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.

 

 

 

 

 

 

 

Some happy year-end thoughts!

An interesting year on many fronts – financial and societal. But have I learned anything I can use in the future? From a financial perspective, I very strongly believe we are going to get more of the same in 2013 that we had in 2012 – notwithstanding the “fiscal cliff” nonsense taking place in the Untied States (deliberate). Resolved or not, my best assessment is that world markets will be slightly chaotic for at least the next 2 years before some level of stability re-appears. Am I psychic?? Absolutely not – but I am a fiscal realist. On a relative basis, Canada is better off that just about everwhere in the world with the exception of New Zealand. For my younger audience, NZ did go bankrupt as a country about 30 years ago – and ever since have kept things fiscally responsible.

Canada may be the best of a bad lot, but we are certainly not having the country’s finances managed in any way, shape or form in a conservative manner. Quite frankly (and I am not, have not been and never expect to be a member of ANY political party), our proclivite spending habits are much more reminiscent of Liberal and NDP spending patterns.

Over the past 18 months or so, there has been a real shift around the world to a more socialistic approach to all levels of government. Citizens of all countries are demanding more services and support from their governments yet no-one wants to pay the price. It is the same in North America, Europe, South America, the Far,Middle and Near-Easts plus the former Soviet states, the Indian sub-continent and Australasia. The people in the Sahara and sub-Saharan regions in Africa are facing even more serious issues of civil wars and genocoide, on one or more levels. The Scandinavian folks are much quieter about things in their part of the world, but they are facing the same issues as the rest of the Eurozone as our our friends in Iceland.

Governments have no money, unless they print more – which brings inflation back into the picture in a big way – something no-one in the world can afford. Some parts of South America are dealing with double-digit inflation now – but on a WEEKLY basis – not annually! So with no money for governments to spend, national debts are growing in leaps and bounds (regardless of the “blue” colours of some leaders), from where does the money originate?

People are still hesitant to invest for the long-term and are spooked every time a politician anywhere in the world, talks about defaulting, restructuring, devaluing or cutting deficits without raising taxes. All of which makes for choppy markets. Yes the Warren Buffet’s and George Soros’ of this world will always make money, because they take the long view.

I haven’t mentioned China and South Korea (or the rest of the Asian-Pacific Rim countries) because despite generally higher levels of “state” control over their economies, they are in no better shape. Closed and partly closed economies may appear to be doing better, but we never really see the complete truth – so in the absence of clarity, investors tend to shy away from them as well.

So what to do now? Stay happy and think positive thoughts! Stay short on the fixed-income side of things and use GIC or GIA ladders to protect yourself against upward movement in rates. Keep at least 5% to 7% in cash. In equities, for less than 15 years holding, stay with large caps that have good dividend histories, or mutual funds/seg funds that hold those stocks. For 15 years and longer – right now, your guess is as good as anyone’s! Have a safe and happy Christmas Season! Cheers Ian

My Top Five ‘Things That Could be a Problem (I Didn’t Say Crisis) For the Global Economy’

 

September really is like a New Year.  Not only does school get into full swing, but everyone is back and work – and the real trading begins.  Maybe that’s the reason that financial crises are more likely to start in the Autumn than in any other season.

 

Let’s be clear: I am not looking for a wholesale world economic crisis to unfold anytime soon. I do, however, think that the world economy is a little shaky right now, and there are a lot of things that are going to come together to cause some volatility over the next few months, and that investors need to understand them.

 

Here are my top five ‘Things That Could be a Problem for the Global Economy’ :

 

  1. Europe

 

Well, what else could I start with? Yes, the policy-makers have pledged to make things work, and yes the most recent plan by the ECB to buy bonds will help.  Still, Europe is in recession and the Eurozone is unlikely to look the way it does now a few years from now.  That means the risks coming from Europe are not over, not by a long shot.

 

  1. China

 

With Europe as weak as it is, the rest of the world desperately needs China to a source of strength.  Sadly, the last batch of numbers shows this economic powerhouse struggling and growth at the lowest in three years.  Policymakers have made some effort to boost growth – in July they cut the key lending rate for the second time in a month – but they are moving slowly lest they re-ignite an already crazy property market.

 

It is so far so good for commodity prices (and stocks) but a little more slowing from China could hit hard.

 

  1. The U.S. Fiscal Cliff

 

Tick-tock: unless some major compromises are reached in Washington, the U.S. falls off the ‘fiscal cliff’ in a matter of months.  The term refers to the menu of tax hikes and spending cuts that will go into effect at the beginning of 2013 as a deficit measure, and the corresponding havoc they would cause. Unless something changes, the U.S. is headed into at least a short recession- or maybe a longer one – in 2013.

 

Chances are there will be some kind of band-aid measures to stop the worst of the damage – but look for some slowing just the same.

 

  1. Oil Prices

 

Since the end of the Second World War, there have been 11 U.S. recessions  – and eleven of them have been preceded by sharply higher oil prices.  Which makes sense: the U.S. consumer sector accounts for about 70 perent of total U.S. GDP, and the generally speaking, there is not a whole lot of room in U.S. budgets to pay more to fill up the car (let alone the SUV).

 

If the U.S. sees a surge in growth and incomes, rising oil prices may not matter too much.  Barring that scenario, even if Europe and China keep chugging along and there is a compromise reached on the fiscal cliff, high oil prices could pull the U.S. economy into a downturn anyway.

 

  1. Lender Caution

 

Not that you can really blame them, but since the end of the last recession   lender have been notoriously careful about issuing credit.  That’s why interest rates at generational lows – and even at zero in some cases – are not sparking global growth the way they should be. Canada, by the way is a bit of an exception ot the rule – the Bank of Canada’s second quarter Senior Loan Officer Survey showed lending standards loosening up a bit – but that’s probably because our lenders were cautious to start with.

 

If things get shakier over the next few months, credit could get squeezed even more –in North America, and around the world too.  That is not good news for the economy or the markets.

 

Now, none of this is to scare anyone out of the market or to have them pulling their money out of financial institutions.  Still, better to understand and monitor the risks than to blindsided if Autumn gives us more than falling leaves.