Interest rates and bond yields continue to decline
On August 2nd, 2016, the Reserve Bank of Australia cut its cash target rate by another 25 bps to an historic low of 1.5%. Low interest rates have been the norm in much of the developed world for many years now. The Federal Reserve kept its funds rate at just 0.25% for 7 years, and increased it in December 2015 by just 25 bps. It is likely to remain at low levels for some time, although the present trend is at least weakly positive. Canada's base rate has been trending down and is now at 0.5%, the Bank of England's official bank rate was cut on August 4th, 2016 and is now 0.25% (its lowest in 322 years), in the Euro zone and Japan rates are at zero to slightly negative and in Switzerland they are at -0.75%. Banks in those countries with negative rates must pay the central bank to deposit their money; they are starting to look at passing those costs on to consumers.
As a result of this low rate environment, yields on bonds have continued to fall. Recently, in many countries, they have done the unthinkable and fallen below zero. For example, as at August 2nd, in Japan bond investors must pay the Japanese government 0.157% per annum for the privilege of lending it money for five years. In the Netherlands, investors must pay 0.415% on a 5 year bond, and in Sweden the yield is -0.52%. In Switzerland, investors on July 30th were paying the Swiss government 0.085% per annum to lend their money to it for 30 years. Using that last example, an investor in CHF100,000-worth of 30-year Swiss bonds would, at the end of that period, get back just over CHF97,481. If that isn't permanent capital destruction, it is hard to imagine what is.
These bonds are being priced as if there will be no inflation (or there will be deflation) for the next five, 10, 20 or 30 years. However, that would be an historical anomaly, at least based upon modern history:
Source: inflationdata.com (U.S.)
So why is this occurring? Since the Global Financial Crisis (or Great Recession), bond yields have fallen as a response to a lowering of interest rates by central banks hoping to stimulate anemic economic growth, fuel persistently-low inflation or lower the value of their currencies. However, yields have also been depressed as a result of central bank "quantitative easing", which involves the government increasing the money supply by buying assets, such as government bonds, from private investors.
The theory is that QE should stimulate economic growth and increase inflation, but there are disagreements over whether or not it has been effective on those measures. On the other hand, it has certainly led to increased asset prices. Central bank bond-buying programs have in effect introduced a "forced buyer" into the market. That is, the central bank is required under the terms of its policy to purchase a certain dollar value of bonds, regardless of their price. This pushes up their price and reduces supply for other market participants. For example, in Japan, the central bank is now purchasing the equivalent of more than 90% of all government bonds issued each month.
What does all of this mean for the private investor?
These concepts, whilst somewhat esoteric, have a direct impact upon individual investors. As a result of falling interest rates and bond yields, money has never been cheaper. This is bad if you are a bond or bank deposit investor: you will see your income continue to dwindle. In addition, the lower bond yields go, the greater the capital losses which bond investors will suffer when they finally go into reverse (which is a question of when, not if). According to Bill Gross:
Global yields [are at their] lowest in 500 years of recorded history... This is a supernova that will explode one day.
Terminological inaccuracy aside, the message is clear. Unless you subscribe to the "greater fool" theory, you should probably be reducing your exposure to these types of bonds.
However, if you are a borrower, you should be celebrating. If you can borrow money at these depressed rates and safely invest it to obtain a higher return than what you are paying in interest (noting that the hurdle is extremely low), you will be a winner. Governments around the world are winners, because they are borrowing at unprecedented levels and the lower interest rates go, the cheaper their debt will be. Cheap money can also, of course, be taken advantage of by private individuals.
Are stocks attractive?
The key is finding investments that will return more than your cost of capital, and which will be relatively free of the risk of permanent capital destruction. This is, of course, easier said than done.
