"If we're in a bubble, it's the weirdest bubble I've ever seen, where everybody hates everything"
- Marc Andreesen
3% is good. Get used to it.
You likely won't hear those words spoken by your financial adviser (especially if he is charging 1% or more to manage your money). You certainly won't hear them spoken by any company with a defined benefit pension plan, many of which are assuming long-run returns in the 7-8% range. It may even seem downright silly after equity markets have returned over 15% in the first 5 months of the year. But it's true.
On May 10, it was widely reported in the financial press that Bill Gross of PIMCO tweeted that "The secular 30-yr bull market in bonds very likely ended 4/29/2013."
What was not widely reported is the second half of Mr. Gross's tweet:
"PIMCO can help you navigate a likely lower return 2-3% future."
Little attention also was given to his follow-up tweet 3 days later:
Never is a long time. Even something less than never, like 30, 20, or even 10 years is a considerable length of time for any portfolio.
Rather than simply taking the opinion of the "Bond King" or anonymous Seeking Alpha contributor that 3% is good, even if you're not happy about it, first let's have a quick review of what brought us to this point and where we are now.
Inflation which has been on the decline for the past 30 years, offer a huge tailwind to fixed income (the longer dated the better) securities. Below is a chart of the US Core Personal Consumption Expenditure Index (seasonally adjusted) for the past 30 years as reported by the Bureau of Economic Analysis. Over this period core inflation has declined from over 5% to sit at 1.05% as of June 2013.
Buildup of Global Debt
As interest rates came down with the inflation rate, and economic growth remained strong by historical standards, virtually every industrialized country went on a massive borrowing binge. Consumers gorged at the trough of an ample supply of cheap credit and ever-increasing home prices, with a little speculation on the side. Governments borrowed to fund expanding programs, or in some cases (Japan) to prevent their economies from falling off a cliff. Businesses levered up for a host of reasons including "optimization" of capital structures, M&A, share buybacks etc.
Financial Crisis and Deleveraging
The 2008 financial crisis marked the end of the "debt supercycle" and a period of deleveraging began. However, one can see in the previous chart that this process is really only at its initial stages.
Drilling into the data, it's clear that while the private sector continues to reduce leverage, the public sector is still leveraging at a fairly rapid clip. The chart below, taken from the Federal Reserve Board's Flow of Funds Accounts (as reported by Yardeni research), shows what is happening in the US from a household, business, and US treasury perspective:
Business Profits Booming
Due to globalization, relatively high unemployment in the developed world, and reduced need for investment in the face of reduced aggregate demand, business profitability has been quite high. The chart below shows corporate profits as a percent of GDP are at a multi-decade high (12.3% of GDP):
Similarly, profit margins are near peak levels, and tend to mean-revert over time (as competitors attack profitable business models). The following chart shows the profit margin for the S&P 500 going back to 1991:
The flip side of this, is that in real (inflation-adjusted terms), median weekly earnings of full time workers in the U.S. are almost exactly where they were over 30 years ago:
Of course the chart above refers to those lucky enough to be working. Although the official unemployment rate has come down to a still-high 7.5%, broader measures of unemployment such as the U-6 unemployment rate which includes underemployed and discouraged workers remain at extremely high levels:
It's worth noting that the consumer sector accounts for over 70% of GDP.
Much of the data presented above are for the U.S. We know Europe is in far worse shape with structural issues (e.g. shared currency for diverse economies) debt and fiscal issues, and country imbalances, and arguably no practical solutions to get out of the quagmire any time soon. Other developed economies such as Japan and the UK also have serious issues.
There are a few relatively bright such as China, but at roughly 15% of world GDP (per the IMF at purchasing power parity), but 15% growing at 7% is only a modest (~1%) contribution to global growth.
Low interest rates have of course elevated bond prices, but they, in combination with high profitability have been very supportive of equity valuations. Equity bulls point to the fact that at a price/earnings multiple of 16x, equities are fairly valued by historical standards and "cheap" in light of low interest rates. The chart below shows the P/E multiple on the S&P 500 for the past 50 years:
They have a point. Equity multiples aren't stretched and could have further to run. The problem, however, is that if corporate profits mean revert, as they tend to do, equities may be on the expensive side. Measures such as the Shiller P/E multiple (which averages earnings over a 10-year cycle) demonstrate that equities are more expensive on a historical basis:
(click to enlarge)
As another warning sign to equity investors, earnings growth has stalled out with weak global growth and limited scope for further productivity (and this profitability) gains. The chart below shows the trailing earnings per share for the S&P 500:
In 2009 PIMCO coined the term "The New Normal," to talk about a prolonged period of slow economic growth, high unemployment, and government debt problems. Sound familiar? Originally PIMCO stated this may be a 3-5 year process if everything went well. While things have gotten a little less bad, it would take some kind of optimist to look at Europe, Japan, a slowing China, the U.S. fiscal headwinds, the global debt overhang, and so on, to think that we are close to the end. One shudders to think what the economy would look like if it weren't on government life support in the form of huge deficit spending, low rates, and massive QE. More likely, to quote Winston Churchill:
"Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning."
So if one buys into the view that:
- Economic growth (and thus demand and profits) will be muted for a long time as the world works out of a debt overhang and massive structural challenges.
- Inflation isn't a concern any time soon, as weak demand, global supply chains, and high unemployment keep wages in check, and QE has minimal incremental impact (most of the money "printed" in QE hasn't been lent out).
