Category Archives: bond market

Shaping a portfolio for 2015 (iv): interest rates

December 9, 2014 By in bond market, securities markets, Shaping a portfolio for 2015, Shaping a portfolio for 2015 (iv); interest rates, stock market, Strategy Tags: , , , , , , , , Leave a comment

The Fed has made it clear that it intends to begin the multi-year process of raising short-term interest rates back to normal sometime in 2015.  The agency says it expects to boost the Fed Funds rate from the current zero to around 1.5% by next December.

This is a good news/bad news development for investors.  On the one hand, the economic data clearly show that the US is finally–after six years–coming out the other side of the Great Recession.  On the other hand, rising interest rates are typically not good for securities markets ( a rising return on holding cash makes long-term investments like stocks or bonds look less attractive.).

If the Fed were to begin next April, it would have to do a .25% interest rate increase about every six weeks to get to 1.5% by yearend.  That’s just the beginning, though.  Fed documents indicate that the final goal is a Fed Funds rate of 3.5%.

what history shows

Rising rates are unequivocally bad for bonds.

In contrast, inpast periods of Fed-induced rate rises stocks have gone sideways to up.  That’s because the downward pressure that rising rates exert has been offset by upward pressure from strong-growing earnings.

 four differences today

1.  In past plain-vanilla recessions, interest rate hikes come pretty quickly after the worst of recession is over.  So consumers are just starting to spend (a lot) to satisfy needs deferred during the downturn.  In this case, however, we’ll be six years past the bottom.  Is there any pent-up demand left?    …probably not.  So the typical surge in earnings may be absent.  This is a minus for stocks.

2.  The Fed has been unusually clear  for a long time in publicizing what it intends to do and over what time frame.  Arguably, investors have absorbed this information and already made some portfolio adjustments in advance of the Fed’s actions.  I don’t see this in fixed income markets, but…

3.  The rest of the developed world hasn’t made anything close to thepost-recession progress in that the US has.  As a result,foreign interest rates  either remain at emergency lows, or are even dropping.  Rising interest rate differentials–and a strengthening US$–suggest that international fixed income investors may increase purchases of Treasury bonds, cushioning the fall in their prices.

4.  The Fed is acutely conscious of the repeated mistake that Japan has made over the past quarter-century of trying to return to normal too quickly–and pushing that country beck into recession instead.  Because of this, it’s possible that stock market weakness might cause the Fed to slow down planned interest rate rises.

my take

I think rising interest rates will make 2015 a sub-par year for stocks.  Will “sideways to up” hold true as it has in the past?  I don’t know.  I think a lot will depend on whether the Fed’s commitment to raising rates is greater than its wish to have relatively stable financial markets.  My guess is that stability is more important.

The Fed’s ultimate target for short rates is 3.5%.  I think that’s too high for a 2% inflation world.  I think 3% is more likely.  But let’s keep 3.5%.  Add a 2% real return to that and we get the endpoint for the yield on the 10-year Treasury,  5.5%.  This would imply a price earnings multiple for stocks of 1/.055, or 18x.  Arguably, then, the current multiple on stocks already discounts all the tightening the Fed is setting out to accomplish.

Even I think that the last paragraph paints too optimistic a picture.  What I’ve written may ultimately prove to be correct, but I don’t think the consensus would be willing to put much faith in this idea.

My starting out point is that interest rate rises will make next year a volatile one for stocks.  Without positive influences from earnings growth or foreign money flows, rising rates have the power to push US stocks down by, say, 5% in 2015..  At the same time, I think that good stock and industry/sector selection will enable investors to generate positive portfolio returns.

Jim Paulsen on 2015 (ii)

November 18, 2014 By in bond market, securities markets, stock market, Strategy Tags: , , , , Leave a comment

To recap:  yesterday I wrote about the latest investment newsletter from Jim Paulsen, a strategist at Wells Fargo.  In it he talks about a belief held widely (including, up until now, by me)–that the Fed’s program of raising interest rates from the current emergency-lows up to normal will be bad for bonds but have little impact on stocks.

How can stocks fare well as rates rise?

…because in past instances of post-recession rate increases, the negative effects of higher rates have turned out to be at least offset by the positive influence of stronger corporate earnings.  Hence, stocks go sideways to up.

Why is this time different?

Past tightening episodes have generally followed relatively mild recessions.  Tightening has come, say, a year after the bottom in economic activity, when the economic bounceback from the downturn is in full force.  Today, however, we’re more than five years past the recessionary low point.  Deferred demand has long since been satisfied.  So we can’t expect the same oomph from earnings comparisons that we’ve gotten in the past.  In fact, in Paulsen’s view, stocks are most likely to go down next year as Fed tightening begins.

Mr. Paulsen is smart, experienced–and has been right about stocks for at least the past five years.  So he’s someone whose opinion we have to take seriously.  He;s also a bull making a bearish statement.  For that reason alone, it’s worth consideration.

