Portfolio Risk Management and the Efficacy of U.S. Treasury Securities in a World of Global Economic Instability
The effects of the bond bubble are upon us; is your portfolio ready?
Well, as it turns out, there is no bond bubble in the bond market, and any suggestion to the contrary is just noise. In reality, as long-term zero coupon U.S. Treasury bonds have been vilified for the past eight years, they have rallied a cumulative 116.57%, besting the S&P 500’s cumulative return of 92.94% during the same period.
Many would be quick to point out that a repeat performance is improbable, yet each time we hear about an end to the bull market in Treasuries we make a new low in Treasury yields, a trend I believe will continue. It is certainly possible we could see the 10-year Treasury go down to 1% or even to 0.5%, and the 30-year to 2% or lower before the end of the market cycle. This would certainly provide investors with a healthy return potential going forward given the value of current rates.
In this piece I want to look at a number of factors that indicate a positive backdrop is in place for investors to increase their allocation to cash and U.S. Treasuries in the months and years ahead. While this may not be the consensus view, I aim to present a contrarian view on U.S. Treasury bonds, and discuss why they are a good investment in a rapidly deteriorating global economy.
Global Valuations Indicate Low Returns for Long-Term Index Investors
There has been a great deal of discussion concerning the long-term prospects for global equities. While valuations in many of the foreign markets in Europe, parts of Asia, and even Emerging Markets are far more reasonable, markets in the U.S. are richly valued. This is largely due to the massive, almost euphoric run-up in equity securities after the election of Donald Trump and a Republican Congress. The market began to swiftly price in what a pro-business White House would mean for earnings, and thus asset prices.
Recently, a team led by Goldman Sachs's Chief Equity Strategist, David Kostin, analyzed the market, concluding overvaluation exists no matter the methodology used to measure it.
"The forward P/E multiple of the S&P 500 has risen by 80% since 2011 ...and now trades at the 89th percentile compared with the past 40 years while the typical stock is at the 99th percentile of historical valuation."
The Federal Reserve meeting minutes echoed this sentiment:
"Broad U.S. equity price indexes increased over the intermeeting period, and some measures of valuations, such as price-to-earnings ratios, rose further above historical norms. … [S]ome participants viewed equity prices as quite high relative to standard valuation measures."
However, as many of the expectations of the current administration have been delayed by an uncooperative Congress, some of the air has started to come out of the equity balloon. YTD, small cap stocks, which would benefit most from changes in domestic fiscal policy, have given back most of their gains for the year, up a mere 3.63%. Investors in the stretch for yield have bid up dividend growth and high dividend yield stocks to rich valuations above 20x earnings, bringing into question whether we will continue to see multiple expansion.
The market is high on expectations of tax reform and other fiscal policy changes that would benefit both consumers and businesses. However, the market is experiencing its second highest valuation measure in history, behind the tech bubble, according to the P/E 10, which seeks to measure price and earnings over a 10-year period. The P/E 10 has been particularly useful in projecting future returns of an index. At current valuations, low, single-digit returns from stock indexes over the next decade are not out of the question, and are in fact quite probable.
With many pension funds, and indeed individual investors planning on returns of 7% to 12% for the most aggressive investors, there would appear to be a great short fall in expected returns and probable returns based on current market valuations.
This makes the case for a different approach to investing that seeks to find attractive individual situations, whether in the private or public markets, that can provide investors with above-average rates of return to meet their expectations. In addition to one's equity positions, U.S. Treasury bonds particularly at the long end of the curve appear very attractive at these levels to preserve wealth, and provide positive risk-adjusted returns over the end of this market cycle. I will now explore many of the reasons why I am now so bullish on U.S. Treasury bonds and cash that they have become the dominant position in my portfolio.
