Thoughts on Current Outlook – April, 2013

There’s always a rally in bonds – either prices or yields are going up!

Do you find bond math confusing and counterintuitive? If so, you are in the vast majority! Fortunately, for the last 31 years, buying bonds and just hanging on was a good thing to do. But that long, pleasant ride may soon be over.

Most of us know that as rates fall, bond prices rise and conversely that prices fall when rates rise. From their current low level, there isn’t much room for rates to fall but there is unlimited room to rise. This is enough to warrant concern about the future of bond prices.

However, there is another major risk that bond investors face today that many non-professionals haven’t recognized. We will spare you the math but as bond coupon rates fall, bonds’ price sensitivity to interest rate changes rises. With rates now so low, price sensitivity to interest rate changes is exceptionally high.

At the current level of rates on US Treasury securities, the duration (a measure of interest rate sensitivity) on a 10 year Treasury bond is now about 9 and the duration of a 30 year bond is over 20. This means that if market interest rates rise by 1%, a ten year Treasury note would lose about 9% of its market value and a 30 year bond would lose about 20% of its market value.

If interest rates on 30 year Treasury bonds rise from the current rate of about 3% to over 5%, those bonds could lose about 40% of their market value. While a 2% rise in interest rates doesn’t seem unreasonable, the accompanying loss of value would be about the same as stocks suffered during the crisis of 2008!

We aren’t suggesting that you rush to sell all of your bonds immediately because we don’t expect this rise in rates to occur suddenly. But we are actively reducing the duration risk in client portfolios as we think this rise could happen as rates return to “normal” levels. This normalization of rates comes with some good news though: interest rates are likely to rise as the economy continues to recover and approaches its long term growth rate.

Better growth ahead for the US

Higher growth will give rise to two conditions leading to higher rates. First, the Federal Reserve will likely back off of its program for purchasing bonds, which we believe has artificially suppressed bond yields. Second, better growth typically means a return of inflation as incomes rise, demand rises and prices respond.

So what will give rise to this better growth? Four major trends that we have been talking about for nearly a year now continue to gain prominence: substantial progress toward energy independence, recovery in residential real estate, dramatic productivity enhancements resulting from mobile capabilities and the emergence of the echo boom generation as the driving force in the economy.

Interestingly, it seems the economy (and the markets) have begun to ignore the machinations in Washington, so long as they aren’t destructive. We cruised right into the sequestration-related spending cuts without so much as a hiccup (yet, anyway) as the markets seemed to decide that if this is the only way we can get spending cuts, so be it. The effect of these cuts and higher taxes may slow down GDP growth in the second quarter but we expect this effect to be temporary. The conversations now appear to have shifted to longer term entitlement reform, also a positive.

Didn’t think your bank deposit could be taken to recapitalize your bank?        Guess again!

Across the pond, things are not so rosy. Cypriots are up in arms about the plan to tax bank deposits as a way of funding part of the bail out their banks need. While the whole of Cyprus’ banking system isn’t meaningful in the context of the size of Europe, this plan sets a dangerous precedent. And, we think it works against the idea of a unified banking regulation and deposit insurance which is critical to a better functioning Eurozone.

Meanwhile, the rest of southern Europe is left to wonder: are we next? It is little surprise that markets in Italy, Spain and even France have not taken kindly to the Cyprian plan even while the bureaucrats that worked out the plan are saying it was a one-off. Given the inconsistencies, skeptics abound. We are somewhat puzzled about what will come next as politics may continue to get in the way of progress. Italy is having trouble forming a new government, the Socialists in France are struggling and elections in Germany are not far off.

Right now, we have the pledge of the European Central Bank to provide liquidity needed to support markets but very little progress has been made toward the structural reforms needed to keep the Eurozone alive indefinitely. We expected this road to be bumpy but the Cyprian plan is a new, large pothole. Meanwhile, the Eurozone recession drags on.

Emerging markets chart their own path while US and Japanese stocks soar

Both the Dow Jones Industrial Average and the S&P 500 stock index reached new historical highs in the first quarter. In the aggregate, we don’t believe US stocks are significantly overpriced. However, our bottom-up work on stocks tells us that it is much harder to find bargains.

Even while the US and Japanese stock markets rallied strongly in the first quarter on the heels of central bank actions, emerging market stocks were declining. Investors became concerned about whether the recent history of strong growth would revive, in the face of continued inflation. The combination of slower growth and inflation does not give investors confidence.

For the next few years, we expect stocks will be a better place to be than bonds, given the risks in current bond prices outlined above. However, if interest rates rise too quickly, stocks could tumble along with bonds as investors place less value on future earnings when rates are higher. We don’t think this is likely but are acutely aware of the risk.

Finally, we continue to like the prospects for high quality companies with worldwide sources of revenue growth. We remain cautious about European stocks as their recession continues. And we are reducing exposure to interest rate risk in the bond portion of client portfolios and adding to long/short strategies in both stocks and bonds.

April 8, 2013                               © Essential Investment Partners