No Place to Hide or No Place to Go?
Fixed Income Outlook
January 2016
2015 was a very frustrating year for investors as there was plenty of volatility, virtually no
standouts and quite a few disappointments. Despite relatively steady U.S. economic growth,
domestic equities were essentially flat for the year with the exception of some tech and biotech heavy
indices. U.S. investment grade bond performance was also essentially flat, while high yield, still
under pressure from declining energy and industrial commodity prices, lost money. Canadian and
Mexican markets crumbled, as did many emerging markets, such as Brazil. In Europe, equity returns
were generally negative, while in Asia, they were mixed. The Japanese and Chinese equity markets
were bright spots, albeit quite volatile, while markets in neighboring countries did quite poorly.
Looking ahead, global growth seems likely to continue at its anemic pace and commodity prices may
have further to fall. While the benefit to consumers of falling prices could eventually show up in
increased consumption, the specter of deflation is never far away. Deflation is a nuanced
phenomenon; it can be good or corrosive, depending on many factors. We are glad that the Federal
Reserve (the Fed) finally began interest rate normalization; now the task of effectively raising rates
begins. It may be early yet, but if rates are rising, does that mean the economy is in fact robust
enough to support higher rates or are we in danger of a recession? We shall see.
Investment returns in 2015 were for the most part underwhelming. We seem to live in a
bifurcated world with energy and industrial commodity suppliers on the one hand and consumers of
those commodities on the other. In strictly economic terms, one side’s loss should be the other side’s
gain. Japan, Germany and China are huge importers of oil and industrial commodities, and their
markets did do better than their regional peers on balance, despite continued economic headwinds
in some of those countries. Canada, Brazil, Australia and other commodity exporters did very poorly
on balance. Where does this leave the world’s largest economy, the U.S.? We seem to have enviable,
but lower than historical, economic growth. While becoming more energy independent, we still
import oil. Our largely consumer based economy should be benefitting from lower commodity and
import prices, and to some extent it is, however, this windfall has so far been skewed towards savings
rather than consumption. While some could argue that this is simply a delay in future consumption
as consumers need to feel confident the decline in prices will last, others may argue there has been a
secular change in spending patterns. We would tend to side with the latter.
The reason for our guarded view on the return of the consumer is based on our view that the
“age of consumerism” is dead. The past 30 years or so have seen some aberrational trends when
looked at over a longer time frame. These diversions from the norm have many root causes, such as
demographics, a secular decline in interest rates and more perfect knowledge. We have experienced
an unprecedented rise of computing power, which has given us incredible access to price discovery,
goods and services and factual knowledge. This era has also given us the largest decline in interest
rates for a developed country on record. In the early 1980s, the aging of the baby boomers, arguably
one of the largest population bubbles in history, coincided both with their peak earnings years and a
decline in tax burden. Add to these an unfettered availability of credit and you had a potent cocktail
for an explosive rise in consumer spending. Rising home prices and lax underwriting standards also
allowed for the deferral of debt repayments, as many used the increased equity in their homes to
fund more spending. Many of us who remember our post-depression era parents and grandparents
exhorting us to save for a rainy day and to live within our means seemed to believe that was pretty
dated advice until this “age of consumerism” ended with a bang during the sub-prime debt fiasco of
2008. We believe that spending since then has been more restrained and will likely continue to be.
We don’t think policy makers or investors have adjusted yet to this sea change in consumer
behavior. Coincident with the rise in computing power was the growth in econometric modelling.
These models are now used routinely to shape monetary and economic policy, as well as to forecast
investment market trends. Our anecdotal observations are that these models’ forecasts remain
woefully inaccurate. Why is this? We believe that most still use relationships and correlations
observed over the past 30 years, which when compared to longer periods of time, as we pointed out,
may have been aberrational. Most are surprised to see that consumers are not immediately returning
to their profligate ways following the windfall of lower fuel and import prices. Consumer behavior
tends to change after a wrenching outcome like the Great Depression (which followed the Roaring
Twenties) and the Great Recession of 2008. We think the greatest change has been an increased
awareness of the true cost of debt by consumers. After 2008, the consumer is the only sector of the
economy to reduce overall leverage, albeit sometimes involuntarily, while losing homes and
destroying credit profiles in the process. The pain was real and is still recent enough to affect
behavior for a long time to come. Any boosts to income, like the recent deflation in energy prices, will
likely go to savings first. Patterns of spending have also changed. Overt materialism, or conspicuous
consumption as it has been coined for the last 100 years, is on the wane. We believe that economists
need to take a hard look at how spending patterns are changing and policy makers need to revamp
how we measure spending to better gauge the health of the economy. For decades we have relied on
measures of manufacturing, despite that sector being a small fraction of the overall economy. We
could go on at length about this, but will end it here as it will likely take years for these adjustments
to happen.
