There is no nice way to state this opinion: the end of Quantitative Easing and the ultimate allowance of the open market to set interest rates will create a grueling multi-decade bear market in U.S. bond investments. Higher rates mean the re-pricing of existing bond instruments to lower prices and the principle risk of longer-dated maturities getting exposed. In 1983, I remember people losing approximately 15% of their market value in one year as Treasury interest rates rose from 11% to 14%, temporarily crushing owners of 25-year tax-free unit trusts. Other than owning bonds held to maturity, long-term bond ownership looks to be a big loser from the demise of QE.
We would argue that rather than trying to allocate capital based on timing the removal of this stimuli, investors should stop and consider who the winners and losers will be when the bond-buying program and the zero-interest rate policy of the Fed ceases. This week's missive will cover the domestic side of the winners and losers, while next week's missive will cover the international effects of eliminating ongoing Fed bond purchases.
Ben Bernanke has been very successful with the Quantitative Easing program (QE), in our view. It provided time for the U.S. economy to heal the banking system and for household income statements/balance sheets to improve. Quantitative easing helped businesses and mortgage holders to refinance and bought time for economic improvements to impact government budget deficits. Unfortunately for institutional and high net worth investors, we believe it has also allowed for some serious capital misallocation to continue in the bond market, in the U.S. stock market and in the commodity markets.
When the open market sets the interest rates in the U.S., businesses which have flourished from access to ridiculously low interest rates, will suffer, in our opinion. Capital intensive sectors of the S&P 500 index have historically eaten capital and include the telecom sector, utilities, industrials, basic materials and the energy sector. Reversion to the mean of profit margins strikes us as a natural recourse of the open market setting the interest rates. Telecoms are either heavily indebted and/or massive ongoing users of capital via high capital expenditures. Utilities have loads of debt and huge capital needs very similar to the telecoms. Industrial companies have massive plant and equipment needs and generate their profits through capital expenditures. Energy companies have ramped up their capital expenditures poking holes in the ground for the last 12 years and are at the mercy of the price of a commodity which has soared in value during those years.
To the contrary, businesses which have strong balance sheets, generate high levels of free-cash flow and have relatively low capex needs should not be impacted in a negative way by any changes in rates. This means that if you generate your own capital, whatever moves the Fed makes and whatever significant interest rate increases occur, you won't likely feel the impact, in our opinion. In his book, Great by Choice, Jim Collins explained that great companies make the best of their bad luck and the most of their good luck as well.
Monetarists tend to believe that the massive expansion of the Fed's balance sheet and easy money policy could trigger inflation. Doomsayers, we think, look at the debt overhang from the last 20 years and see deflation. To us, the ability to raise prices faster than inflation in an inflationary environment is the ticket to success. We like what we consider to be "wonderful" companies. Warren Buffett describes a "wonderful" company this way:
A couple of fast tests about how good a business is. First question is "how long does the management have to think before they decide to raise prices?" You're looking at marvelous business when you look in the mirror and say "mirror, mirror on the wall, how much should I charge for Coke this fall?" [And the mirror replies, "More."] That's a great business.
Whether the inflationistas or the deflationistas are correct, we believe the kinds of companies we own will be able to maintain prices better in a deflationary environment and can't be lived without in an inflationary set of circumstances.
We believe that "addicted customer base" companies in the consumer discretionary sector with strong balance sheets and copious free-cash flow like Gannett (GCI) are winners in the post-QE long haul. Healthcare companies like Merck (MRK), fit into this same category. Lastly we believe that financial companies generating high free-cash flow and which are pruning capital investments will enjoy the higher profitability of better interest rate spreads as they gravitate to market rates. For us, JP Morgan (JPM) is in the list of potential winners.
Lastly, we contend that commodity investing and the ownership of gold have been driven by historically low interest rates. The low rates were a negligible opportunity cost. At our firm, we believe that most U.S. individual gold owners came out of CDs and other short-term interest-bearing instruments and will go back there as interest rates normalize. We think farmers and other domestic commodity producers have feasted on low rates and have now laid the groundwork for much lower prices in their commodities by over-producing and over-expanding.
In summary, we view Ben Bernanke's temporary reprieve as postponing for a short time the inevitable transition to the market setting interest rates. We'd like to think that this is an excellent time to own what we consider to be "wonderful" companies and avoid those domestic investments which have benefited the most from the easy money policy of the last five years. In our view, this is the domestic story. Next week, we'll explore the implications of QE "tapering" in the international investment markets.
The information contained in this missive represents SCM's opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. It should not be assumed that investing in any securities mentioned above will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.