End of Trend Shifts Focus to the Future
April 1, 2010
Investors who continue to rely on old habits for asset allocation decision-making are due for a wake-up call. As the 30-year trend of declining interest rates comes to an end, resourceful investors will realize the need to throw out stale assumptions in favor of fresher methods to guide them. One of the challenges they face in this undertaking is scant historical precedent for the current economic situation. Another challenge is that artificially low interest rates, asset subsidies, and government stimulus programs are fogging the view of the road ahead.
Modern portfolio management advocates the use of forward-looking data to make asset allocation decisions. In practice, however, managers largely rely on backward-looking methods such as data mining and historical analysis to extrapolate a glimpse of future trends. While this sometimes leads to decent asset selection decisions, there are critical reasons to question the efficacy of this approach going forward. The main factor is the change in the long-term trend for interest rates.
Since the early 1980s, bond yields (proxied by the 10 year Treasury yield in the chart below) have experienced a steady secular decline as the Federal Reserve reduced rates from a high of 20% to the current near-zero rate.
This long-term decline in the Federal Funds rate has been supportive of resource utilization and economic growth. Until fairly recently, it has also been accompanied by improvement in employment conditions (note the decrease in rates in 2002 and the lagged decrease in unemployment in the chart on the next page).
Beginning in the late 1990s, an environment of relatively stable yields encouraged the use of debt to increase returns. For example, institutional investors who sought a minimum return of about 7% on an asset currently yielding 5% would commonly employ debt financing to increase that asset’s internal rate of return. Yet, access to credit is not a panacea. Think back to the height of the housing market when lenders were offering 100% financing at low interest rates. At a certain threshold, consumer thirst was quenched and demand for debt subsided. Despite lowering of the Fed Funds rate to near zero (see chart above), asset prices tumbled. This led to a huge harvest of capital destruction at both the household and institutional levels, the effects of which will afflict our economy for years to come.
Getting back to the conundrum faced by investment managers: the present economic situation confounds their efforts to mine past data for meaningful guidance, because the dearth of economically equivalent historical periods offers few opportunities for comparison. In an environment where interest rates can no longer decrease and the lever of generous consumer debt can no longer be applied, the trusty metrics investment managers relied upon over the past three decades are suddenly obsolete. Return on Equity (ROE), for example, was one key measure of investment performance in past times, but with a limited ability to increase leverage to juice this statistic, it now comes in a poor second to Return on Assets (ROA).
By noting this changing dynamic, we are not suggesting that inflation is an imminent problem. As we stated in the March edition of the Saturna Sextant, we do not view inflation as a near-term problem. Evidence of this can be seen in the shift in the yield curve since the end of last year (chart below).
While the decreases in yields were modest, it is interesting to examine these changes relative to investor fears as 2010 began. Capital markets were counting the days until the Fed would have to reverse policy with expectations of increasing economic growth and fears that the increase in the money supply would cause inflation to rear its ugly head. But here we are one quarter of the way through the year and the investment community is telling us that inflation expectations have actually decreased.
Despite the absence of inflation, a great deal of this shift in the yield curve is due to fatigue brought on by having the Fed Funds rate sit at zero for an extended period of time. Another byproduct is the increasing allure of risk assets. With a zero Fed Funds rate, investors will eventually seek higher yields by investing farther out the yield curve causing long yields to decrease. Early signs of this include the fact that risk assets are being bid up to the point that swap spreads have turned negative by 0.023% for the first time in history1 (no consideration of counter-party risk in that price!). It also appears that lingering concerns over commercial real estate were not sufficient to prevent commercial mortgage-backed security (CMBS) issues from making a comeback. This falloff in risk aversion can be seen in the above chart, which shows a declining spread between 2-year treasury yields and 10-year treasury yields.
The conundrum continues as government intervention makes modeling forward-looking financial dynamics extremely difficult. With the proliferation of government asset purchase programs, taxpayer grants and tax-breaks, estimates of intrinsic asset values become clouded, thereby making institutional and individual household balance sheets appear healthier than they really are. Lack of transparency therefore emerges as a complicating factor.
It is important to recognize that there is a limit to any government’s ability to borrow, just as there was a limit to consumer borrowing. It is this risk that continues to be reflected in yield spreads which remain at record highs (see the longerterm view next page). Credit default swaps (CDS) written to hedge the risk of default on U.S. Government debt have also seen significant increases (see chart next page) reflecting the rising concern among investors over the level of indebtedness being incurred. The ability to socialize asset losses with prolonged economic support from various levels of government is unsustainable and will inevitably succumb to negative taxpayer sentiment.
With this in mind, investors should be leery of chasing returns without a commensurate evaluation of an asset’s risk profile. Think back to the time before the sub-prime crisis. Bear Stearns, Merrill Lynch, Lehman Brothers, and a host of other issuers of highly leveraged financial products were unable to withstand the onslaught of lower realized cash yields and lower asset prices despite their decent credit ratings. Bear Stearns and Merrill were bought by less leveraged financial institutions, while the Lehman Brothers’ bankruptcy resulted in the corporate equivalent of a garage sale (with Nomura and Barclays picking up the biggest pieces). The interest rate dynamic that once supported the values of their riskiest products is a thing of the past.
We can no longer rely on support from the 30-year-long trend of declining interest rates to support asset values. This alone should motivate the investment community to adopt a different (and more cautious) approach to investment management. After all, why should historical performance parameters continue to hold when the single largest determinant of investment returns is experiencing a long-term shift in trend? In our view, a forwardlooking, methodical, active management process is more important now than ever before.
Copyright 2010 Saturna Capital Corporation and/or its affiliates. All rights reserved. Vol. 4 · No. 4
¹ Zeng, Min. “A 1st for Booming Swaps Market.” The Wall Street Journal. March, 24, 2010, http://online.wsj.com/article/ SB20001424052748704896104575139531882439078.html
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