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.

 

 

 

 

 

 

 

Is AAPL bruised or beginning to rot?

There’s a huge difference between Apple the company and AAPL the stock.  Back in July when the stock seemed to headed to the stratosphere I began to get concerned.  At the risk of seeming ridiculous (which has never stopped me before fyi) I will quote myself at the time:

 “The market value of Apple Inc. has ballooned.  It really hasn’t mattered that Android devices are kicking butt; rapidly gaining market share and being adopted by the more technology-savvy consumers (the nerdy trailblazers).  Until now?” July 29th, 2012

Apple’s 2nd quarter results had just been released and were considered disappointing by most analysts.  However my misgivings were based more on experience than the company fundamentals.  Over decades I’ve watched stock market darlings follow a pattern time and again.  At the outset it’s product itself that folks fall in love with, but eventually it’s the company’s stock they become infatuated with.

Admittedly the rewards to the company are plentiful if the product catches fire, especially in the middle stages of the lifecycle (pricing power and growing demand), but gradually management is obliged to focus on producing more and more of the product; which can mean skyrocketing revenues and economies of scale (reduced costs of manufacturing) – good for the company and its investors.  Eventually competition rears its ugly head, and the company is forced to innovate rapidly (rising expenses) to keep market share.  Competition (Android devices offered by the likes of Samsung, Research in Motion) will inevitably cause prices and profit margins to fall.

Finding a new hit ‘premium-priced’ product is difficult to do unless the company is managed by a tyrannical genius like Henry Ford or Steve Jobs (who can be oblivious to the rantings of those myopic stakeholders who’d rather have dividends than invest in research and development).

One might think that the stockprice should mirror the fortunes of the company.  But there are periods when this just isn’t the case.  This is the chart I was looking at (back in the summer months) when I began to get the heebeejeebies.  The financial results weren’t that impressive, but the share price had gathered its own momentum.

A GOOD  THING: Lineups to buy iPhones and iPads.  DANGEROUS: Lineups to buy shares.

I like to think the stock market  is like a party.  When my daughter was a teenager, she asked if my wife and I could disappear for a few hours one evening so she could invite some friends over for a party (I’m sure this has happened to many of you).  Things went fine until a contingent of uninvited guests began showing up.  No doubt a few more youngsters added to the fun, but once the house was too crowded bad things began to happen – items got broken, drinks were spilled on hardwood floors and carpets, there were empty bottles scattered all over the property and suddently her little party turned into into a nightmare.

When uninvited people (not really investors) scramble to own a stock it usually ends up like my daughter’s party.  At first a few more (uninvited) investors drives up the price which is great for existing shareholders and the company.  Indeed, AAPL shares continued to ramp up into the final quarter of 2012.  But just like my daughters party, things began to get ugly for the stock once it got too crowded.

 There is much speculation concerning the causes of the rapid decline in the price of AAPL shares:  Weak demand for the iPhone V, the threat of Android market penetration and so forth.  Some of this might be true, but pure speculation doesn’t ordinarily impact the price of a company’s shares this radically.  Hard evidence will hurt the stock to be sure but my own experience is that as soon as people realize they’re at a party that just isn’t as much fun as they’d hoped for then they all try to leave at the same time.  There is a great deal of risk associated with buying into stock market darlings.

I mentioned above that there can be a huge difference between the fortunes of the company and the behavior of the stock.  It could very well turn out that Apple (the company) will continue to thrive despite the decline in the share price.  After all there are a great number of people that still plan to buy iPhones.  No doubt there are also many planning to buy other Apple devices.

A recent survey suggested that 50% of those asked what smartphone they intend to buy over the next ninety days said they wanted an iPhone.  This is the same result Apple has enjoyed for that past couple of years.  There will come a time when the company will have to come up with another big hit product or re-invent itself.  After all the company was nearly banktrupt once (1987) and survived.  The introduction of the iPhone in 2007 certainly gave Apple another shot of adrenalin.

There’s no evidence to suggest Apple the company is beginning to rot just yet, but AAPL the stock was due to take a bruising.  Can Apple continue to take advantage of its solid franchise indefinitely without Steve Jobs?  Well that’s the billion dollar question isn’t it?

Mal Spooner