The Case for U.S. Treasury Securities in a Post QE World
For many investors, the thought of holding U.S. Treasury bonds is unthinkable. Why, they argue, would you want to hold U.S. Treasury bonds in a rising rate environment when dividend paying stocks give you a nice dividend and the potential for growth? My simple answer to this question is that there is no guarantee that you will get the dividend on your equity. There is also no maturity date upon which you can dependably obtain your principal and interest payments. I would also point investors to the financial crisis where dividend stocks, which had nothing to do with the real estate market, were hit just like every other stock, falling some 47%. What is the point of obtaining a dividend when the possibility of losing 47% of your capital is on the table? For this reason, investors should not confuse the purposes of different asset classes. Stocks are to obtain growth, and bonds are to obtain income and stability.
In this piece, I want to make the argument for U.S. Treasury bonds, particularly zero coupon bonds at the long end of the curve. In a world of constant geopolitical and market risks, U.S. Treasury bonds play an important role for long-term investors. The current economic environment provides many catalysts that may send yields on U.S. Treasury securities to new lows.
There is no shortage of investors and media pundits who express their hatred of U.S. Treasury debt. This vilified asset has been thrown aside as equity markets have risen substantially since the election of the 45th president of the United States, sending Treasury rates across the curve moving higher. So the questions remain, are the bond bears correct in their belief that the low in U.S. Treasury securities is behind us, or are the bond bulls right that this is simply a backup in rates that will once again resume their grind lower? I would assert it is the latter.
The Federal Reserve has recently expressed an intention to reduce its balance sheet as well as deciding to increase interest rates by 0.25%. I would expect the Fed to be on hold going forward despite the insistence of many that it will be continuously raising rates. The economy is simply not strong enough to support any further raise in rates, and I would argue it has done too much already.
The economic data continues to be weak, showing an economy that is slowing. In this piece, I will investigate many of the reasons why investors should consider long-term zero-coupon U.S. Treasury bonds and why the secular low in long-term bond yields is ahead of us, not behind us. I want to make it clear however that I am not suggesting investors should not own equities. To the contrary, I continue to be overweight to the equity market particularly in specific stocks in overseas markets. But U.S. Treasury bonds play an important role, and there is no reason why investors should not own some of them.
Market Valuation Remains Extended
Stock markets continue daily rallies, hitting new all-time highs; yet, this has not reduced investor optimism for equities to continue to grind higher. As investors continue to buy equities, the market becomes more and more overvalued. A recent analysis of advisor perspectives identifies this period as the second most overvalued period, only behind the 2000 tech bubble. Investor psychology continues to make the same mistakes in the present that they made in the past, allocating hard earned capital to overvalued markets, especially through the rise of indexation.
I have written a great deal about the fact that investors are making a huge mistake trusting in index funds particularly at this stage in the cycle. The fear of missing out on gains is a real psychological challenge for investors, and we are seeing it yet again. Investors are failing to recognize the risks in this market are asymmetrical to the downside, leaving investors' nest eggs vulnerable to unforeseen economic shocks or geopolitical events for minimal return. I simply believe investors are largely not being compensated for the risk they are taking in this market, and would be wise to reconsider risk exposures. Practicing value investing as opposed to indiscriminate index buying allows investors to purchase undervalued assets rather than putting new money into overvalued indexes. One of the assets I particularly believe to be undervalued is the long-term zero-coupon U.S. Treasury, which I think can rally substantially from here.
Economic Data Remains Weak
While investors continue to flee bonds, worried about rising rates, such fear is misplaced based on the economic data. One data point has me particularly concerned. The PCE, a measure of inflation, continues to weaken. This is bullish for zero-coupon long-term U.S. Treasury bonds, which benefit during periods of deflationary pressure. While many economists expect higher inflation, the realities of the economic data continue to act as a drag on the U.S. economy. An extended GDP gap and a 60-year low on velocity have made inflationary pressure hard to come by despite the drastic efforts of central bankers. I continue to believe inflationary pressure will trend lower and the 2% target will remain elusive.
Debt Continues to Restrain Growth
One particular element of the economic weakness that we hear little about is the debt situation in the United States and the deleterious nature of debt on overall GDP growth. We hear a great deal out of the current administration about wanting to achieve 4% GDP growth. I believe its efforts will be futile given the structural dynamics of the U.S. economy and the vast debt overhang that continues to plague any president's efforts to stimulate real organic economic growth. Academic literature has been very clear that there is an observable, measurable link between debt and GDP growth.
