A recent short term strategy outlook from a large buyside firm walked through market expectations for Fed policy, S&P earnings, the election and drew conclusions about the likely direction of stocks over the next six months. Such analysis is endlessly fascinating even if trading profits are unreliable.

The essay touched on, but didn’t examine, what must be the biggest force driving markets – persistently low interest rates.

The real return on ten year treasury notes going back almost a century is 2%. Given 2% inflation, a neutral Fed should cause long term yields to drift up towards 4%. The Fed has been manipulating rates lower for most of the past decade since the 2008-9 financial crisis, but last year the bond buying ended and short term rates began moving higher. Yet ten year note yields peaked at 3.3% in November before descending to 2% recently.

Clearly, the historic relationship has changed. The balance between demand for and supply of safe, long term assets has shifted. Bond investors collectively have accepted lower future returns. There is plenty of interesting academic research to explain why. Real interest rates have been in decline for thirty years, as shown in this chart from the Federal Reserve Bank of Minneapolis. They now appear to be negative, as defined by the average short term rate over the past decade.

Although many commentators fret over what they perceive as unsustainably high stock prices, the plausible explanations for low interest rates largely reflect reduced risk tolerance by investors. While the decline in real rates has been steady, gross fixed investment fell sharply in the U.S. during the financial crisis and has barely recovered. This implies companies have remained cautious, dampening the issuance of long term corporate debt.

Another factor, highlighted in The Safe Asset Shortage (Caballero et al), notes that the financial crisis and subsequent Eurozone crisis led to a reassessment of which assets really were safe. Debt issued by FNMA and FHMC was assumed to be more risky following their conservatorship by the U.S. Unsatisfied demand for AAA debt instruments led Wall Street to produce Collateralized Debt Obligations (CDOs), which sought to pool riskier debt and repackage it into tranches of varying risk. But it turned out that the AAA tranche of a CDO retained some tail risk that sovereign debt did not. This perspective blames the 2008 crisis on unmet demand for safe assets.

Oddly, Caballero concludes that German and French sovereign debt similarly lost their allure. However, their yields are more than 2% lower than U.S. equivalents and solidly negative, which suggests ample holders willing to pay for what they perceive as highly safe investments.

Although memories of the financial crisis are receding, it seems to have permanently lowered risk tolerance. This, combined with a reduced supply of safe assets and perhaps the demographics of aging populations in wealthy countries have moved equilibrium long term rates lower. In recognition of this, the Fed has been adjusting their own long term equilibrium rate down in recent years.

A compelling solution is for a substantial increase in government funded infrastructure investment. This would take advantage of demand for long term debt and, assuming better infrastructure raised productivity, would not increase debt:GDP.

The shortage of safe assets is also reflected in the Equity Risk Premium (ERP), the difference between the earnings yield on the S&P500 and ten year treasury yields. It shows that stocks are cheap relative to bonds.

Since any investment is worth the net present value of its future cashflows, discounted at an appropriate interest rate, this has profound implications for stocks. Bond yields that are permanently lower suggest that stocks need to adjust substantially higher before fixed income can offer a competitive return.

The historically wide ERP underpins an investor’s choice to overweight equities. A return to its 50-year average of 0.6 (versus 3.6 today) isn’t imminent. But if next year it narrows halfway, to 2.1, and earnings grow by the 11% Factset bottom-up forecast, the S&P500 will be at around 4,400, nearly 50% higher than today.

U.S. energy infrastructure is an even better bet than the broader equity market. The shortage of high quality long term assets makes this sector especially attractive, as private equity funds seem to appreciate more readily than public markets.

Whatever the causes of permanently low interest rates, they strengthen the case for owning equities.

Join us on Thursday, July 11th at 1pm EST for a webinar. We’ll discuss the pipeline sector’s growing Free Cash Flow. To register, please click here.

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund.  To learn more about the Fund,  please click here.

SL Advisors is also the advisor to an ETF (USAIETF.com).

A couple of months ago we noted in Blinded By The Bonds the paltry yields available on long term debt. Since the 2008 financial crisis, the main driver of returns has been capital appreciation, since current income has been so low. Sure enough, over the last couple of months ten year treasuries have dipped another 0.3%, to around 2.1%. German ten year bunds now “yield” -0.20%. For an institution, the alternative is to hold currency in a vault. The cost of physical safekeeping of cash explains why investors are paying the German government to look after their assets.

The fall in long term yields reflects growing expectations that the Fed will cut short term rates. JPMorgan is forecasting two reductions in the Fed Funds rate by year-end. Yield curve historians fret that the inverted curve warns of a pending recession. It depends on the Fed. The bond market is telling them they have the wrong short term rate. The Federal Open Market Committee’s (FOMC) transparent process has removed all mystique.  Who remembers William Greider’s 1989 Secrets of the Temple: How the Federal Reserve Runs the Country? Or Bob Woodward’s 2000 volume Maestro: Greenspan’s Fed And The American Boom. The transition from deity to technocrat in FOMC leadership is complete.

