During this week's testimony to Congress, Bernanke was asked the question regarding the impact on savers due to the Federal Reserve's ultra-low interest rate policy. Bernanke's response was that the Federal Reserve understands the impact on savers and retirees but the Fed is concerned about the overall economy. The Chairman's answer to this direct question indicates that low interest rates are here to stay until the U.S. economy experiences a real and sustainable recovery.
The financial crisis has done lasting damage to U.S. households. According to the Federal Reserve's Survey of Consumer Finance, the financial crisis wiped out 18 years of gains for the median U.S. household net worth, with a 38.8 percent decline from 2007 to 2010 that was led by the collapse in home prices. The report stated that the median net worth declined to $77,300 in 2010, the lowest since 1992, from $126,400 in 2007.
Households will be faced with another significant headwind as they focus on rebuilding their lost wealth. Low interest rates used by the Federal Reserve to bolster beaten down bank balance sheets act as a tax on investors and retirees. Whereas five years ago investors could count on 5% yields on short duration certificates of deposit or short duration bills, now those same investors are being forced into more risky investments including 30 year bonds of less credit worthy nations, corporate debt or equities.
After experiencing two 50% declines in equity prices over the last 12 years, investors are rightfully skittish. While investors are skittish of "risk" assets, the Federal Reserve has pledged low rates until late-2014. Policymakers are concerned about the slack in the labor market. I believe that policymakers are fighting a structural labor problem with cyclical remedies. Historically when the labor market was weak, lowering interest rates would bolster aggregate demand and ultimately bolster employment levels. I believe a large portion of the slack in the labor market is simply due to outdated education which can only be remedied through re-education. With this view, I believe that ultra-low rates are here to stay beyond 2014, simply due to the fact that policymakers will not see the declines in the unemployment rate they require.
I believe that investors will need to deploy a highly diversified strategy of asset accumulation to rebuild their wealth in an ultra-low interest rate environment. Due to the highly uncertain set of outcomes, diversification will provide a risk mitigation strategy. Investors no longer have the long-term strategy of simply "going to the sidelines" and earning 5% in certificate of deposit. Investors are required to take on risk to earn 5%.
The frustration that investors face is that we are living in a bi-polar market with significant imbalances. Markets vacillate from concerns about a deflationary collapse to an inflationary boom. One's investment strategy will take meaningfully different strategies based on the view. There are risks to virtually every strategy today.
Long-term Bonds - a rise in rates would impact the sale price prior to maturity or inflation could severely reduce the purchasing power of your principle.
Short-term Bonds - investments provide very little yield. Investment grade corporate bonds and government securities with less than 2 years of duration provide very little yield.
Equities - a deflationary period would impact earnings making the market significantly overvalued.
Commodities - prices tend to be very volatile for individual investors. Similar to equities, a deflationary period would likely impact aggregate demand.
A Diversified Approach: Fitting in Pieces of the Puzzle
Investing in a bi-polar world where the outcomes are highly diverse requires a focus on safe yield. Instead of going "all-in" on one type of security I am looking to construct a portfolio that will provide income in a period of declining prices, yet help me retain purchasing power in a period of rising prices.
- Current Yield - Mortgage Real Estate Investment Trusts and Master Limited Partnership.
- Current Income + Inflation Hedge - Large Capitalization Equities.
- Commodities - Gold and Silver.
- Options Hedging Strategy - Utilize a covered call hedging strategy to provide additional current income.
Current Yield Focus
Annaly Capital Management (NLY)
- Price to Book Value: 1.1x
- Dividend Yield: 12.9%
- Market Capitalization: $16.6 billion
- Beta: 0.28
Rationale: Agency focused REIT that will perform well with a low and stable yield curve.
MFA Financial (MFA)
- Price to Book Value: 1.0x
- Dividend Yield: 11.7%
- Market Capitalization: $2.8 billion
- Beta: 0.33
Rationale: Hybrid (Agency and Non agency) REIT. Agency book will perform well with a low and stable yield curve. The non-agency will perform well as the housing market recovers.
Boardwalk Pipeline Partners, LP (BWP)
- Enterprise Value to EBITDA: 14.6x
- Dividend Yield: 7.4%
- Market Capitalization: $6.0 billion
- Beta: 0.23x
Rationale: MLPs are insulated from commodity price fluctuations. The Tisch family is a large investors which provides a strong balance sheet to help the Company with liquidity.
Large Capitalization Equities - Focused on companies that can pass along cost increases and have strong brands and market share in their respective markets. The companies below are leaders in their markets, provide strong yield and have shown an ability to grow earnings.
Medtronic, Inc. (MDT) - Healthcare
- Price to Earnings: 11.9x
- Market Capitalization: $39.2 billion
- Dividend Yield: 2.7%
- Beta: 0.84x
Pepsico, Inc. (PEP) - Consumer / Beverage
- Price to Earnings: 17.3x
- Market Capitalization: $109.4 billion
- Dividend Yield: 3.1%
- Beta: 0.47x
Waste Management, Inc. (WM) - Waste Management Services
- Price to Earnings: 16.3x
- Market Capitalization: $15.2 billion
- Dividend Yield: 4.3%
- Beta: 0.55x