Once again, news of the death of the secular bull market in bonds has been greatly exaggerated, especially as the yield on the 10-Year Note dipped below 2.4% on Wednesday. So continues the intellectual gymnastics around the future of fixed-income markets, with key items of contention being, is the multi-decade secular rally over?; how does the Fed go about unwinding a $4 trillion balance sheet?; what happens if monetary policy is behind the curve should incipient inflation rear its ugly head?; and perhaps most vexingly, should an advanced economy really be so dependent upon central bank largesse? The last issue is all the more alarming given that six years of zero-percent-interest-rate policy (ZIRP) and unprecedented financial market intervention has only managed to deliver growth in the neighborhood of 2%.
Given the challenges of a low interest-rate landscape, many a portfolio manager are grappling with novel tactics that enable them to meet client obligations. In doing so, yet another phrase has entered into the already convoluted lexicon of investing: unconstrained fixed-income funds; unconstrained being a euphemism for "where on Earth do I find satisfactorily yielding investments?" In an April note, when the 10-Year Note yielded 2.8%, we turned bullish on bonds, given a lack of viable alternatives… e.g. overheated equities…, an underwhelming recovery in employment, and the expectation that even after the cessation of QE3, the Fed would likely maintain ZIRP deep into 2015. So far we have been proven right, and continue with this call for the short term. On the more distant horizon… ignoring for now Keynes' maxim about the long-run… there is much to worry about. Given the nebulous outlook for both the global economy and fixed-income markets, it is never too early to hatch a plan to mitigate risks. After all, markets are inherently forward-looking, and once the rough patches become obvious, it's often too late to act. One strategy worth consideration is for retail investors to follow the lead of institutional players and include yield-producing residential property as a component of his/her portfolio. Despite its central role in the financial crisis and the fact that several regions have seen a recent run-up in prices, wisely-chosen real estate is well-suited to position one's portfolio for a range of scenarios likely to play out as the Fed closes the door on this era of extraordinary monetary policy.
The here-and-now: fine for bonds, lousy for your kids… and their kids… and so on.
This year's rally in bonds occurred even as the market was fully aware that the Fed would end its latest round of asset purchases this month and that eventually rates would start to tick up. The latter expectation has already been manifested in financial markets, as the yield on the 2-Year Note had nearly doubled… rising 25 bps… to 0.58% over the past year before Wednesday's flight to safety. This gradual rise in yields in the belly of the curve infers that within the next few years the Fed Funds rate will be allowed to slowly rise, taking with it yields on these shorter-term notes.
Meanwhile, the yield on the 10-Year Note has fallen by as much as 34 bps over the past six months in what is known as a bull-flattener. Much of the action is due to recent elevated geopolitical risks, but it still can be construed as odd that just when the Fed is stepping back from its role as the marginal buyer in the bond market, yields have fallen. In addition to the world seemingly going up in flames, another explanation is that investors see little sign of inflation on the horizon. In fact, despite its best efforts to stoke upward pricing pressure, the Fed's favored inflation gauge has dipped to 1.5% YOY for both the headline and core reading. This is below the bank's target range of 1.7%-2% and well below the wink-and-nod acceptable level of 2.5% that would be tolerated should it be accompanied by robust economic growth.
Further evidence of the market discounting the risk of inflation is seen in the future inflation expectations implied in the TIPS market. As seen below, not only have expectations of average inflation over both five-year and ten-year time horizons dipped below 2%, but also the implied average between 2019 and 2024 has fallen from 2.8% at the beginning of the year to 2.3% at present.
One could put forth the naïve… I mean bullish… argument that this summer's low rates, accompanied by record highs in equities, is a sign that the economy is in a proverbial sweet spot, meaning impressive growth has returned, but inflation… namely the demand-pull variety… has yet to appear. Keep dreaming. Although not as distorted as the bond market, Fed shenanigans have almost certainly been a contributing factor to currently frothy equity valuations.
