“ZIRP” and “NIRP” as Features of a Black Hole
It is difficult to sort out what’s happening in confusing time periods like the present one. Great change may be on the way, and uncertainty has never been higher. Prominent economists and financial sector thought leaders like Claudio Borio, Robert Shiller, Neil Howe, Brad DeLong, Ray Dalio and John Mauldin have become concerned that we are in a period that resembles the 1930s in many ways (Claudio Borio, 2014; Robert J. Shiller, 2014; Neil Howe, 2014; J. Bradford DeLong, 2017; Ray Dalio, 2019; John Mauldin, 2019). I have even had some concerns about parallels between the present day and the 1930s myself (Kevin Wilson, 2016; Kevin Wilson, 2017a; Kevin Wilson, 2018a).
The resemblances are many, but perhaps the most pertinent ones today are those delineated by Ray Dalio: 1) we are at the end of the long-term debt super-cycle that started in 1971 (Charts 1 & 2), when we abandoned the gold standard, and we faced the same kinds of end-of-cycle threats seen at the 1929 debt super-cycle peak; 2) we have grown a huge wealth gap or level of wealth inequality (Chart 3), which has simultaneously produced deep political polarization; and 3) a rising power (China) is now challenging an existing global hegemon (the US), just as Germany and Italy challenged the British Empire in 1933-1945, and Japan challenged the US in 1937-1945 (cf. Kevin Wilson, 2017b). As a result of these threats to stability, economic equilibrium appears to be at risk, and the levers of monetary and fiscal policy appear to be ineffectual right now. In fact, our overwhelming debt overhang and already extremely low interest rates suggest that policy efforts may remain ineffectual for quite some time (Kevin Wilson, 2019a).
Chart 1: Ray Dalio’s Long-Term Debt Cycle Model
Chart 2: Exploding Debt Since 1971
Chart 3: Wealth Inequality Recently Equaled that of 1929
It was in the midst of this strange new environment of increasing economic and political threats within a time of decreasing monetary and fiscal policy efficacy that I happened to choose to take my retirement two years ago. As time has passed over the last two years, it has become clear to me that we will soon be driven (by events) back to the zero bound for interest rates, just as we were 10 years ago.
When I retired, I merely joined the flood of Baby Boomers who have been retiring in huge numbers over the last few years. And we, as a group, all face a similar set of problems. That is, it is arguable that there has rarely been a worse time in modern history to transition to living on primarily fixed income (CD interest, bond coupons and stock dividends) than we face right now (Charts 4-6). This fact seems to parallel (although in a much less distressing way) the 1930s experiences of many retired people 80-90 years ago. Since my retirement, I have had to work hard to understand asset allocation in what is already such a strange time. I am now preparing for what I believe will soon be an even stranger (or more bizarre) time.
Chart 4: CD Rates Have Been Falling Since 1984
Chart 5: Drop in Long Bond Yields since 2000 Nearly Matches That from 1930 to 1950
Chart 6: Near All-Time Low Dividends from Stocks Lately
The New Investing Environment for Retirees
Indeed, this time period isn’t behaving at all like the last 50 years did for investors, nor will that situation change (barring calamity) for quite some time (Kevin Wilson, 2019b). Treasury bonds--e.g., the Wasatch-Hoisington US Treasury Fund (MUTF:WHOSX); or the I-Shares 20+ Yr. Treasury Bond ETF (NASDAQ:TLT)--do not produce much income at all anymore, but capital gains lately have been just great (Chart 7). Not only is that a fairly new twist for retirees, but the extremely rich current valuations for stocks indicate that future annual returns for moderate or conservative portfolios will likely be very low. Indeed, it has been estimated that over the next 12 years, a conventional 60/30/10 stock/bond/cash portfolio allocation will average just 1% total return annually, more or less (Chart 8). This looks pretty bleak for those who are retired, assuming there’s no lasting deflationary impulse to offset the damage, and it puts all of us in a quandary. So I’ve thought a great deal about the impact of the historic end-of-the-super-cycle problems we now face, especially with regard to how retired investors like myself must somehow adapt to this bizarre investing environment.
