ensure that there are very few limits to growth. We’ve come to appreciate over the years that a ‘price’ isn’t necessarily a dollar amount. Increasingly some things are just too expensive if they also cause irreparable harm to the environment. When one non-renewable resources becomes just too expensive, we find substitutes (biofuel, gas, nuclear, clean coal and hydroelectric).

I’ve read that recent polls show falling support for capitalism all over the world. This is sad when you consider the alternatives. Was it better when no system existed? I visited Africa several years ago and learned that some areas had long ago been cleared of all indigenous tree varieties. In a primitive society everything belongs to everyone, and everyone managed to destroy every tree. A quick study of the former Soviet Union should make it clear that communism inflicted serious environmental damage and scarcity. The population of China only stopped starving once a more capitalist system was tolerated.

So fret not my friends. You are energy efficient, and no doubt one day your home will consume no fossil fuels at all. You will no doubt substitute an electric vehicle for your hybrid. Personally, I pray there will be enough oil and gasoline left, no matter how expensive, so that I can still ride my Harley-Davidson motorcycle.

 

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