We now see a bunch of government economists with no more information than the better private sector economists trying to figure it out. The mental dexterity to switch from raising rates (the FOMC’s posture through 4Q18) to cutting may take a year. The odds of a recession depend on the FOMC’s humble acceptance that they have little unique insight. Crowdsourcing monetary policy, relying on the signal from bond yields is the logical evolution. The FOMC faces a Behavioral Finance problem – over confidence, combined with anchoring to their previously held beliefs. The economy’s growth path will turn on how well they adapt their behavior.

Trade friction is a growing cause of concern. On this, we’d simply note that when President Trump moves into re-election mode, China’s then-current proposal will be seized and another victory for America claimed. Trump can’t control the market, but a president who Tweets the Dow’s milestones (even when they’re a return to old highs) is unlikely to let policy get in the way of boosting stocks (see The Trump Put). Tariffs are only an issue for 2019. The way bonds are moving, Trump may claim further credit for persuading the Fed to lower rates.

Falling bond yields and stock market weakness once again highlight the Equity Risk Premium (ERP), which is the difference between the earnings yield on the S&P500 and ten year treasuries. This starkly reveals the superior choice stocks offer versus bonds. At just over 4.0, the ERP is at a level reached only three times since 1962 (in 1979, 2011 and 2012). In each case, subsequent equity returns were quite satisfactory. Moreover, Factset is forecasting 11% S&P500 earnings growth, so the 2020 ERP looks even more compelling.

There will always be surprises. The biggest potential problem we see is Iran, where U.S. policy seems to have an undefined objective while steadily denying Iran access to sell its oil. It resembles U.S. policy towards Japan prior to World War II, when we denied them access to oil imports. As tensions rise in the Gulf, a military miscalculation is possible. Iran’s options are unclear. Although there are many more compelling reasons to be invested in midstream energy infrastructure, holding U.S. energy assets during a Middle East war would be a better bet than many.

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund.  To learn more about the Fund,  please click here.

SL Advisors is also the advisor to an ETF (USAIETF.com).

German 30 year bunds yield 0.6%. Investors are inured to insultingly low yields, but somehow this still shocks. The ECB defines price stability as inflation “…below, but close to, 2% over the medium term.” Assuming it averages 1.5%, investors are accepting a negative real return virtually in perpetuity.

French energy company Total (TOT) issued perpetual bonds at 1.75%, to buyers who are apparently satisfied with never earning a real return on a corporate credit.

Germany’s ten year yields are -0.05%. Could their 30 year bonds one day join them in negative territory? Japan’s ten year yield is -0.08%. U.S. ten year treasury yields of 2.4% are profligate by global standards.

There is some logic to accepting negative returns over the short term. You can only stuff so much currency under the mattress. But the point of investing is to preserve purchasing power. Somehow, bond investors have become trapped by inflexible thinking into self-destructive actions on a vast scale.

Asset allocations that rely on a split between equities and fixed income persist in maintaining some bond exposure even while loss of purchasing power is guaranteed. Clearly, tens of billions of dollars in assets has accepted this. The stewards of this capital retain a rigid adherence to portfolio diversification. Since falling yields have supported positive returns on bonds through capital appreciation, maintaining bond exposure hasn’t caused visible losses, for now.

Perhaps there’s a principal-agent problem here. The certain knowledge that an investment will lose money should cause an investor to change her selection. Self-evidently, if the purpose of saving is to consume tomorrow, when you know your purchasing power will be lower, perhaps you should consume more today and not save as much. If your career is buying bonds for clients, you’re unlikely to promote radical thinking.

The Equity Risk Premium favors stocks over bonds. This is true even though S&P500 2019 consensus earnings forecasts are being revised down. The current $168 forecast is down $10 since October, and puts the market’s P/E at around 17. But bond yields have also fallen, which has maintained equities’ relative attraction.

We’ve often illustrated the wide spread between the earnings yield on the S&P500 and bond yields by showing how little money invested in stocks could generate the same return as $100 in ten year treasury securities. Today, only $15 in the S&P500 would match the return on $100 invested in ten year treasuries at 2.4%, assuming (1) 5% dividend growth (which is the long-term historical average), (2) an unchanged S&P500 yield in ten years, (3) unchanged tax policies, and (4) that the other $85 is invested in a money market fund at an average yield of 1%.

A German investor fleeing the tyranny of low domestic rates for the U.S. would have to hedge the currency risk, which thanks to the magic of interest rate parity would precisely eliminate the yield advantage. But German stocks yield 3%, a substantial advantage over ten year Bunds.