Chart 7: I-Shares 20+ Yr. Treasury Bond ETF (TLT) Since Late 2017
Chart 8: Projected 12-Yr. Returns for 60/30/10 Portfolio
First, we need to realize that the dire picture projected for retired investors in Chart 8 (above), although temporary in nature, will still last long enough to do serious damage to the unprepared. Historically, as that same chart shows, huge excesses in valuation are followed by huge selloffs that adjust (mean revert) the forecast for total returns back to a more “normal” range, but only after a period of years. Thus, the low-return forecasts of the late 1960s shown in Chart 8 (above) were followed first by the bear markets of 1968 (-36%), 1973 (-48%) and 1980 (-27%), and then some years later by the much higher actual returns of the great bull market that started in 1982. In essence, the period from 1968 to 1982 was a secular bear market with total losses of 58% (in real terms--Chart 10) over 14 years. It is not unreasonable to assume that losses this time around will be similar in scale (John P. Hussman, 2019), although it is not at all clear how long a bear market would last. The first task of retirees then is to weather the coming storm. This can best be accomplished by pulling back on risk and allocating defensively, which suggests significantly fewer stocks, with more bonds and cash, and even some gold in retirement portfolios.
Chart 9: 20-Yr. Rolling Returns for S&P 500 Drop to Zero Every Few Years
Chart 10: Real Secular Bull and Bear Equity Markets, 1870-2019
The problem in our modern economy is that we now may be facing a changing notion of which assets are risky and which are not. With bond yields nearing all-time lows, some observers think there are reasons to doubt the safety of bonds (e.g., Cliff Asness, quoted by Shawn Tully, 2019). Because there are also secular bull and bear markets in bonds, many people have wondered whether we are about to enter a new secular bond bear market in the near future (e.g., Mark Hulbert, 2014; Lou Carlozo, 2019). While I would grant to these doubters their assertions that things are indeed very unusual in the bond markets--there is about $17 trillion of negatively yielding global sovereign bonds now outstanding and a 35-year bond bull market already in the rear view mirror--I am not yet ready to abandon my bond allocations as a traditional safety net or source of income.
There are several reasons for this stance: 1) the bond market forces driving the recent plunge in bond yields (and rise in bond prices), which have arguably been triggered by a major shortage of US dollar-denominated “good” collateral in the huge overnight repo markets (Jeffrey Snider, quoted by Andy Kessler, 2019), have not yet abated, nor are they expected to do so; 2) the economy is structurally unsound due to extremely high debt levels, and recent forecasts of weak growth (which will be supportive of low yielding bonds) suggest this weakness is expected to continue for years (Larry Summers, quoted by Dan Weil, 2019); 3) bond bull markets can last far longer than most people expect, with the longest on record running 100 years (Chart 11), while those who thought Japanese JGBs must have reached their lower yield limits years ago have helped finance the infamous “widow-maker” trade; and 4) the ultimate cause of the slowing global economic growth trend is the stupendous global debt pile now weighing on the world economy (Charts 12 and 13), recently estimated at about $244 trillion or 318% of GDP (Chibuike Oguh & Alexandre Tanzi, 2019), and this is not expected to decline at all in the years ahead.
Chart 11: Bond Secular Bull and Bear Markets Since 1798
Chart 12: Gross Government Debt/GDP Ratio for Japan and the US Since 1870
Chart 13: Private Debt/GDP Ratio, Six Countries, 1740-2015
Indeed, if we continue our present love affair with debt, our weakening economy will continue to drive our short policy rates, 10-year bond yields, and long bond yields (Charts 14-17) ever downward, which both empirical evidence and theoretical arguments (Van R. Hoisington & Lacy H. Hunt, 2019) expect. I say that this trend is expected to continue because the debt/GDP ratio has been increasing, and the long bond’s yield has already been trending downward--for almost 30 years in Japan, the UK, the European Union, and, of course, the US. The claim that we risk the “Japanification” of our economy (cf. Mohamed A. El-Erian, 2019) will soon become a stark reality, if it hasn’t already. We may indeed be only one recession away from this outcome, as many now claim.