The U.S. total aggregate debt burdens are astronomical and growing daily. As the debt bubble grows, so does the eventual reality that you can't push on a string. Many borrowers' ability to finance future consumption with ever more debt will be constrained, having serious consequences for the U.S. economy. The debt burdens in the American household continue to skyrocket with the Fed's pursuit of excessively low interest rates even after yesterday's increase.
Student loans continue to balloon, recently hitting over $1.2 trillion. This will surely have an effect on young people's ability to consume, placing even more debt on to their backs in order to finance consumption. A recent Reuters article indicated that by 2024 we could see student loan bailouts that would put the government on the hook for $491.8 billion, larger than TARP or the AIG bailout.
The greatest challenge with such staggering aggregate debt (both public and private debt) burdens in the U.S. in excess of 370% of GDP is that future growth will be significantly diminished. A Wall Street Journal article from 2013 highlighted a study done by investment firm ING concerning world debt. In that article, the author discusses the findings of the study and the unsustainable levels of global debt to GDP in the developed world.
"In a comprehensive report on global indebtedness, economists at ING found that debt in developed economies amounted to $157 trillion, or 376% of GDP. Emerging-market debt totaled $66.3 trillion at the end of last year, or 224% of GDP. The $223.3 trillion in total global debt includes public-sector debt of $55.7 trillion, financial-sector debt of $75.3 trillion and household or corporate debt of $92.3 trillion… Per-capita indebtedness is still just $11,621 in emerging economies (and rises to $12,808 if you exclude the two largest populations, China and India). For developed economies, it's $170,401. The U.S. alone has total per-capita indebtedness of $176,833, including all public and private debt."
Further academic research spells out in clear terms the direct negative effect of over-indebtedness on GDP growth levels:
In 2010, Carmen M. Reinhart and Kenneth S. Rogoff concluded in Growth in a Time of Debt that "across both advanced countries and emerging markets, high debt/GDP levels (90 percent and above) are associated with notably lower growth outcomes." (p.577)
Reinhart and Rogoff, along with Vincent R. Reinhart, authored Debt Overhangs: Past and Present - Post 1800 Episodes Characterized by Public Debt to GDP Levels Exceeding 90% for At Least Five Years, in which they state:
"Consistent with Reinhart and Rogoff (2010) and other more recent research, we find that public debt overhang episodes are associated with growth over one percent lower than during other periods. Perhaps the most striking new finding here is the duration of the average debt overhang episode. Among the 26 episodes we identify, 20 lasted more than a decade. Five of the six shorter episodes were immediately after World Wars I and II. Across all 26 cases, the average duration in years is about 23 years. The long duration belies the view that the correlation is caused mainly by debt buildups during business cycle recessions. The long duration also implies that cumulative shortfall in output from debt overhang is potentially massive." (p.1)
In The Real Effects of Debt, authors Stephen G. Cecchetti, M.S. Mohanty, and Fabrizio Zampolli conclude:
"Our examination of debt and economic activity in industrial countries leads us to conclude that there is a clear linkage: high debt is bad for growth. When public debt is in a range of 85% of GDP, further increases in debt may begin to have a significant impact on growth: specifically, a further 10 percentage point increase reduces trend growth by more than one tenth of 1 percentage point." (p.21)
Cristina Checherita and Philipp Rother's piece, The Impact of High and Growing Government Debt on Economic Growth, An Empirical Investigation for The Euro Area, states:
"On average for the 12-euro area countries, government debt-to-GDP ratios above such threshold would have a negative effect on economic growth. Confidence intervals for the debt turning point suggest that the negative growth effect of high debt may start already from levels of around 70-80% of GDP, which calls for even more prudent indebtedness policies. We also find evidence that the annual change of the public debt ratio and the budget deficit to-GDP ratio are negatively and linearly associated with per-capita GDP growth." (p.6)
They further conclude:
"A higher public debt-to-GDP ratio is associated, on average, with lower long-term growth rates at debt levels above the range of 90-100% of GDP. The long-term perspective is reinforced by the evidence of a similar impact of the public debt on the potential/trend GDP growth rate." (p.22)
Andreas Bergh and Magnus Henrekson's paper Government Size and Growth: A Survey and Interpretation of the Evidence found that as government size increases, GDP growth declines.