Global Economic Data Points to Lower U.S. Treasury Yields Ahead
The central problem with much of the discussion that takes place in financial media and amongst financial pundits is that it is largely a distinctive American conversation. This type of myopic analysis leads to conclusions limited by home country bias. Listening to people from around the world and reading local publications about what is going on in the real economies of Europe, Japan, China, as well as other nations helps one to understand what will happen with U.S. Treasury yields. It also leaves you with the conclusion that the world has a serious problem with debt and drumming up enough demand to fuel growth in their sagging economies. In Japan, Europe and the United States, we have seen an unprecedented program of monetary accommodation by the central banking authorities that has failed to stimulate velocity, and thus inflation. Focusing in on the U.S. and looking at the velocity on M2 reserves is a great first indicator to explore the failure of monetary policy.
Currently, velocity on M2 is at a 60-year low and continues to fall, presenting solid evidence that while ample liquidity remains in the banking system, money is simply not moving through the economy.
Inflation continues to be a serious concern as well and is a mystery to central banking officials, who have been stating for some time that this lack of inflationary pressure is simply transitory. It is time we stop describing the inflation problem as transitory and start seeing it for what it is, a very serious problem for the Fed and for the economy as a whole. I believe the winds of deflationary pressure have not blown for the last time. We continue to have very serious risks of falling into a deflationary environment in the U.S. and the western world. During deflationary periods, having ample cash is a necessity, and U.S. Treasury securities, particularly at the long end of the curve, are an advantageous asset to own.
We are currently dealing with monetary policy we have never seen before in Japan, Europe, and the U.S. governments around the world are in flux, with Brexit, contentious elections in the U.S. and France, with more elections to come, yet financial pundits continue to push the notion that everyone should be a long-term player in the equity market, buying index funds at the second highest valuation in history. It is my belief that in addition to a globally diversified equity allocation, every investor should own a healthy amount of cash and U.S. Treasury Bonds for the rough seas that may lie ahead. Increases in volatility will eventually mean greater opportunities in risk assets. Buying the index at current valuations levels almost assuredly locks in sub-par long-term returns.
World GDP, Debt, and Expectations for Future Returns Favor U.S. Treasuries
The United States
One of the true treasures of economic history made it on to my summer reading list this year. The Great Depression: A Diary is a collection of journal entries during the Great Depression. It explored many of the same conversations we have seen take place over the last decade and demonstrates in clearly written prose that history does in fact repeat itself and this time is not different.
Our environment today in some ways is far worse than what we saw in the 1920s. This is largely because of the extensive central bank intrusion into the market during the most recent crisis. While all seems well, all they have done is postpone the inevitable date with destiny that awaits us, you cannot QE your way out of problems, and in fact they have likely made things much worse. The fiscal cliff that awaits us will be all the more painful as deleveraging must occur at some point. The debt situation in the U.S. of 370% of GDP presents a permanent barrier to growth. Debt in the U.S has risen 76% from 294% of GDP in 2000 to 370% today and growing. The President and his administration seem to be intent on using low interest rate debt to finance much of their agenda. This will only drive the U.S. into more debt, thus making the deleterious effects of debt on GDP growth all the more severe.
Academic research has proven the negative relationship between GDP growth rates and debt.
- 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)
- Checherita and Rother 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. The Bank of International Settlements recently released its 85th Annual Report in which it 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)
"The latest household debt for Q2 2017 was up 0.9% from Q1 and currently at $12.84T, exceeding the 2008 Q3 peak of $12.68T."
Quarterly Report on Household Debt and Credit
The consumer continues to fuel much of this boom in consumption and consumer confidence by going deeper and deeper into debt, which only exacerbates the demographic trends and spending challenges the economy will see ahead. Americans are particularly going to town on cars buying more and more expensive cars, and financing them through longer-term car leases, and delinquency rates have been rising across the board. Most concerning is the large amount of auto loans being provided to sub-prime borrowers, and the subsequent bundling of those loans as securities. According to a recent article in the Financial Times, there are echoes of the mortgage crisis we saw not a decade ago:
"Lenders...have pumped out billions of dollars of loans, which have been bundled together, then sliced into securities...According to Morgan Stanley, the share of auto securities tied to “deep subprime” loans - those given to borrowers with scores below 550 on the commonly-used FICO creditworthiness scale - rose from 5.1 per cent of total subprime deals in 2010 to 32.5 per cent last year."