Chart 14: Parallel Paths of Japanese and US Policy Rates, Normalized to the Same Start (i.e., Panic) Dates
Chart 15: Secular Downtrend in Japanese 10-Yr. Bond Yields As Japanese Debt/GDP Soared
Chart 16: Secular Downtrend in US 10-Yr. Bond Yields As US Federal Debt/GDP Soared
Chart 17: Secular Downtrend in Long Bond Yields after Debt/Deflation Panics
Income from traditional safe assets (various types of bonds) will therefore continue to decline (ceteris paribus) even though they are already near all-time lows. However, capital gains on these same assets will continue to be very good in the short run. By the short run, I mean until the next great fiscal or central banking experiment during a recession or financial crisis changes something important, like inflation expectations. This could easily happen if, for example, the issuance of 50-year or 100-year federal debt instruments were undertaken to attract funding (Kevin Wilson, 2019b; Op. cit.; Lloyd B. Thomas, 2019). It could also happen if we undertook an outright debt monetization to fund the so-called “helicopter money drop” scenario long discussed in economic circles (Kevin Wilson, 2016). If and when either of these scenarios happens, my ceteris paribus constraint mentioned above will have been violated and the secular bond bull market really will be over. So even though the secular bond rally will probably continue for a while yet, it could end rather abruptly at any time through some drastic government action once funding the deficits becomes a problem, and/or a severe recession is recognized to have set in.
Asset Allocations in a Changing Landscape
Retirees will need to find some way to boost their incomes in this declining yield environment, at least for a while yet. Obviously, retirees will also have to find a way to get that better income stream at an acceptable level of risk. There is more than one pathway to this goal, and I would also submit that most people will need to use more than one potential model of the economy and markets to be assured of some level of safety. This simply means that the current situation is likely to change radically at some point. To me, the most obvious first move is to decide upon an asset allocation for the current situation that will combine safe income, modest growth, and the ability to weather storms. But since a recession is likely (Kevin Wilson, 2018b), and the continuation of the above-mentioned trends (in the short run) is also likely, some flexibility will be required. For those who like to “set it and forget it,” I would suggest that this is not the time to ignore change in the markets. Big events may transpire, and, therefore, it behooves us to keep our options open for a time. Almost certainly the initial allocation will have to be altered in major ways as time progresses.
With all this in mind, I would initially favor a “Wait and See” portfolio allocation with something like the following allocations (ranges reflect differing risk tolerances): 1) long-term bonds, e.g., the Wasatch-Hoisington US Treasury Fund (WHOSX) and/or the I-Shares 20+ Yr. Treasury Bond ETF (TLT) would be about 50%-60%; 2) dividend-paying stocks, e.g., Proshares S & P 500 Dividend Aristocrats ETF (BATS:NOBL) would be about 10%-20%; 3) gold ETFs, e.g., SPDR Gold Shares (NYSEARCA:GLD), but only as a short-term hedging trade, or alternatively the I-Shares Gold Trust (NYSEARCA:IAU), or the Sprott Physical Gold Trust (NYSEARCA:PHYS) would be about 10%-20%; 4) cash, including CDs, money markets, or T-bills, e.g., SPDR Bloomberg Barclays 1-3 Month T-Bill ETF (NYSEARCA:BIL) would be about 10%-30%; 5) alternative long/short funds, e.g., Otter Creek Prof. Mngd. Long/Short Portfolio OTCRX) would be about 5%-10%; and 6) real estate equity income funds (e.g., Real Estate Select Sector SPDR Fund (NYSEARCA:XLRE) would be about 3%-10% (separately allocated from other equities).