Another point in Paulsen’s favor:  the rest of the world seems not able to provide much support for S&P 500 earnings next year.  If anything, non-US businesses will be a drag on profit growth.

How might Paulsen be wrong?

I can think of three ways:

1.  It’s hard to predict the Fed’s tactics in raising rates.  The agency’s current plan is to start raising short-term rates sometime in the Spring and boost them by 0.25% every month or so, to arrive at around 1.50% by yearend.  However, if this timetable makes the stock market start to unravel, it’s conceivable–likely, in my view–the Fed will slow the pace, or even stop until stocks stabilize.  The disastrous moves by the Japanese government in the 1990s to prematurely return to normal–and the consequent lost quarter-century of economic growth–appear to be very fresh in the Fed’s mind.

2.  The Fed has been highly vocal for a long time about its plans.  They come as no surprise.  It’s possible, therefore, that investors have already made some adjustments in their thinking, and in their portfolios.  If so, the rate rise won’t be as harmful to financial markets as might be.

3.  (or maybe 2a, or both)  For investors not willing to hold highly illiquid investments in large amounts (that is, for almost all of us) the investment choice is among stocks, bonds and cash.  The return on cash will be negligible for a considerable time.  So the practical choice is between stocks and bonds.  Two points:

–the 30-year Treasury currently yields 3%.  An earnings yield on stocks of 3% translates (in the way Wall Street has generally worked since the 1980s) into a 33.3x price earnings multiple.  The S&P 500 is currently trading nowher close to that level, however.  It’s at less than 20x earnings.  20x earnings is the equivalent of a 5% yield on the 30-year Treasury.

I take this to mean the markets are already factoring into today’s stock prices a considerable rise in fixed income yields.  This doesn’t mean stocks won’t decline as rates start to rise.  But I think it does mean that part of this is already in prices and that the downside to stocks could be limited.

–we’re already beginning to see European bond managers buying US bonds.  They see: safe haven, higher current yields and rising currency (in euro terms) as offsets to possible losses from rising rates.  As rates begin to move higher, this trend may accelerate, bringing a higher dollar and a subdued effect on long-term bonds from rising short-term rates.  If long-term rates don’t rise less than expected, the effect on stocks should be positive.

what I’m doing

The rising currency scenario isn’t an unadulterated plus for the US.  Currency rises act in much the same way as interest rate increases do.  They lower economic activity.  Of particular concern to stock market investors, a dollar rise against the euro will lower the dollar-denominated results for S&P companies with European exposure.  That’s about a quarter of the S&P’s earnings total.

I don’t think we have to decide right away how stocks and bonds will play out next year.  But we do have to continue to assess possible outcomes and mull over what we want to do as new news makes one or another outcome seem more likely.

peer-to-peer lending, the next big banking innovation

October 28, 2014 By in Banks, bond market, Industry Analysis, junk bonds, P2P lending, securities markets Tags: , , , , , , Leave a comment

the demise of the department store

The story of the big commercial banks over the last forty years is sort of like that of the department stores, only in slow motion.  In the case of the latter, entrepreneurs targeted the most profitable “departments” of the cumbersome retailing giants and competed against them with freestanding specialty store chains offering a wider selection, trendier products and lower prices.  Toys, consumer electronics, jewelry, household goods, cosmetics, and, of course, various types of apparel were all targeted.

The financial world, for some bizarre reason known only to itself, calls this process “disintermediation.”  It has been underway for almost a half-century.

Consider what a bank does for a living:

in the simplest terms, it borrows money from some people, paying, say, 2% interest, and lends it to others at, say, 8%.  It uses the difference (the spread) to cover costs and make a profit.

money market funds

The first big disintermediation came in the 1970s, with money market funds.  These substitutes for bank checking or savings accounts take deposits from customer and make short-term (meaning a few months) loans to governments and corporations.  The entire spread, less expenses, goes to the money market shareholder.  So in normal times, money market funds pay considerably higher interest than banks.  The banks’ only advantage has been government deposit insurance.

The emergence of the money market fund produced a massive shift of customer deposits away from banks.

junk bonds

The second was  junk bond funds.  The first junk bonds were “fallen angels.”  That is, they were issued with low coupons by companies whose businesses subsequently deteriorated.  As a result, their bond prices had dropped sharply (and therefore the bonds’ yields had risen to high levels).  Careful credit analysis would turn up either companies that were on the cusp of a favorable turn in their fortunes or others where the market had considerably overestimated the chances of default.

As they become popular, junk bond funds soon faced a shortage of suitable bonds to buy. This led to the creation of an original-issue junk bond market–or junk bonds as we know them today.  These bonds were direct competitors to the corporate lending operations of banks.  However, junk bond issuers offered lower interest rates plus fewer restrictive covenants to borrowers and they delivered the entire spread, less expenses, to the fund shareholders.