While President Donald Trump continues to tell us that better days are ahead and full-year 4% GDP growth is possible, I believe fiscal reality will catch up with the President's delusion of grandeur. The economic reality and negative impact of continued expansion in household debt simply places a permanent barrier on sustainable organic growth. As we continue to fail to achieve the GDP growth targets set by the administration, and tax reform eludes us as a result of a dysfunctional Congress, concern will grip the market, and asset prices will be repriced...lower. Velocity on M2 reserves and subsequent readings on inflation and a host of other important indicators continue to be a sign that something is not right structurally in the economy.
Anecdotally, when the markets' continued rise seems to be tied to Congress getting tax reform done, and not organic growth in earnings, I become concerned. There is no doubt, the F.A.N.G. (Facebook (NASDAQ:FB), Amazon (NASDAQ:AMZN), Netflix (NASDAQ:NFLX), Google (NASDAQ:GOOG) (NASDAQ:GOOGL)) stocks have run up to excess, pricing in perfection to any subsequent earnings report. The risks investors are taking in the more richly valued parts of the market are especially significant moving forward. Caution is warranted; nothing goes up in a straight line forever.
The debt issue is not simply an American issue either, proving why it is important to have these discussions in the aggregate. The developed world seems to be drowning in debt, and the IMF says it sees challenges ahead for Emerging Europe as well. In Australia, Europe, Japan, and China, debt continues to be an increasing impediment to growth for these nations, even as central bankers attempt to stimulate growth with unprecedented monetary accommodation. This should be far more concerning to investors than it is.
"Altogether there are five European nations whose debts are larger than their economic output, and 21 that have debts larger than the 60 per cent-of-GDP limit set out in the Maastricht Treaty. Greece’s public debt is, unsurprisingly, the highest in the EU - standing at 177 per cent of its GDP. Italy and Portugal are the next most indebted countries, with debts of 132 per cent and 129 per cent of national economic output respectively."
There is a very real fear that China's debt bubble could burst, which would cause ripples throughout the global economy.
"Growth in China has been propped up by rapid increases in debt in recent years. 'Nominal credit to the non-financial sector more than doubled in the last five years, and the total domestic non-financial credit-to-GDP ratio increased by 60 percentage points to about 230pc in 2016,' the IMF found. Those debts are expected to rise to almost 300pc of GDP in 2022."
Australia & Canada Show Debt Continues to Explode
In Australia, a recent report by the Reserve Bank demonstrated that Australians are holding debt equal to 190% of their household income, a new record. This is largely due to exploding mortgage debt. Of the 3.1 million mortgaged households in Australia, an estimated 669,000 are now experiencing mortgage stress.
A report from the Bank for International Settlements warned that the surge in Australian household debt increases the instability of the Australian economy and makes the country more susceptible to another financial crisis.
Canadian housing prices are also approaching bubble territory. The Bank of Canada has cited rising housing prices and growing household debt burdens as significant concerns. In a piece from CBC, it states:
"Highly indebted households have less flexibility to deal with sudden changes in their income...As the number of these households grows, it is more likely that adverse economic shocks to households would significantly affect the economy and the financial system."
The world is drowning in debt, and consumers continue to finance their lifestyles beyond their income through more and more debt. Eventually we will need to enter a period of protracted deleveraging to deal with the build-up of debt from decades of overconsumption. Until then the game of musical chairs continues.
Portfolio Implications: Raise Cash & Buy U.S. Treasury Bonds
I have slowly been building my U.S Treasury position, and for the first time this year, U.S. Treasuries and cash are now a larger portion of the portfolio than equities. This does not mean that I do not see value in the equity markets. There are certainly pockets of value that exist in high-quality businesses trading at lower valuations due to a host of, what I believe to be, temporary factors. However, holding U.S. Treasury bonds must be looked at as insurance at this point in the cycle.