Bund yields are negative because short term securities are even more negative. Two year German bunds yield  -0.63%. To some degree, investors in long term bunds are fleeing even worse short term yields. The example above using equities and cash to achieve the return on ten year bunds still works though. Assuming cash rates of -1.0% for ten years, a 23/77 split between German stocks and cash would achieve the ten year Bund return of approximately 0%. This assumes no dividend growth, which is a highly conservative assumption and would suggest the DAX finish the decade where it started. Just 2% dividend growth improves equity returns and lowers the split to 14/86.

Returning to Total and their perpetual bonds – energy has been a miserable sector and is cheap, as regular readers know. Energy infrastructure offers dividend yields of 6% or more, with distributable cash flow yields above 10%. The buyers of Total’s 1.75% perpetual bonds prefer this to the 5.2% dividend yield on its stock. There’s too much money in bonds struggling to find an adequate return.

Although central banks have been substantial participants in global bond markets since the 2008 financial crisis, plenty of commercial buyers are also investing at current yields. They’re exhibiting a remarkable lack of intellectual flexibility. When returns are certain to leave you poorer, it’s time for some fundamental questions about the purpose of investing. Bond investors will probably have to endure a couple of years of steep losses before making that assessment. By then, the folly of investing in debt at today’s yields will be completely obvious and too late to correct.

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund.  To learn more about the Fund,  please click here.

SL Advisors is also the advisor to an ETF (USAIETF.com).

For almost my entire 38 year career in Finance, we’ve worried about the U.S. Federal deficit. Someone recently asked me if we should still be worried. You’d think that it should have been a problem by now, but it’s not. Thirty year treasury bonds yielding 3% don’t look enticing, but evidently a lot of investors feel differently. Low as they are, U.S. yields are substantially higher than Germany, whose 30 year bonds yield a paltry 0.73%.

U.S. publicly-held Federal debt to GDP rose sharply following the 2008 financial crisis. Circumstances justified a temporary spike to provide fiscal stimulus, but instead it’s continued to grow. Nonetheless, rates just can’t rise — even though the Fed has stopped buying bonds, others have stepped in. Short term rates might even have peaked, following Fed chairman Jay Powell’s communication missteps in December.

The deficit doesn’t seem to matter. As President Reagan joked, “I am not worried about the deficit. It is big enough to take care of itself.”

This view is easily criticized as needlessly reckless with our country’s future. Markets are forward-looking, and most observers are pessimistic about our long-term fiscal outlook. But yields don’t reflect that. Since our current indebtedness is clearly manageable, it’s worth considering alternative outcomes.

Excessive debt was part of the reason for the 2008 crash. As the economy recovered, the U.S. pursued a stealth devaluation by maintaining negative real interest rates. It’s a well-worn path, and while Ben Bernanke didn’t articulate it as such, treasury yields were so low that buyers suffered a loss of purchasing power after taxes and inflation. Even today there’s hardly any return, although a large proportion of the holders aren’t taxable.

Populism adds an interesting dimension. Let’s suppose that U.S. bond yields rise to more fully reflect the sorry state of fiscal policy. Increased interest expense crowds out other expenditure. The Congressional Budget Office forecasts that net interest expense will double by 2024 and almost triple by 2029. They assume ten year yields rise to around 3.7%. The U.S. Debt Clock has some interesting figures.

If the buyers of our debt demand higher rates as compensation for the outlook, interest expense will rise even more. This will crowd out other priorities and add further to the deficit. Stocks would weaken; growth would slow. We can all imagine how a populist-leaning president, like Trump, would respond. Rather than focus on cutting domestic spending, foreign buyers would be warned to keep investing. The U.S. might threaten a withholding tax on foreign holdings of our debt, effectively lowering the rate. It would constitute a default. Who seriously thinks Trump would blink at the prospect?

It needn’t be a Republican. Early Democrat presidential contenders are similarly populist. How would a president in the mold of AOC (gulp) react to foreign creditors slowing the Green New Deal’s hugely expensive re-engineering of America’s economy?

The moral requirement to repay debt has been steadily weakening for years. Federal debt represents an obligation passed down from one generation to the next. It’s easy to see the political appeal in questioning why the country should repay money that was spent on entitlements by a cohort long gone. The bond buyers should have known better. In 2013, in Bonds Are Not Forever; The Crisis Facing Fixed Income Investors, I expanded on this line of thinking. It’s no less relevant today.

Such problems are in the future, but should be well within the time frame of a thirty year bond investor. Today’s yield curve suggests they’re not worried at the prospect. They should be. Publicly held U.S. Federal debt is $16TN. Another $6TN is owed to other agencies, half of which is Social Security. When you owe $16TN it’s their problem too.

Join us on Friday, February 22nd at 2pm EST for a webinar. We’ll be discussing the outlook for U.S. energy infrastructure. The sector has frustrated investors for the past two years, but there are reasons to believe improved returns are ahead. We’ll explain why. To register please click here.