Once a major equity selloff has occurred, I would gradually reallocate to a “Opportunistic Hedged Income” portfolio allocation in response to the increasing value opportunities on the equity side, and the likely diminished capital gains opportunities (and increased interest rate risk) on the fixed income side. I would reallocate some of my bond holdings to cash, and some to value stocks, e.g., Vanguard Mega Cap Value ETF (NYSEARCA:MGV) and dividend-paying stocks (NOBL) in 10% increments (5% to cash and 5% to equities), starting somewhere in the vicinity of a 35% stock market SPDR S&P 500 ETF (NYSEARCA:SPY) draw-down as a minimum, and probably continuing until the draw-down has reached an expected level of >50%). The goal would be to add enough additional equities (NOBL and MGV, etc.) over time to bring the total portfolio equity allocation up to about 30%-50%, and the portfolio cash holdings (BIL) up to about 25%-45%, with likely no bonds at all. This naturally presumes that the fiscal and monetary authorities will have done something so drastic to encourage reflation that inflation finally takes off from very low levels. Gold (IAU or PHYS) would remain at about a 10%-20% portfolio allocation under this scenario, and alternative long/short funds (MUTF:OTCRX), etc. would drop back to about 5%. Real estate equity as a separate category (XLRE), etc. could be increased to about 10%-20%. Within the equity and real estate allocations, I would favor an emphasis on the larger, higher dividend-paying energy, mining, real estate, and healthcare stocks.
The financial implications for investors if the Fed undertakes “NIRP” might be considerable (Gautam Dhingra & Christopher J. Olson, 2019). Investors in that case would do well to avoid bank stocks, e.g., SPDR S&P Regional Banking ETF (NYSEARCA:KRE); Financial Select Sector SPDR Fund (NYSEARCA:XLF). Investors would also do well to avoid low-rated debtor companies (e.g., many companies in the i–Shares Russell 2000 ETF (NYSEARCA:IWM) or the i-Shares Micro-Cap ETF (NYSEARCA:IWC), which will continue to survive as zombies but will also avoid changing what’s wrong with them because of perpetual easy financing. Large-cap or mega-cap dividend-paying stock funds, e.g., Proshares S & P 500 Dividend Aristocrats ETF (NOBL); Vanguard Mega Cap Value ETF (MGV) would be my choice for the main equity allocations, or one could choose deep-value stocks on an individual basis when the time comes. Real estate equity income funds, e.g., Real Estate Select Sector SPDR Fund (XLRE) would be separately allocated from other equities.
Long Treasuries (Wasatch-Hoisington US Treasury Fund (WHOSX); i-Shares 20+ Yr. Treasury Bond ETF (TLT) will do well as the recession develops, but this will likely be a trade, not a buy and hold position. Bond holders will want to keep an eye out for extreme futures market positioning as a contrary indicator. Also important would be any marked change in direction for the 5-year TIPS break-even amount. After the 10-Year US Treasury passes the test of decreasing to a new low (below 1.32%) and as it nears a (prospective) yield of 0.50% to 1.00% or, alternatively, whenever the Federal Reserve reinstitutes “QE” policy, or under yet another alternative the impending bear market for stocks bottoms out (whichever of these comes first), I would expect very high risk of a bond selloff. Depending on circumstances, it is possible this hypothetical selloff could even be a pretty big one.
Right now, it makes sense with all the uncertainty, deflationary trends, and negative real rates to invest some money in a gold fund like SPDR Gold Shares (GLD), but only as a short-term hedging trade, not a buy-and-hold position. The I-Shares Gold Trust (IAU) or the Sprott Physical Gold Trust (PHYS) are alternative ETFs that may be safer for those who want to hold a gold position for a somewhat longer period of time. For those discounting a possible near-term recession and bear market, some liquid alternatives like the Otter Creek Prof. Mngd. Long/Short Portfolio (OTCRX) could be held to protect assets in the event of a much sharper market draw-down associated with deteriorating economic data.
Disclosure: I am/we are long OTCRX, IAU, GLD, WHOSX, TLT. 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: Disclaimer: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks or other securities mentioned or recommended. This post is illustrative and educational and is not a specific recommendation or an offer of products or services. Past performance is not an indicator of future performance.