We have seen a lot of worry on bonds over the past few months, with rates turning up again and affecting the prices of bond-like stocks such as utilities. But this looks no different from the bond scares we have seen over the past year or more, particularly the scare surrounding the Fed’s 0.25% rate hike in December 2015. What happened then? That rate hike pretty much marked the end of yields going up, at least until recently.
Should we be scared about the possibility that yields and yield-focused stocks like utilities will get hurt? We hear a lot of reasons suggesting that we should be scared. GDP is going to get better (but it hasn’t yet). GDP in the UK was surprisingly good (for one quarter). Inflation is rising (barely, and health care cost and similar increases do not in any way help consumer discretionary spending, which is a large part of economic growth). Employment is still good (perhaps in number of jobs for those still looking for work, but certainly not in job disposable incomes). And, of course, the Fed is going to raise rates (early in 2016 the Fed was going to raise rates four times this year; we are still waiting for the first time).
Let’s look at what actually correlates with yields. Number one, by far, is economic growth. Get your growth outlook right and you generally will get yields right. There are other factors that matter, but not as much. Inflation doesn’t matter much – it is mostly a result of economic growth. Rate hikes do have an effect, but it is a much smaller impact, and, as we all know, because rising rates tend to slow growth they tend to balance out over time.
As portfolio managers we have to make decisions on how to build and tilt the portfolios. We could panic, like of lot of investors, over the latest reason du jour for why bond yields “have” to go up. Or we can focus on a process, based on real data, that gets the long term trend right. Obviously, we choose process. Is a one quarter improvement in UK GDP a reason to sell utilities and buy Netflix? Only if you like storytelling and happy narratives, rather than data.
Probably the most interesting recent storytelling claim is that economic data is getting better. It is true that there was a time about three months ago (June-July) where some economic data was getting better, but that was pretty transitory. The bigger trend in economic data is still down. Real GDP has dropped every year from 2013 to 2016, going from 2.7% in 2013 to a projected 1.4% for 2016. Interest rates on the 10 Year Treasury also have declined from a bit over 3% to the current 1.8%. Despite Fed claims of various stimulus actions that will improve economic growth, the data tell us that government actions have resulted in slower economic growth and lower interest rates. We expect that market risks are to the downside.
Perhaps the most important note is that quarterly growth data has been slowing every quarter for six consecutive quarters, and should likely slow for at least another two quarters. That’s what really matters. What we have seen in the data is that more debt from various stimulus actions generates weaker economic growth and falling treasury yields. 2017 looks like more of the same – more government spending and debt, with the most probable result being more slow economic growth and low interest rates.
As an aside, what makes growth slow? It sounds obvious, but it is a lack of growth in underlying factors like productivity, capital investment, and asset/inventory turnover. We have all of these negatives in our economic data. We also have rich data showing how debt above a certain level (such as over 50% of GDP) is detrimental to growth. You don’t have to guess where we are now on growing debt loads at all levels.
As we have said before, at some point growth prospects will get better, if only due to easier year-over-year comparable economic data. But there is nothing indicating that the time for improving growth prospects is now. For now we have a slowing economy that appears to be trending slower, lots of burdensome debt, and lots of global volatility – something that tends to happen more with downside risk than upside optimism.
We have managed similar scenarios before. Financial markets are not always an accurate reflection of reality. Just recall the Technology and Financial stock market bubbles. Those and other experiences have taught us that it is important to manage portfolios consistent with the objective data, not based on happy narratives that all will be well.
We see the probable outcome as continued pressure on stock valuations. Our priorities are capital preservation and patiently looking for opportunities. If we have continued weak economic growth and low rates, there is not much immediate upside. If somehow we see economic growth, we would expect higher rates, which is added pressure on stock valuations. Either way, we see limited market upside from current market valuations. BUT, as always happens eventually, volatility creates opportunities. If we have no economic or geopolitical surprises, such as European bank failures, we would not be surprised to see multiple modest retreats where opportunities arise, such as occurred in the third quarters of 2011 and 2015. If we do have a big surprise, like we did in 2000 and 2008, then we would expect fewer but bigger opportunities. Bottom line, there are multiple paths to a range of sensible opportunities.