The higher the index fund valuations go, the more insurance I continue to buy. Eventually when market prices decline, I will convert this insurance into higher equity allocations at severe discounts to current value. But for now I wait, and continue to earn a competitive return on my investment. YTD 30 Year Zero Coupon U.S. Treasury Securities have returned over 7%.
It is also important to note the important risk management properties U.S. Treasury securities play in an equity-dominant portfolio. A portfolio of 50% stocks and 50% U.S. Treasury zeros, for example, creates a risk spread that allows for losses to be taken on either side of the trade without overall portfolio losses materially derailing an investor's long-term plan. Investors largely rely on corporate credit portfolios to buffer their risk and create income in the portfolio. However, looking at correlations demonstrates that corporate bond portfolios are highly correlated with equities, especially as one goes further down in credit quality.
This further demonstrates why traditional bond index allocations are ineffective at managing risk and leave investors exposed to more equity risk than desired or known in many cases. In 2008 many popular traditional bond funds produced a negative return along with equities, providing investors with little if any benefit from their inclusion in the portfolio. Only U.S. Treasury securities provide a negatively correlated asset to equity securities and sufficient protection from adverse market events.
While many are quick to cite the volatility in long-term zeros, it is important to note the negative correlation of the two asset classes, which actually decreases overall portfolio volatility. Investors holding a 50% allocation to zeros and 50% to an S&P 500 index in 2008 earned a return of 9.24%. In the mini draw-down of 2011, the same portfolio returned 28.99%. U.S. Treasuries are an important part of any portfolio for long-term investing, especially for an investor's retirement portfolio where the investor depends on that money to replace income in the future, and where a worst-case scenario offers you a modest return on your money.
In conclusion, we hear a great deal about what a poor investment U.S. Treasury bonds are especially at the long end of the curve. However, the Fed is currently limited by the present environment in its ability to continue to raise rates. With inflation rates and expectations below the Fed's 2% target, long-term Treasuries are telling you that something is seriously wrong structurally with the economy. With rates at the long end of the curve trading far above their European counterparts, U.S. Treasury bonds also are a relative value in a world of global overvaluation. I continue to believe that owning some U.S. Treasury bonds is not a bad idea; how much, and at what duration is for each individual investor to decide based on their situation.
However, with fires burning throughout the world, including increasing economic challenges in Europe, a possible debt crisis in China, and a sustained failure in the U.S. to achieve targets of GDP growth and inflation, not to mention geopolitical tensions in North Korea, the debt ceiling, and a host of other factors, I continue to believe that long-term zero coupon U.S. Treasury securities offer a unique opportunity for investors concerned with return OF their money as much as the return ON their money.
The calls for excessive losses by pundits in the media are quickly silenced with the realities of how a U.S. Treasury bond works. A U.S. Treasury bond held to maturity is guaranteed by the full faith and credit of the U.S. government. The holder gets their principal back plus interest at maturity. Your worst-case scenario on a 10-year zero is 2.26%; however, if I am correct and rates go down to 1%, that would be a 56% reduction in rates, offering a very nice return for investors.
Overweighting stock indexes at the current valuations of asymmetrical risk and return patterns, I believe, is engaging in pure speculation. Market participants are playing a game of musical chairs, and many are overexposed to market risks through index products at the worst time in the cycle, assuming stocks will go up forever, and there is no alternative.
When the music stops, the principles of investing will once again apply as euphoria ends, and valuation will once again matter. Cash will be king, and investors with cash and U.S. Treasury bonds will be able to buy more of everything, cheaper. Time will tell whether the contrarian view or the consensus was correct, but my money says that the secular low in long-term U.S. Treasury yields is ahead of us.
Disclosure: I am/we are long ZERO COUPON U.S. TREASURY BONDS.
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: 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.