Again, there was a massive shift of profitable business away from banks.

peer-to-peer lending

We’re in the early days of a third big disintermediation.  Peer-to-peer lending is, I think, will end up replacing banks as makers of small personal and commercial loans.

As things stand now, P2P lenders are simply internet-based intermediaries.  They do credit analysis to determine an interest rate for a given loan, put potential lenders and borrowers together and take a fee.  As I see them, they’re very much like the creators of money market funds or junk bond funds, only targeting a different “department” of the banks.  In the junk bond case, though, the “department” quickly morphed into something else.  That could easily happen with P2P, as well.

What’s most interesting about peer-to-peer to me is that the leading firms are preparing to go public by issuing common stock.

More when IPO dates are closer.

 

Bill Gross: a wave of (self-) destruction?

October 10, 2014 By in bond market, Current Market Thoughts, Industry Analysis, Investment firms, securities markets Tags: , , , , , , , Leave a comment

As even casual readers of the financial press know, Bill Gross, the bond guru, recently left PIMCO, the firm he founded, for smaller (everything is smaller than PIMCO) rival Janus.  Two aspects of his departure strike me as particularly noteworthy:

–Gross has been saying very emphatically, both at PIMCO and Janus, that he has absolutely no intention of retiring or of ceding any measure of control over his portfolios to colleagues.  This is despite an extended period of poor performance.  If he’s thinking at all about the impact of his statements on clients, he surely believes he is reassuring them.  However, it seems to me that the opposite is most likely the case.

What clients are likely hearing is that although he’s been charting a losing course for his portfolio for an extended period, he refuses to consider any changes or even to take any input from his 700+ professional colleagues. The way he’s delivering his stay-the-course message also makes him sound like an adolescent having a tantrum.  It’s hard not to connect this unusual behavior with the fact of extended underperformance, raising further issues about his temperament and his judgment.  This it’s-all-about-me attitude is very scary for anyone how has bet on Gross’s management prowess.

–PIMCO as a firm clearly made a terrible strategic mistake in making the idea of continuous outperformance by a single manager the exclusive focus of its marketing to clients for so many years.  Yes, the message is powerful and simple to understand, but one that’s also very risky and that invests a huge amount of power in a single individual.

PIMCO would probably have imagined any possible parting of the ways with Bill Gross to be somewhat akin to Derek Jeter’s final season as a Yankees.   …that is to say, a nostalgic feel-good farewell tour for a player who may be a shadow of his former self, but which validates both personal and institutional brands and generates large profits for both sides.  What PIMCO got instead was the unflattering glare of tabloid coverage of a messy divorce.

Bad for PIMCO.  But bad for Gross, too, I think.

As a client, how eager are you going to be to hitch your star to an apparently erratic 70-year-old who has weak recent performance, no longer has access to PIMCO’s extensive information network and whose assets under management are too tiny to have much clout in the brokerage community?    The default reaction of the pension consultants who advise institutions seems to be:  PIMCO without Bill Gross isn’t good enough; Bill Gross without PIMCO isn’t good enough.  It seems to me that PIMCO has a much better chance of changing consultants’ minds than Bill Gross does–it already has infrastructure, other managers with strong records and huge assets under management.

If I’m correct, absent a return to his form through the long period of interest rate declines, Mr. Gross appears to be in a much more difficult position than his former firm.  Much of this is his own doing.

 

Stockton, bankruptcy and municipal workers’ pensions

October 2, 2014 By in bond market, Current Market Thoughts, Portfolio management Tags: , , , , , , Leave a comment

In June 2012, Stockton, CA entered bankruptcy, burdened, as one would expect, by two types of obligations it was unable to meet:  debt service on borrowings, and funding of pension/health care plans for city employees.

The city’s initial reorganization plan called for employee pension obligations to be met in full–as California state law mandates.  This meant most of the restructuring losses would be borne by lenders, with some suffering virtually total losses.  Naturally, these lenders, or their insurance companies complained, arguing that such treatment violated fairness provisions of the federal bankruptcy code.

Yesterday, Judge Christopher Klein, the federal judge presiding over the bankruptcy proceedings, ruled that the lenders are right.  To my layman’s eye, he seems to be saying that because it legislated a strict set of criteria that a town must meet before being allowed to seek bankruptcy, California was also implicitly releasing a bankruptcy-qualifying town from having to comply with the state law on municipal pension integrity.

The judge’s opinion is a little more complicated than that, since it also involves the position of CalPERS, a  state-wide organization that administers pension plans for both the state and municipalities in California.  But it follows a similar ruling in the Detroit bankruptcy.

This is a complex and controversial topic.  And we’re still in the earliest stages of the journey toward it resolution.  But from an investment point of view, I can’t imagine that these ruling will do anything to increase spending by Baby Boomers who are state/local employees or retirees.  Another reason to think harder about Millennials.