If you are concerned about daily, weekly or monthly volatility, you should not be investing in the stock market (unless you enjoy gambling). However, with historically cheap money and bond yields at historic lows, stocks as an investment class continue to look attractive. This is, of course, nothing new. Although stocks are volatile from day-to-day, month-to-month (and sometimes, from year-to-year), this short-term volatility is of no concern to the long-term investor. Over the long term, stocks have performed extremely well. Just take a look at this:
At the top-right of the graph, we see two dips represented by the 'tech wreck' at the turn of the century and the GFC in 2008-2009. However, even if you had invested in a broad basket of stocks back at the peak of the tech boom, you should not have experienced any permanent capital destruction if you continued to ride out the bumps - in fact, you would have made a profit.
This demonstrates that long term investors should be ready to take advantage of any short-term market weakness induced by macro events, particularly those which may have little real effect. As Warren Buffett has said, the way to be successful in investing is to "be fearful when others are greedy, and greedy when others are fearful." Doing so can allow you to buy more of a good thing when it is cheap, leading to a permanent boost to long term wealth creation. We do not know where the current trend will go from here in the short-term, but we can be reasonably confident about where it will be in the long-term.
A more recent example of this process is Brexit. Others were fearful then. But what were they actually fearful of? The vote was not binding, senior U.K. politicians immediately indicated that they would take a slow and deliberate approach to exiting the EU, and we did not (and still do not) know what Brexit will actually look like: will the U.K. be invited to join the European Free Trade Association (whose members are members of the European Economic Area, but not members of the EU)? Will Brexit (as it is now understood) even happen?
(One possibility is that the European Union will negotiate (or offer) a more attractive package to entice the U.K. to remain; if that occurs, a further referendum might be required, or the U.K. Parliament might even make a decision to stay on its own).
In addition, investors in markets outside of the U.K. (and Europe) should have been asking themselves, "What difference will this actually make to the businesses I am invested in?"
Whilst macro uncertainty leads to short term volatility, when the dust inevitably settles, everyone tends to realize that today looks a lot like yesterday did. In the case of Brexit, this realization has since been reflected, albeit belatedly, by the market.
Warren Buffett is famous for ignoring macro factors in his investing strategy. This is because, over a long timeframe, macro issues like Brexit, the GFC, political instability in the Middle East, and so on, tend to have minimal impact on the returns of individual businesses (which are in turn reflected in stock prices). Macro issues have been at the forefront ever since the Global Financial Crisis, with events such as the recurring 'debt ceiling' crises in the United States and the ongoing European sovereign debt crisis. Yet in the face of all of that, since its March 2009 low, the U.S. S&P 500 (NYSEARCA:SPY) has returned over 215%.
Which stocks should I buy?
That said, it is clear that on some measures of overall stock market valuation, values currently appear stretched. Although in the long run you will still profit (if history is anything to go by), now may not be the best time to simply buy a market index or broad basket of stocks. Particularly in the current environment, where macro issues dominate, bond yields are at historic lows and the overall stock market has done extremely well over the last 7 years, a disciplined and thoughtful approach to stock selection is more important than ever.
Whether or not the market as a whole is over- or undervalued, it can be possible to find undervalued stocks. Netflix (NASDAQ:NFLX) at a valuation of 290 times earnings offers a very different value proposition to IBM (NYSE:IBM) at a valuation of 13 times earnings or Synchrony Financial (NYSE:SYF) at a valuation of around 10.5 times earnings (although this measure is simplistic). Whilst this isn't the time to set out an analysis of those stocks, both IBM and Synchrony Financial are just two examples of stocks that are attractive at current levels.
Over the long term, the best chance an investor has at making money is to identify companies with attractive business models which generate (or are capable of generating) large amounts of cash, which have high and stable returns on equity, and which are undervalued either because of overall market weakness, or because they are unloved due to individual but temporary factors.
As the father of value investing, Ben Graham, said, "in the short run, the market is a voting machine but in the long run, it is a weighing machine." Eventually, regardless of what the market does as a whole, prices of individual stocks will catch up with their true valuations, whether they are presently overpriced or underpriced. Money can be made from this process, but it requires detailed analysis, confidence and extreme patience.
Disclosure: I am/we are long IBM, SYF.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Nothing in this post is intended to constitute financial, legal or other advice or a solicitation or offer to enter into any investment. Before making any investment you should obtain your own advice and rely upon it and your own enquiries.