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Safety Is Rich

The capital markets continue down their uncertain saw-tooth path; alternating between fear induced flight-to-quality and greed seeded pops in global equity indices. Certainly, current market conditions are affected by 1) it's the summer, volumes are traditionally light, 2) dim US growth prospects and declining Euro-zone GDP, 3) poor performance by the year's largest IPOs, and most important, 4) uncertainty surrounding the viability of the euro.

Take a moment to look at the table below:

Govt

2yr yield

10yr yield

YC negative out to

Denmark

-0.3%

1.1%

Early 2016

Germany

-0.1%

1.4%

Mid 2015

Finland

0.0%

1.5%

Mid 2014

Switzerland

-0.5%

0.5%

Mid 2017

USA

0.2%

1.5%

N/A

Japan

0.1%

0.8%

N/A

We've seen negative short sovereign debt yields before but clearly they are becoming a little more the norm. Market participants are willing to pay the Swiss or Danish governments to hold their investment capital; Give the Swiss $100, you'll get back $99 in two years. Our first thought is: buy a safe and keep it in your basement. However, given some of the capital flows in question, that could require a pretty big safe.

There's a small amount of logic for buying expensive Swiss or Danish debt; they each have their own currency and it's not called the euro. That explanation does not explain why German yields are negative out to 2015 and Finnish yields are inching their way to that area. Both of those countries use the euro though, yes, their financial condition is better than their Mediterranean colleagues. Yields are negative because the immense hunt for safety by European capital dwarfs the capacity of these respective bond markets to absorb the flow. It is only a matter of time before the capital starts moving more aggressively to the two largest bond markets in the world - the US and Japan. Unless, of course, the sovereign states that make up the euro are willing to give up substantial fiscal control over their own economies. We have a tough time believing the Bundestag will abdicate some of its elected authority to some central bureaucratic authority in Brussels.

What does this mean for you, a US resident/investor? Well, as we've stated before, things are bad here, but they're worse everywhere else. Rates will continue to stay low for several years. The US dollar is the only currency able to absorb massive capital inflows. Our bond market is the largest in the world. The demographics in Japan are appalling and their debt-to-GDP ratios are almost 2x that of the US. As absurd as it sounds as we type, a case can be made for US rates going lower. One day, rates will go up, but not for awhile. Do a little bond math and it's clear that the upside is limited from current levels and the downside, when it occurs, will be on the order of 20%. All this while the S&P500 has a 2.4% dividend yield and the MSCI World an even better, 3.6% dividend yield.

Safety is absurdly rich, risk is cheap.

Bert

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