Back to jobs
More likely, persistently low yields are an indictment of U.S. growth prospects. It is important to remember that in a service-based economy, a major contributor to inflation is upward wage pressure. That only occurs once all of the workers idled by the great recession happily find their way back to the nation's manufacturing lines and cubicles. That has not happened. Ignoring the headline unemployment rate, which is so deep-fried with exceptions as to render it essentially meaningless, other data in the broad population survey continue disappoint. As illustrated below, key employment metrics, from the labor force participation rate, employment to population ratio, and the U-6 broad unemployment rate, including those marginally attached to the workforce, are all worse than their 20-year averages, with the LFP at a multi-decade low of 62.8%.
Daggers have been thrown when arguing how much of these weak data are due to secular trends or cyclical vagaries of the business cycle. Rather than delving into that debate, if we simply split the difference somewhere near the middle, we most certainly wind up with an unemployment rate much higher than the illusionary 6.1% headline rate. This matters as substantive gains in employment tend to precede wage gains. With a glut of idled workers, employers have little incentive to outbid each other for additional labor. What's more, the quality of the jobs being created is famously lower than those that vaporized during the recession. This is especially true for historically male-centric trades such as constructing and manufacturing. True, salary gains are rockin' along in the Silicon Valley, but we all cannot be the next millionaire software developer. Flat wages and grim prospects for new opportunities do not instill sufficient consumer confidence to cause one to go out and buy a new house or other big-ticket items on credit, which over the past several decades had been the country's get out of recession free card. More on that later.
Eventually this will hurt
All things equal, weak jobs data are bullish for bonds. But there are many other factors at play, and these are the hurdles that could eventually sink the fixed-income rally. While the Fed has ended its monthly asset purchases, it will continue to maintain its massive balance sheet size deep into the foreseeable future for fear that large-scale selling could send interest rates higher and further hobble an already lame economy. ZIRP will likely keep a lid on short-term yields well into 2015. But eventually these two initiatives will end, and when they do, one doesn't want to be the last fund manager out the door. With bonds at current valuations, it does not take much of a loss in principle to eliminate the meager coupons attached to the instruments issued in recent years. And any corporate treasurer worth his/her salt has most assuredly locked in these low rates for years to come.
On top of this, there is realistic possibility that a dovish FOMC will be behind the curve in fighting incipient inflation. Yes, we just laid out the argument that without robust jobs growth, crazy high inflation seems unlikely, but there are four-trillion reasons as to why this call may be wrong and the mother of all macroeconomic beasts… stagflation… makes an appearance. Not to be an alarmist, but plenty of potential unintended consequences lurk in the shadows once the Fed backs its way out of uncharted territory.
Given that such frightening scenarios are not yet within sight, the market has continued its favorable view of bonds, although not without a bit of divergence. As seen below, the spread between investment grade corporate bonds and 10-Year Notes is still several basis points narrower than what was registered earlier this year. Not so with speculative-grade bonds. Using two popular measures, spreads on these bonds are presently at their widest of 2014.
Despite this slight widening, spreads for each of these series are anywhere from 52 bps (for investment grade) to 107 bps (for junk) below their five-year average. It is such a basic concept, but investors often overlook the power of mean reversion, and in this case it infers that eventually conditions will be ripe for a material sell-off in bonds. What will be the catalyst? Does one really want to stick around to find out? The same holds true for Treasuries, where the 10-Year to 2-Year spread sits at 192 bps, below this year's average of 219 bps and YTD maximum of 261.
Before rushing to the exits, which is not necessarily prudent given growth and geopolitical factors, investors must ask what are the alternatives to bonds and even more basically, what attracts one to the fixed-income space to begin with? The textbook answer to the latter question is the certainty of cash payments and relatively lower volatility than riskier investments such as stocks. Attractive coupons appear a thing of the past given how the Fed has sucked the oxygen out of the room, and volatility could always spike given the increasingly long shadow extraordinary monetary policy casts over the market.
