I have a highly diversified portfolio of U.S. equities, international equities, REITs, bonds, and precious metals.
For the equity portion of my portfolio, I'm overweight high-quality, low-debt North American dividend stocks and emerging markets ETFs.
Recently, I shifted my bonds to being very short term, more like cash-equivalents. I specifically bought the SPDR Bloomberg Barclays 1-3 month T-Bill ETF (BIL) and the Invesco Ultra Short Duration ETF (GSY). This article explains why.
Recent 10-Year Yield Changes and Risk/Reward Ratio
As the Federal Reserve raised rates throughout 2018, and the bull market in stocks remained intact, 10-year treasury yields reached a local peak in October 2018 of over 3.2%.
Chart Source: St. Louis Federal Reserve
Since that peak, U.S. stocks entered a technical bear market, the Fed began using more dovish language, and investors fled to safety and pushed 10-year treasury yields down to under 2.7%. Yields have since recovered to just above 2.7%.
At the moment, I'm not a big fan of intermediate/long government or corporate bond funds like the Vanguard Total Bond Market ETF (BND), the iShares U.S. Aggregate Bond ETF (AGG), the iShares 7-10 Year Treasury Bond ETF (IEF), or the iShares 20+Year Treasury Bond ETF (TLT). I'm not aggressively bearish on them, but I simply don't view them as the best bond funds for my money.
Instead, with 10-year treasury yields so low, I'm shifting to shorter-duration exposure, and specifically into 1-3 month T-bills (BIL) and a smaller position into various ultra short-term securities that average about 4 months (GSY). This sharply minimizes interest rate risk.
From this point, there's only about a 30 basis point difference between 1-month and 10-year treasuries. Due to a partial yield curve inversion, 1-year treasuries have slightly higher yields than 5-year treasuries.
So right now, there isn't much of a case to hold long-term U.S. government bonds for their yield. Instead, the main case to hold them is to lock in higher yields and benefit when the U.S. enters a recession, the Fed cuts interest rates, bond yields drop further, and thus bond prices go up.
However, the lowest-ever 10-year yields in the U.S. were around 1.4%. If we look more globally, Japanese 10-year yields have at times dropped into mildly negative territory. In a bullish case for U.S. treasuries, yields could drop to 1.4% within a few years, or possibly to unprecedented low levels like Japan, and give investors a nice little boost in bond prices. But overall, there's not a whole lot of upside potential for treasury prices from these low rates.
On the other hand, it's not an impossible scenario for U.S. bond yields to spike to 4, 5, or 6 percent or more if there is stagflation or out-of-control deficits and debt. Many perma-bears have argued for this scenario, and a few more mainstream voices like Jeffrey Gundlach have also argued for high treasury yields within a few years, and there's more on that below.
I'm not an economist and I don't really have a strong view either way on 10-year yields, but that's the point. Safe-haven assets are supposed to be more certain. Longer-term U.S. treasuries are not the safe haven I'd prefer them to be, given low existing rates and rising fiscal debts and deficits. Instead, for the defensive portion of my portfolio I prefer ultra-short duration securities along with an allocation to gold, silver, and a few high quality precious metal stocks.
The United States' Uncontrolled Federal Deficit
If government debt grows at an equal or slower rate than GDP, then debt as a percentage of GDP can be sustainable over time by staying flat or going down. Unfortunately, U.S. debt has been growing faster than GDP on average for 40 years.
Normally, the United States has relatively low deficits during economic expansions, with spikes in deficits during recessions or wars. Our debt as a percentage of GDP peaked after WW2 and drifted down until the late 1970s. Since then, debt as a percentage of GDP has drifted up, with a big spike during the aftermath of the 2008 subprime mortgage crisis. Due to increasing entitlement spending for an aging population, it's projected by the Congressional Budget Office to keep sharply rising from here.
Here's the past and projected federal debt chart:
Chart Source: CBO June 2018 Long-Term Budget Outlook
Looking at that chart, it doesn't seem sensible to lock money away in treasury bonds for 10-30 years for ~3% nominal rates.
The federal deficit hit a recent low in 2015, at about 2.5% of GDP. Since then, it has been rising, and the recent unfunded tax cuts were a further stimulus and deficit accelerator, so that now we're up to deficits of 4% of GDP, which is unusually high during an economic expansion. The CBO projects we'll hit 5% deficits within a few years, and that assumes no recessions. They always just project smooth GDP growth with no recessions ever.
Chart Source: CBO Projected Deficits
A recession would most likely spike us closer to 10% of GDP again as tax revenues fall and government support picks up, since we're already at 4-5% deficits during an economic expansion.
For that reason, as I discussed in this recent article, I don't currently view the U.S. economy as "strong." It's only strong in the sense that it's supported by unsustainable fiscal stimulus.