Deflation and its potential benefits and risks have been a topic of some debate. Lombard
Street Research (LSR) has written extensively on the subject over the past year. In their research they
note we have not had a meaningful deflationary period since the Great Depression.1 Before that, the
longest deflationary period occurred in the years following the American Civil War, from 1874 to
1896; this was marked by a 40% fall in general price levels in America, Britain and Germany. This
was partly due to many countries adopting a gold standard, causing the demand for gold and
gold-backed money to rise. As a result, the price of many commodities fell relative to the price of gold
and gold-backed money. As the falling cost of living enabled people to increase their savings, there
was also increased demand for interest bearing instruments, so interest rates remained low, despite
the rise in the value of money relative to goods. Also, the spread of railroads, steam ships and
refrigeration caused a reduction in transportation costs and opened up trade with geographies not
previously exporting in great quantities, which caused an increase in world output of commodities to
feed the appetite of growing economies (sound familiar?). It seems that during this period, wage
earners fared very well relative to producers of goods and commodities. As Brian Reading of LSR
points out as he paraphrases Layton and Crowther’s “An Introduction to the Study of Prices”, Third
2
Edition, they claim that the “index (1850=100) for real wages per head of the working population
stood at 135 in 1875 [and]…by 1896 reached 176, an increase of 30% or 1.27% a year. Allowing for the
unemployed, the index goes up 29% or 1.21% a year.”1 This is a case where deflation was a tailwind to
growth as productivity and real wages both rose during this period.
By contrast, the Great Depression was not a pleasant experience, either for producers of
goods or the general populace, due to very high rates of unemployment and defaults. However, if you
were lucky enough to still have a job throughout the period, you fared relatively well. Whether this
current period of low inflation and low wage growth resembles the late 19 th century or morphs into
another depression remains to be seen. Our guess is the former.
We have similarities to both eras today. We are most likely on the cusp of a large leap in
productivity thanks to the rise of computing power and connectivity. Some say that we are well into it
but that we are not accurately measuring it. Either way, prices for many goods and services have
been coming down (ignoring hedonic adjustments for a moment) and don’t seem like they will
reverse course soon. This is good deflation. We also have a large debt load globally. Some would
argue that this is the result of misguided monetary policy. As Leigh Skene of LSR has pointed out
“QE and ZIRP constitute financial repression, which depresses household incomes. Strong growth
factors such as pent-up demand, rapidly rising productivity and/or labour forces or falling
dependency ratios are required to offset it.”2 He has provided the example of Japan, “…the globe’s
most indebted nation [whose] industrial production is no higher today than when the bubble
collapsed in 1990, showing that QE and ZIRP do not help over indebted economies. Also corporate
hoarding of savings and the consequent fiscal deficits have depressed Japan’s economy so much that
falling money velocity has more than offset M2 growth […]. Creating sustained inflation is
impossible.”3 We would agree, but would add that the policies favoring corporate welfare in the face
of a demographic time bomb have also been largely to blame for the lack of productivity, not simply
their single minded expansion of the money supply.
Many economists lament the lack of capital spending in many developed economies, feeling
that future productivity may suffer. While this may be true, monetary largesse is not the answer.
Again, Mr. Skene notes: “Capex is much less important in economies that are operating significantly
below capacity, so classic monetary policy is far less effective – regardless of whether a demand
problem […] or a supply problem […] is causing inadequate GDP growth.”4 If it is a demand problem,
then monetary stimulus is rather ineffective because inventory first needs to be reduced before new
jobs can be created. Also, in most developed markets, the service sector is where many new jobs will
come from and those are typically lower paying and usually have a lower contribution multiplier to
GDP growth than does capex. He thinks the best solution is to simultaneously and equally increase
consumption taxes while lowering income taxes. Given our political gridlock, we say good luck with
that!
Traditional thinking regarding monetary largesse and inflation posits that an increase in
money supply is inflationary. Some are still worried about massive inflation once the velocity of that
money begins to accelerate. As we have witnessed in Japan, that is simply not happening. LSR points
out that in a cash society that may be true, but in a credit based economy: “Excessive monetary
growth chases limitless supplies of financial assets in credit based economies. Creating money faster
than financial assets raises asset prices...”5 In other words, it creates asset bubbles, which eventually
need to deflate. The worst example of this was the housing bubble of the last cycle. More recently,
European bond markets in the second quarter, which essentially wiped away more than the interest
streams to maturity on German, French and other 10-year sovereign bonds as growth showed some
signs of life. This illustrates to us how distorted some markets have become following years of central
bank intervention. Could it be that the next big asset bubble is in exquisitely priced sovereign debt? If
so, the silver lining is that the agents who hold much of this debt (i.e. the central banks) are different
than holders of past bubbles. Specifically, central banks are the strongest hands and have much more
staying power, given their ability to print money and not being required to mark their holdings to
market. Therefore, this asset deflation cycle will likely be slow and drawn out and may not cause as
much collateral damage. Unfortunately, this means we will have this headwind to growth for quite
some time. As a result, we think investors may need to temper return expectations for now.