- Bond and equity values are on the high side.
Where can one find value?
To answer that question, I look at it through three lenses - what is relatively attractive? and what is absolutely attractive? And what adds value to my portfolio?
Now let's have a look at the current yield curve of the US Treasury market:
I added the white line, which is the most recent reading of core inflation. You can see one needs to go out 5 years just to earn 0% real (at a 1% inflation rate). At a 2% inflation rate you would need to go out 10 years just to breakeven in real terms.
What about going out 30 years? Is 3.3% in a risk free asset (if held to maturity) that bad? The answer is "yes" according to many, They point to murky long-term inflation concerns, concern about loss in a rising rate environment, government fiscal woes, and cling to the hope that they can do better.
Those are valid concerns, but does that mean they should have a 0% weighting in our portfolios. Is there any value there at all?
Applying our first of three lenses, on a relative basis (that is relative to the rest of the yield curve), the long bond is very attractive from a yield perspective:
On a relative basis, the long bond is yielding 69 times that of a 3-month treasury, 11 times the 2-year bond, and 50% more than even the 10-year bond. Relative to equities? It depends on your outlook for both the "E" and the "P/E" in the earnings equation over the relevant time horizon. With little growth in "E," does one count on continued multiple expansion? What if profits mean revert and E actually declines in absolute terms? Food for thought.
Looking at the curve itself, since the late 1970s the 30-year bond has traded, on average, about 35 basis points above the 10-year yield. It is near a multi-decade high now at 1.16% above the 10-year yield:
In that light, even if the 10-year yield were to back up all the way to 3%, the 30-year yield may not move much at all if it adheres to its 35-year average (I believe the very long-term average is in the 50-60bps range but could not find the data).
What about Europe, with all its problems? The German 30-year bond yields 2.39% (almost a full percentage point lower than the US long bond). Some may be shocked to learn that France's long-term debt trades at a 3.1% yield, also lower than the U.S.
What about on an absolute basis?
Looking at historical yields on long-term bonds going back to 1870, they have averaged about 2.1% above inflation:
At 3.3%, one could argue that 30-yr USTs are pricing in long-term inflation of about 1.2% (a nick above the current 1.05% core reading).
While it's hard to get excited about a 3.3% return (although it is very respectable in the "New Normal," what is exciting about this asset is what it can do to a portfolio of risk assets.
Anyone who follows financial markets on a daily basis will be familiar with headlines such as "Stocks Rally, Treasuries Fall" and "Treasuries Rally As Stocks Swoon." For better or worse, for the foreseeable future when it comes to safe haven assets, US treasuries are it. The volatility of "risk on" and "risk off" can be dampened by adding these securities to our portfolios. ETFS such as TLT and ZROZ allow for easy exposure.
Why not just go to cash, or something "safer" like a 5-year or 10-year bond? While that can be a reasonable defensive strategy, those instruments do not provide the "juice" one gets on a long-duration treasury holding. When risk assets are getting clobbered, the value of having something that appreciates is enormous especially if one has the smarts to rebalance during such periods.
To illustrate, let's look at the yield on the 30-year bond over the past 7 years:
Now let's overlay the S&P 500:
One can see that during each equity market decline, the long-term bonds rallied significantly. What does this mean from a price perspective? See below:
When equities fell 35% during the Lehman collapse, how valuable is an asset that actually appreciates by 20-25% as yields went to 2.5%?
So can this trade work with a 30-year bond at 3.3%. Yes. To illustrate, let's look at the sensitivity to the long bond price to moves in interest rates. First I will look at the current 30-year benchmark bond, then the even longer-duration 30-year strip bond.
You will see in the above sensitivity matrix that even in a relatively most move to 2.78% (-50bps - where it was just over a month ago), the bonds could appreciate over 10% in a short period. If the bonds moved to where the German yield currently resides, there is 23% upside. It's important to note that this would likely be occurring during an equity market sell-off, providing a valuable opportunity to sell bonds high and buy equities lower, or simply enjoy the reduced overall volatility.
For those looking for some real torque, it can be found in the strip bond. The current 30-year bond maturing 05/15/43, stripped of its coupons, currently trades at 35.9 (meaning if you invest $35.9 now, you will get paid $100 in 30 years' time. Below is its sensitivity to 5-150 shifts in interest rates (note this bond has a current YTM of 3.51%):
With this instrument, a move to 2% (just below German levels) would send this bond up 57%. Even a move to 3% offers a 16% return.
Of course, observers will note what happens to these instruments if interest rates move up significantly. It is for that reason they must be looked at in the portfolio context. Sized appropriately they have the potential to add tremendous value. For example, an investor with a 10% allocation to US treasuries might be happy to lose on that part of his portfolio, as it means the other 90% may be doing well (e.g. if in equities, high-yield debt, or other risk assets).
As Bill Gross says, just because a 30-year bond bull market may have ended, it doesn't mean a bear market is about to begin.
It's hard to have a bubble in an asset that is almost universally despised.
To those that think interest rates have nowhere to go but up, I will finish with this chart of the Japanese 10-year government bond yield since 1987:
"Just because something doesn't do what you planned it to do doesn't mean it's useless"
- Thomas A. Edison
Additional disclosure: This article reflects my personal views only. I have a long position in TLT and ZROZ. All data and calculations presented are accurate to the best of my knowledge but have not been vetted, checked, proofread, or independently verified. This article should not be relied upon for any purpose other than for entertainment. I welcome comments and or corrections.