The U.S. is not the only country that has eclipsed both 100% of GDP in public debt, and well over the average of 263% in aggregate debt, comprised of public and private debt. Debt levels continue to rise over the entire global economy, especially in the developed world, which is further supportive of a lower for longer outlook on interest rates. Governments simply cannot afford to raise rates any further.
The Bank of International Settlements released its 85th Annual Report, in which its states:
"Another drag on long-term growth in most advanced economies is the level of public debt. Already generally high pre-crisis, this has ballooned since 2007. The average ratio of gross public debt to GDP is expected to reach 120% in the advanced economies at the end of 2015, well above the pre-crisis average of 75%. Some countries have much higher debt ratios, for instance Japan (234%), Greece (180%) and Italy (149%). While most countries have taken steps to strengthen fiscal positions, with fiscal balances forecast to improve by around 1.6% of GDP in 2015 compared with 2012-14, this has not yet set them on a sustainable long-term path. With much higher public debt compounded by demographic pressures, governments now have little fiscal room for maneuver." (p.51)
Debt will continue to restrain growth, which is a positive catalyst for long-term zero-coupon U.S. Treasury securities.
Gross Domestic Product - GDP
GDP for the first quarter came in very weak, and as I have written about before, there are challenges in calculating Q1 GDP, so I tend to take the numbers with a grain of salt. I tend to take more from the average of Q1 and Q2. According to the Atlanta Federal Reserve's GDP NOW forecast, GDP for Q2 has been steadily falling and currently sits just at 3.2%. If this number materializes, this would give us an average for the first two quarters of 1.95%, which would indicate that we are running below the 2-2.5% average we have seen in this recovery period. Weakening GDP is the result of weakening velocity and a Federal Reserve which continues to raise rates into weakness.
Velocity on M2 reserves continues to fall even as the rhetoric out of the current administration and Wall Street continues to be bullish for risk assets and economic activity. But as they say on Wall Street, the bond market is always smarter than the stock market, and the bond market continues to tell us that this economy is not healthy.
Velocity falling is not strictly a U.S. phenomenon. Velocity across the eurozone, China, and Japan continues to fall. The money supply, multiplied by the rate of velocity, gives us a reading on GDP, which continues to weaken, pointing to structural challenges in the global economy.
The Federal Reserve has a dual mandate from Congress; achieve full employment within a context of price stability. While the employment rate remains low, there is more work to be done on the U-6, a more complete measure of unemployment, which includes marginally attached workers. Chair Yellen has made it clear from the start that her priority was getting unemployment down rather than worrying about inflation. While the inflationary data has popped above the 2% level, it has not been able to hold the 2% target rate. Recent readings of inflationary pressure demonstrate a declining rate of inflation. This is not surprising to those of us who are watching economic indicators such as the GDP gap, velocity, and other indicators pointing to an economy that is structurally unhealthy. Long-term Treasury bonds are telling us that the long-run inflation rate will be below the central banks' expectations, which I believe is bullish for long-term U.S. Treasury securities.
Foreign Buying of Treasuries Is Bullish
Massive liquidity-chasing positive yields remain a continuing catalyst to yield compression. Foreign buyers dealing with negative yielding sovereign debt are looking to U.S. Treasury securities to get a positive yield. Value-seeking foreign buyers look to the STRIP market to obtain a positive-yielding asset with positive value characteristics despite the increase in convexity and subsequent increased volatility. Foreign buyers will continue to buy U.S. Treasury bonds, offering a floor to any notion of weakening demand.
While I continue to believe that equity markets can grind higher, I believe investors are best served through a value investment philosophy that seeks to own undervalued assets rather than indiscriminately adding to overvalued market indexes.
I do not see an immediate financial crisis on the horizon, but there is no doubt that risks are rising as we continue in the ninth year of this economic expansion. Given the increased risk in the economy and in the overall market, I continue to believe that increasing exposure to fixed income securities and increasing duration will benefit a portfolio going forward, especially when combined with a carefully selected portfolio of businesses that can outperform in this market.
I continue to believe the thesis for long-term zero-coupon U.S. Treasury securities remains intact and the secular low in U.S. Treasury yields lies ahead of us. I expect the 10-year to hit 1% and the 30-year to hit 2% before the end of this market cycle.
Disclosure: I am/we are long LONG TERM ZERO COUPON US TREASURY SECURITIES, EDV, TMF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article is for informational purposes only and is not an offer to buy or sell any security. It is not intended to be financial advice, and it is not financial advice. Before acting on any information contained herein, be sure to consult your own financial advisor.