Friday evening, August 6, Standard & Poor's announced a controversial removal of its long-standing AAA imprimatur on U.S. Treasury bonds. S&P's reason for the slight downgrade to AA+ is that they see no evidence that our political process can reverse the growth of government debt in relation to either government revenues or the nation's private sector activity. Both the deficit and the nation's debt burden appear out of control.
In the following memo we offer some insights into what is really going on, as well as a summary of FAI's investment approach to prospering in this new environment.
Was The Downgrade Warranted?
The opinion of highly-regarded investors range from Bill Gross' congratulations to S&P for showing "spine" in stating what everyone already knows about the government's spending addiction, to Warren Buffett's insistence that he would rate the U.S. credit AAAA!
In the short run, AA+ or AAA doesn't really matter to bond prices (and interest rates) because markets, and not rating agencies, ultimately make that call. In post-downgrade trading, the going rate on Treasury's 30-year bond is actually down a tad to 3.69% from Friday's 3.85%. The price has risen two full points! Since stock prices fell about 5% the first day of trading, a fair implication is that investors are more worried about the economic outlook than the downgrade, and capital is flowing from equities into the world's most liquid security, the U.S. Treasury bond.
FAI Opinion On U.S. Bonds
Whether a government bond represents sound investment value depends on its expected "real' or inflation-adjusted return, and whether that is attractive relative to alternative investments, adjusted for differences in risk.
For some indication of inflation, the CPI rose 3.6% in the latest 12 months. We think long-term Treasuries should provide a yield in the vicinity of 2% above inflation, suggesting that something like a 5.6% nominal yield would be appropriate ... assuming the trailing 12 month CPI is a valid indicator of long-term inflation.
The 30-year Treasury yields 3.69% at this writing, and the 10-year a paltry 2.38%; neither is even close to what we might consider attractive. We also believe that CPI understates actual inflation experience by the fact that residential rents constitute 1/3 of its calculation; rents have been flat for a year and are now beginning to rise. Furthermore, if S&P and Bill Gross are correct that large federal deficits are baked into the cake as far as the eye can see, and if the Fed continues to accommodate Washington's largess, the CPI can only go higher.
We believe long-term U.S. government bonds are overpriced; possibly very overpriced. Bond prices could actually rise further if the "flight to safety" proceeds, but we think it is an emotional trade that can reverse quickly.
Only a deflationary outlook could make current government bond prices a decent value. We cannot embrace the deflationary world view because we believe a) outright deflation is unlikely given the probability that the Fed would "roll the printing presses" 24/7 to avoid it and b) deflation would crush tax revenues, making actual U.S. default much more likely if inflationary monetary policies failed.
Are Stocks A Better Value?
The short answer is, "Yes, stocks are currently a better long-term value than bonds."
This morning, the major stock indexes are recovering a bit from Monday's lows, but remain about 5% below Friday's close. Coming on the heels of last week's 7.6% avalanche, stocks are not only causing their owners heartburn but they are also 16% cheaper than they were this past spring! Because we have been underweight equities all year, we consider this good news in terms of future buying opportunities.
Annualizing the 2Q earnings rate, the S&P 500 is trading at only 11.6 times earnings. That's an "earnings yield" of 8.5%, which looks awfully good compared with the 2.46% yield on the 10-year Treasury. But is "better than bonds" a good enough reason to own stocks?
Well, it's certainly a good start. The big question about corporate earnings, as always, is whether they are sustainable. In that regard we point to one highly encouraging aspect of businesses in general and to one somewhat disquieting feature of recent business earnings.
The "encouraging" aspect is the best reason for owning shares in well-managed companies. Business people live every day on the front lines of change. They are well informed about customer needs and preferences, and they are highly motivated to adapt their product and service offerings to the market reality. When they grow their company's profits, they prosper. When the company's stock rises, they prosper along with the outside shareholders.
The one "disquieting" feature is that pretax corporate profits are as high as they've ever been at 12.6% of GDP. (See chart.) On the one hand, it shows just how well companies have been able to adapt to even an unsettled economy (our GDP has gone nowhere in 4 years). On the other hand, business profits are inherently volatile and they have ranged widely between 6% and 12% of GDP. In every economic downturn of the last 40 years profits have fallen to 7.5% or less. The message is that we cannot trendline today's profits into the limitless future.
Since the early 1980s wages have trended lower as a percentage of GDP, from 59% to about 55%. Since the economic downturn in 2008 the slump has been especially noticeable, falling from 57% to 55% in just 3 years.
This coincides with the dramatic drop in homebuilding and with the quick recovery in corporate profits. While this trend suggests that companies have benefited from controlling employment costs during this sluggish recovery, the bad news for the economic outlook is that wage earners are consumers and consumer spending accounts for about 70% of GDP.
As everyone knows, the domestic economy lost over 8,000,000 jobs during what has been called "The Great Recession" of 2008-2009, and only added back about 2,000,000 during the unusually tepid rebound since then. So, unemployment has become stuck just above 9%. It's important to ask what that might imply for economic growth prospects.
Slow Growth Ahead
Investing is always about the future; yet, as every investor is keenly aware, nobody knows the future. To help us manage in this bifurcated reality, we like to label our various predictions as high-, medium- or low-conviction, and to temper their influence on our portfolio construction accordingly. One of our highest conviction predictions is that economic growth in the U.S. and Europe will be noticeably slower than it was in the post-WWII heyday of free market capitalism.