On a positive note, in mid-December the Fed did finally begin interest rate normalization
[toot your horns now]. The Armageddon scenarios that some were forecasting following the initial
rise have not come to pass; initially markets were very accepting of the modest rise and interest rates
are still very accommodative. Given that economic growth is subdued, it begs the question: How high
can the Fed raise rates? Only time and the trajectory of future economic growth hold the answer but
for now we would expect this will likely be a very deliberate and modest march to higher rates.
Basically, things are going according to script; short rates are rising and long rates are basically
unchanged, meaning the yield curve has started to flatten; so far, so good. Next, we would hope to
see deposit rates move up as well, or else there could be the risk of depositors leaving non-interest
bearing bank accounts in search of higher yields. If this migration were large enough, it could pose a
problem for the banks’ funding requirements. We do not think this will materialize as we have
already seen evidence of at least one major bank announcing it will offer higher deposit rates to large
customers; we expect more will follow.
The high yield market, where we have been positioned for some time now, has been weak for
the past 18 months. Near the end of 2008, when we were mired in the fear that our banking system
could collapse and in the midst of the great recession, it was certainly much cheaper than it is today.
With no recession on the horizon, it has only traded cheaper one time since then. That was in 2011,
following the bungling of the debt ceiling and fears of an imminent default on U.S. government debt,
which never came to pass. In October of that year, yields approached 10%. Late in December 2015,
yields approached 9% and have since receded a bit. Investor expectations and conviction seem very
low now, so little optimism is priced into the market today. Whether we rebound from here depends
on a continued economic recovery, even at its current subdued pace, and no black swan events that
could plunge us into recession. While we cannot precisely predict the future, we think chances are
better than even that the U.S. should continue on its slow growth trajectory and we therefore feel
that there is some real value in the high yield market today.
Stepping back, we continue to believe that we are likely to remain in this slow growth and low
interest rate environment for some time. Given that, we think our shorter duration, high yield
positioning should serve investors well over the long term. Additionally, we have been carrying a
healthy cash position in order to buy what we feel are bargains being created by the sometimes
indiscriminate selling we’ve seen recently. Here’s a toast to a better 2016!
4
We thank you, our investors, for the faith you put in us and hopefully the future will bring
blue skies and healthy returns.
Sincerely,
Carl Kaufman
Simon Lee
Bradley Kane
1 Lombard
Street Research, Required Reading: Falling Prices are Good for Workers, January 23, 2015.
Street Research, Skene’s Scene: America’s Conundrums, April 6, 2015.
3 Lombard Street Research, Skene’s Scene: Changing the World Order – Part 3, December 1, 2014.
4 Lombard Street Research, Skene’s Scene: The Argument for Deflation, November 23, 2015.
5 Lombard Street Research, Skene’s Scene: Inefficient Debt=No Growth, September 28, 2015.
2 Lombard
________________________________
Past performance is no guarantee of future results. This commentary contains the current opinions of the authors as of the date
above which are subject to change at any time. This commentary has been distributed for informational purposes only and is not
a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been
obtained from sources believed to be reliable, but is not guaranteed.
No part of this article may be reproduced in any form, or referred to in any other publication, without the express written
permission of Osterweis Capital Management.
Duration measures the potential volatility of the price of a debt security, or the aggregate market value of a portfolio of debt
securities, prior to maturity. Securities with longer durations generally have more volatile prices than securities of comparable
quality with shorter durations.
Yield is the income return on an investment.
Quantitative Easing (QE) is an unconventional monetary policy in which a central bank purchases government securities or other
securities from the market in order to lower interest rates and increase the money supply.
Zero Interest Rate Policy (ZIRP) is a macroeconomic concept describing conditions with a very low nominal interest rate, such as
those in contemporary Japan and December 2008 through December 2015 in the United States. It can be associated with slow
economic growth, deflation, and deleverage.
M2 is a measure of money supply that includes cash and checking deposits (M1) as well as near money. “Near money” in M2
includes savings deposits, money market mutual funds and other time deposits, which are less liquid and not as suitable as
exchange mediums but can be quickly converted into cash or checking deposits.
Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country's borders in
a specific time period.
One cannot invest directly in an index. [18522]