September Investment Comments

Cautionary Signs or False Signals?

The 30-year Treasury bond recently yielded just over 2%, an all-time low.  Think about it:  investing one’s money for three decades for a negative return after taxes and inflation are factored in.  Usually long-term Treasuries perform well during periods of economic uncertainty, especially at the onset of a recession.  That’s the initial message investors perceive from this low bond yield.

 Another cautionary sign is that the Treasury yield curve is partially “inverted.”  A “normal” yield curve is upwardly-sloping, meaning that investors demand a higher yield in exchange for taking on the risks of investing over a longer period of time.  The 30-year Treasury typically yields more than the 10-year, and the 10-year more than the 2-year or a 90-day Treasury bill.  An inverted yield curve occurs when the opposite is true, that short-term Treasuries pay better than long ones.  This is rational only when the outlook is for lower interest rates as long-dated bonds will appreciate more than shorter bonds when interest rates fall.  Recently, shorter maturities like the 2-year and 5-year Treasury and the 90-day bill yielded more than a 10-year Treasury.  The 30-year bond still yields about half a percentage point more, hence the term “partial inversion.”

Investing would be simple if all we had to do was follow simple rules.  These bond-market signals would tell us to sell stocks and wait for a recession to buy them back cheaply.  However, nothing in investing is so simple or rules-based, and the world has become more complex.

Let’s step much farther back.  Starting in 2008, the Federal Reserve lowered interest rates to zero and flooded the world with dollars through its “Quantitative Easing” program.  The Fed’s balance sheet ballooned as it bought Treasury and mortgage bonds while essentially printing new money.  Eventually these programs ended: the Fed started raising interest rates and gradually began cashing in some of its bonds.  It raised rates as recently as last December.

Much of the rest of the world duplicated Quantitative Easing, most notably the European Central Bank.  While the Fed’s program rescued the economy, in our opinion, and set up the U.S. for a return to acceptable economic growth, Europe hasn’t had it so well.  Japan’s economy, the third largest in the world, has struggled off and on for almost 30 years.

Yields on government bonds are actually negative in many countries including Germany, Japan, and France.  Investors are paying these governments to hold their money for them.

Remember, very low interest rates frequently portend economic trouble.  Germany is flirting with a recession as GDP growth has been negative in two of the past four quarters.  The UK’s economy is shrinking amid doubts about its withdrawal (“Brexit”) from the European Union, while France’s is barely growing.  Japan had a strong showing in the second quarter, propped up by surging sales in advance of a hike in its national sales tax.  Its growth may turn negative as well.

It is logical that countries facing possible recession would have very low interest rates.  That they are below zero is a creation of government central banks.  In some cases, yields have been below zero for well over a year, and yet even these “low” interest rates have failed to stimulate economic activity as they are supposed to do.

In contrast, the U.S. economy has been growing above 2% for 11 of the past 13 quarters and above 3% for four of the past eight quarters.  Second quarter GDP growth seemed a bit light at just 2.1%, but underlying trends appear stronger.  The first quarter, which grew 3.1%, was aided by net exports and higher inventories.  Both of these hurt second quarter growth.  Final Sales to Domestic Purchasers (which excludes foreign trade and inventories) rose 3.5% in the second quarter while inflation-adjusted personal income grew 2.5%.

Two separate measures of consumer spending were both strong in June, the most recent month for which data is available.  Consumer confidence surged in July.  Employment growth remains solid.  On the other side, measures of the factory sector remain subdued, most likely due to weak international economies and trade skirmishes.

In deciding to lower interest rates in July, the Fed cited global economic concerns and muted inflation.  Some liken this move, and another cut anticipated for September, to an insurance policy in case the economic outlook weakens.  The Fed did this successfully on two separate occasions in the 1990s.

Putting all this together, it is very possible that weak economic conditions and low or negative interest rates abroad are attracting capital to the United States, where yields are significantly higher.  This flood of capital would cause U.S. interest rates to fall, but the magnitude is unknowable.

It seems unlikely that overseas economic weakness would be sufficient to bring the U.S. economy into a recession as implied by the Treasury market.  The U.S. is the least dependent on international trade among the world’s major economies.  The U.S. consumer powers about 70% of GDP growth, and the consumer seems to be fine.

Market volatility may continue due to global trade jostling, weak outlooks in some countries, and the U.S. political environment.  The historical relationship between interest rates and the economy has been upended for more than a decade by unprecedented extremes in government central bank policy around the world.  Given this constant interference in monetary policy and interest rates, it would be premature to assume the traditional yield-curve signals remain valid.  Diverging economies and markets around the world may widen the spread between winning stocks and losers so security selection remains very important.

Scott D. Horsburgh, CFA