The main reason for our high conviction about shrinking growth is that during the last 30 years, the developed world has made unproductive use of debt capital to increase consumption and expand government ... both of which boosted GDP growth during the debt expansion phase. But the credit/liquidity crisis of 2008, last month's embarrassing and fruitless Washington debt limitation quarrel, and now the first U.S. credit downgrade in 70 years ... all point to the inescapable reality that we have entered a period of deleveraging; an era when the credit tailwinds that we all enjoyed have finally morphed into a violent headwind of both voluntary and involuntary debt reductions.
For stocks, a drawn-out economic slowdown in the world's largest economies almost certainly means that a big cyclical downturn in corporate profit margins lies ahead. And it will not be one of those 9-month recessions that the central banks can boost us out of. No, this one is more serious. Let's listen to the most informed spokesman for this conviction, Kenneth Rogoff (Former Chief Economist for the IMF, Harvard Professor and co-author with Carmen Reinhart of financial best seller, This Time Is Different).
The Second Great Contraction
It is wrong and misleading, says Rogoff in a recent op-ed piece ( www.project-syndicate.org/commentary/rogoff83/English ) to call the 2008-09 downturn "The Great Recession," as has become fashionable. It was not just a bigger-than-usual version of an ordinary business cycle contraction. Its origin is entirely different; it is a credit contraction. That's why typical policy responses like loose money and fiscal stimulus not only don't help, they make it worse. And making analogies with other postwar downturns, as most commentators have, will lead to poor investment judgments and unwise policy prescriptions.
Additional borrowing only makes worse what is the actual cause of the symptoms ... an unmanageable debt burden. The only way to restore normal economic conditions is to de-leverage.
Rogoff and Reinhart's detailed study of similar credit overloads across "eight centuries of financial folly" (their book's subtitle) indicates that working out of a credit crisis is probably going to take at least 6 years. The United States in the 1930s, "The First Great Contraction" is an example (didn't mean to scare you!) Just suffer through a few days of financial television and you will realize that the securities markets and people offering investment advice are treating the current "soft patch" like a run-of-the-mill recession. They are certainly not ready for a 6-8 year workout. I have to wonder whether today's sharp sell-off in equities is the beginning of such an "ah ha" moment.
For the necessary de-leveraging to occur quickly, Rogoff says, will require "a scheme to transfer wealth from lenders back to borrowers by way of defaults, financial repression or inflation." Otherwise, the only way out is a slow grind. It occurs to me that the political class hopes for such a phase in, but the "debt deal" they forged last week seems to fall very short of that hope, leaving only Rogoff's solutions still on the table.
Policy makers need to focus on facilitating debt workouts and reductions. For example, government might pay a lender to reduce someone's mortgage in return for a share in any future home price appreciation.
A "sustained burst of moderate inflation" is another policy approach to hastening the return to a healthy national balance sheet. He admits that, "inflation is an unfair and arbitrary transfer of income from savers to debtors," but he suggests, "it could broaden the inescapable pain of default and hasten the day when an economy can start over with optimism."
Our readers know that we lean toward expecting inflation-friendly policies from our government; as the world's biggest debtor, they would enjoy repaying with a devalued currency. Our fear is that once undertaken, inflation may not be all that easy to control. There is also the risk that loose money may sit in sterile reserves (as has been the case this year) and fail to prevent deflation. In such a case, investments made because of inflation concerns could prove disastrous.
This offers an ideal segue to an outline of our investment policy for these unusual times.
FAI Investment Policy
As long-term value investors, our highest-confidence asset class is equities. In a slow-growth economy that could persist for several years, and that could be the scene of price inflation greater than we have seen in 40 years, it is especially important to own shares in the very best businesses, ones that can be expected to adapt well to difficult circumstances. Characteristics we want in our stock portfolio include:
o Proven management
o Competitive advantages
o Global reach
o A powerful balance sheet and, where it is appropriate,
o A substantial and growing dividend.
We maintain three distinct "risk profiles" to accommodate clients' different investment time horizons. In each of the profiles our current equity allocation is at the bottom of our policy range. This puts us in a very good position to buy stocks when the long-term credit contraction eventually begins to clarify and/or when investor discouragement leads to irresistible values!
With defaults and inflation likely to be buffeting the debt markets at all credit levels, the following characteristics dominate our fixed income portfolios:
o A strong emphasis on investment grade issues
o Fairly short maturities so that we have a steady flow of repayments to roll over as protection against rising rates
o More corporate bonds than sovereign (balance sheets are stronger and they pay more!)
Gold still has a prominent role in our portfolios. We regard it as the best defense against currency devaluation. It can also serve as a profitable bastion in times of international turmoil.
Cash, while paying nothing, has the distinct advantage of maintaining its nominal value when other asset classes are in retreat. Cash is currently higher than usual in all three profiles.
Since equities and bonds are less attractively priced today than we would prefer, we are currently underweight these asset classes. In the meantime, we are using some of the freed-up liquidity to maintain modest positions in a few mutual funds with a record of success in non-correlated investment strategies.
When You Have To Invest...
The global credit crisis that defines our times has reduced to less than zero the inflation-adjusted yield on traditional safe havens such as bank deposits, money market funds and short-term Treasuries.
With traditional low-risk returns foreclosed, and since inflation risks are increasing, retirees and others of us who require a reasonable return on our savings need to have a liquid, realistically diversified investment portfolio. While investing in publicly-traded securities necessarily entails short-term price volatility, we are confident that attention to the macro-economic reality and adherence to our value discipline will produce ample returns over time.
We trust that these communications help reduce uncertainty for you and build your confidence. Please know that we are at the other end of the phone if you have questions or need additional information.
J. Michael Martin, J.D., CFP, is principal and chief investment officer of Financial Advantage Inc., a registered investment advisory firm based in Columbia, Md.