For most times in modern U.S. history, whenever the Federal Reserve was in the process of raising rates, the federal government typically had shrinking deficits, because it was during a strong economy. As Jeffrey Gundlach presents in the following chart from DoubleLine, the previous rate-hiking cycle was accompanied by shrinking federal deficits, and the one before it was accompanied by a rare fiscal surplus. This current situation is unusual in that the Federal Reserve is tightening rates while the federal deficit is increasing:
Chart Source: DoubleLine, December 2018 Presentation
The case for higher treasury rates within a few years comes with several arguments, and only a subset of them have to be true for it to potentially unfold that way:
- The Federal Reserve is shrinking its balance sheet, thus reducing demand for treasury bonds.
- Foreign demand for treasuries may diminish as China and other players wish to diversify away from the dollar.
- Supply of treasuries will be increasing due to major deficits.
- The deficit will balloon higher during the next recession, hurting the credit score and quality of U.S. debt, potentially demanding higher yields.
- U.S. corporate debt is bubble-like, and yields will likely go up, which could provide a basis for relatively safer U.S. treasury yields to go up too.
- Tariffs or other factors may be inflationary in an otherwise dis-inflationary economic environment.
On the other hand, the Fed could reverse course during the next recession and resume quantitative easing by printing money, buying more treasuries, and driving yields down. In addition, investors may very well continue to view U.S. debt as a safe haven despite high debts, much like they still do for Japan. In that case, with negative real rates on cash and bonds, I'd rather own gold and gold stocks.
And the federal debt and deficit is just one of 4 major economic bubbles in the United States that I'm concerned about from an investor perspective.
The Long-Term Case For Gold
I think holding a 5% portfolio allocation or more to gold and gold stocks makes a lot of sense. It's a safe haven asset that does not correspond to someone else's liability, unlike cash and bonds.
I'm not historically a gold bug. I collected small gold and silver coins in my adolescent years in the late 1990s and early 2000s. I sold all of them in 2011 at high prices during the huge run-up in gold price, when everyone on TV was talking about gold going ever higher, "we buy gold!" and "cash for gold!" ads were everywhere, and companies began installing gold vending machines to take advantage of all the excitement in gold at the time.
I didn't buy gold for several years after that as prices remained elevated and stocks were more attractive, but over the past couple of years I have been buying gold (GLD), silver (SLV), and gold/silver stocks for a small portion of my net worth.
Economic growth in developed countries, ranging from Japan to Europe to the United States has decreased to very low levels. The IMF predicts 2.1% GDP growth in 2019 for developed countries on average, which is then projected to drop to 1.7% in 2020 and lower thereafter, which again doesn't assume any recessions.
Low growth combined with high global debt means central banks will want to keep real interest rates very low, and there's a good chance we'll see yet more money-printing and quantitative easing during the next recession in the United States and Europe, whenever that occurs. Japan's central bank balance sheet is already bigger than their GDP, compared to the U.S. Fed balance sheet that is about 20% of U.S. GDP.
In this world of high debt, low growth, low interest rates, and frequently negative real interest rates, holding gold makes sense. It's volatile, but has maintained good pricing power for thousands of years and serves well as crisis insurance.
I also like holding gold streaming and royalty companies, as the major players in that space - namely Franco Nevada (FNV), Royal Gold (RGLD), and Wheaton Precious Metals (WPM) - have had a more lucrative business model than most miners, with much lower break-even costs than gold miners for better downside protection.
That being said, I also have exposure to a small number of historically well-managed gold miners for balance. Specifically, companies with low debt and low ASIC with managers that have a strong record of capital allocation.
Additionally, several central banks around the world that wish to distance themselves from the dollar have been buying gold. Russia in particular has quadrupled its gold reserves over the past decade, and they continued buying like clockwork straight through their recession with no signs of stopping:
Chart Source: Trading Economics
With a number of countries interested in reducing their reliance on the dollar and thus buying plenty of gold, this helps prop up physical demand and keep the gold price up, all else being equal.
I don't really know what will happen with the gold price over the next year or two, but over the next 5+ years I certainly want to have some gold and gold stocks as a hedge.
Developed economies consisting of Japan, Europe, and the United States have low projected growth and historically high levels of debt.
While U.S. 10-year and 20-year government bond yields are higher than other developed countries, they're still not very attractive from a risk/reward standpoint. Neither are intermediate/long-term corporate bonds.
With the yield curve being as flat as it is, and real interest rates being so low, ultra short-duration securities, cash-equivalents, and gold are more attractive safe-haven assets in my opinion.
I view it like this:
- If treasury yields stay where they are or go lower, I'd rather own precious metals than long-term bonds, even as long-term bonds do reasonably well.
- If treasury yields stay where they are or go up, I'd rather own cash-equivalents than long-term bonds, since long-term bonds will do poorly.
Over the long term, I'm bullish on high-quality dividend stocks, several emerging markets with low valuations and high growth, and precious metals. I'm more concerned about Europe, Japan, the United States, and intermediate/long-term debt in general.
Disclosure: I am/we are long BIL, GSY, FNV, RGLD, SLV, IAU. 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.