It is on these questions that the concept of unconstrained fixed-income investing has been hatched. Some attractive alternatives are still well within the bond space, such as locally denominated sovereign debt, often from juicily-yielding emerging markets, and certain shorter-duration speculative bonds that may have recently sold off but still have favorable default probabilities. Outside of bonds, investors may consider dividend-paying stocks that have historically exhibited lower volatility than the broader market. Consumer staples and utilities come to mind. Dividends also have the added benefit of adjusting to account for the presence of inflation, an advantage missing in the fixed payments of bonds. Another alternative to bonds, which can exhibit many similar attributes, is real estate. While many savvy… and not so savvy… portfolio managers and retail cash investors have been plowing money into the space since the nadir of the crisis, there are still plenty of reasons for investors to consider increasing exposure to this oft-overlooked asset class.
Real estate? You cannot be serious.
After the excesses of the last decade, the idea of real estate as an investment should be treated with more than an ounce of caution. But rather than nakedly banking on unsustainable capital appreciation, this time around other characteristics of the asset class are what draw the interest of investors. Chief among them is, as the name states: it is a real asset, which can act as a suitable inflation hedge. Real estate accomplishes this not only by being a store of value, but also by throwing off cash flows which can be adjusted (through increased rents) to account for the deleterious effects of inflation. And if things really go to pot, one can build a heavily-fortified bunker on the property or cultivate root vegetables should it come to that.
The focus of this series of investment notes is concentrated on financial markets. But in taking the lead from the aforementioned unconstrained fund managers, including hedge funds and private equity shops, the broader universe of investors perhaps should also consider diversifying one's wealth outside of established securities markets. Why not gain access to the asset class via real estate investment trusts (REITs)? As seen below, despite such benefits of returning substantial cash to investors, REITS are highly correlated with broader equities, so one is not capturing the benefits of diversification that is gained when holding physical assets.
Location, location, location
Of course, a successful investment depends upon where and how to gain exposure. Commercial segments of the market are often the domain of accredited investors. And many residential markets have already rebounded substantially… perhaps even too much so… since the collapse of 2008. Regions with sound fundamentals and that have yet to see a spike in valuations are more likely to have an inventory of attractive properties. By sound fundamentals, I mainly mean a healthy jobs market. In fact, the employment climate impacts nearly every segment of real estate. Without stable, well-paying jobs, banks are not likely to extend mortgages and prospective buyers are hesitant to take on a greater debt load. This keeps a lid on the residential market. Retail properties… with the possible exception of liquor stores… depend upon robust consumer confidence that accompanies steady work and improving wages. And both commercial facilities (e.g. factories) and offices see demand for their properties rise when tenants have the confidence to expand their workforce.
While the tepid jobs recovery does no favors for improving the prospects of home ownership, it's a boon for landlords. Furthermore, continued hesitation on behalf of banks to lend to anyone other than the most qualified borrowers, also pushes more individuals into the realm of renting. The drying up of the RMBS channel means that banks no longer can be practitioners of the bigger fool lending tactic by passing lousy loans unto unsuspecting investors. And even if they did so, they risk being fined back to the stone-age by shakedown-artist regulators. 2005 this is not.
"Hand me the pliers, please"
Pulling money out of financial markets and purchasing plumb local real estate is not without risks. First and foremost, it's not liquid. Identifying a fairly valued property is a daunting proposition for the newbie landlord. One must also factor in closing costs, taxes, the risk of deadbeat stoner tenants, and Victorian-era boilers bursting in the middle of the night. But then again, is that any riskier than a distorted bond market, overheated stocks or zero-yielding (literally) cash? And what of that other renowned inflation hedge, gold? Well, at present it yields a cash flow of… let me check… exactly zero... the same it has for the past 10,000 years of recorded civilization.
There are plenty of late-night infomercials and cheesy seminars dedicated to investing in real estate, which alone should raise some red flags. But when an investor has justified trepidation concerning other asset classes, is willing to expand the universe of investable assets, is one of the chosen few with access to credit markets, and is handy with a wrench, then owning… and even managing… a few properties may be a viable strategy. The asset class is also uniquely positioned to mitigate the two major areas of risk that may come to fruition as the Fed attempts to exit this era of expansive monetary policy: an inflation hedge should price gains accelerate, and a store of value should an already sputtering economy slide into an even deeper mire.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.