Strategy
Last quarter we wrote that an end to the pandemic may be in sight by the end of March. I’m happy to report that more than 150 million Americans have been vaccinated. Roughly 2-3 million people are getting vaccinated every day. Positivity rates are falling sharply, hospitalizations for the elderly are a fraction of what they had been, and more states are allowing vaccines for the public regardless of age (over 16). Airlines report full flights, higher fares and demand is rising quickly. The pandemic in the U.S. is nearly under control but global COVID hotspots remain. As more vaccines are manufactured, we should see improvement in most parts of the world.
The combination of multiple stimulus packages, millions of people getting vaccinated, and a robust economic forecast have resulted in a sharp increase in interest rates. The intermediate and long end of the yield curve increased 55 to 85 basis points in the first quarter. Long treasuries suffered a loss of 13% so far this year making it one of the worst quarterly returns in years. The short end is anchored by the Fed and they do not intend to raise short-term rates until 2023. The bond market is clearly concerned that inflation is going to rise, and we warned about that last quarter. The speed at which rates rose is what concerned many investors. If rates continue to rise, the fear is that the Fed gets, “behind the curve” and is forced to raise rates much sooner than expected. If that happens, look for a correction in the stock market.
Short-term interest rates barely changed during the quarter, but the 5-year Treasury note yield increased 56 basis points, the 10-year Treasury-note yield increased 81 basis points, and the yield on long bond increased 75 basis points. The S&P 500 advanced 6% in the 1st quarter, the NASDAQ advanced 3%, and the small cap index increased 18%. The brighter outlook for the economy, due to the vaccine rollout combined with yet another stimulus package, put a little fear into the bond market and boosted the outlook for corporate profits.
While the yield on many non-agency mortgage-backed securities is less than zero due to the combination of high premiums and very fast prepayment speeds, agency-backed mortgaged-backed securities (MBS) are looking much more attractive after the rise in rates last quarter. We analyzed a 20- year Freddie Mac pool with a 2.0% coupon. The rate to the homeowner is 2.85%. Using the current prepayment speed of 12 CPR the MBS has a 1.65% yield to a 5.3-year life. The yield spread over the like maturity treasury is 65 basis points. An increase in the prepayment speed to 25 CPR results in a 1.40% yield to a 3.0-year life. Which is a yield spread of 103 basis points. The yield spreads are as wide as we have seen them in many years.
On the shorter end, a 15-year agency MBS with a 2.0% coupon is currently priced in the mid 102s, with a base case average life of 4.4 years and a yield of 1.35%. The yield spread is 61 basis points. Increasing the prepayment speed to 25 CPR results in a 2.8-year average life, a yield of 1.00%, and yield spread of 68 basis points. Both the 20-year MBS and the 15-year MBS offer very good value. It boils down to your preference for a higher yield and longer life or a lower yield with a shorter life.
The best value can be found by studying the yield curve. The difference in yield between a 3-year maturity treasury and a 5-year maturity treasury is 55 basis points. The difference six months ago was 10 basis points. Buying maturities of 4 to 4 1/2 years gets the investor all the benefits of this yield curve steepness without having to commit for 5 years. Why? Bonds maturing in 4 years are priced based on the 5-year treasury yield not the 3-year treasury yield. It’s one strategy to increase yield in an otherwise low yield environment.
Last quarter, we lamented the fact good ideas were scarce, interest rates were very low, and sometimes “the best strategy is to be patient and wait for a better environment.” This proved to be timely advice. We discussed the value in agency MBS currently and we are advising investors to take a hard look at this sector. We also find very good value in 4-year maturities due to the steepness in the yield curve between 3 years and 5 years. One thing is certain: the relative value of different sectors changes over time. We highlighted a few pockets of value and expect these will change throughout the year. Our goal is to update you quarterly and we anticipate next quarter’s recommendations will be different.
Interest Rate Outlook
Many people and institutions are enjoying seeing money in their bank accounts or in some cases, spending a little found money. It would be reasonable to think this could be the “pump primer” that gets the economy moving. The feeling of having some extra money will likely create an imprint for some consumers that cause them to want to continue to enjoy spending. That little dopamine rush that people can get from acquiring things can be a significant draw to focus on the next acquisition. Putting money in the hands of consumers may be a smart political move, but it also may be an attempt at learning a lesson from past economic history.
At the end of 1989, Japan’s Nikkei stock market index hit 38,916. Japan moved in and out of recessions throughout the 1990’s and the low point for the Nikkei was in late 2002 when the index bottomed out at 8,303. The episode is often referred to as “The Lost Decade.” In overly simplified terms, the main causes were a central bank that reduced the money supply (in response to signs of inflation) which precipitated the stock market crash, along with a real estate market sell-off, translating into a credit crunch as banks became conservative (since real estate collateral was rapidly falling in value), followed by a “liquidity trap” where households increased savings and were slow to spend. One could argue that the U.S. feels like it is in a liquidity trap now that savings rates have increased and since the Great Recession, the Fed’s ability to get people to spend (stimulate demand) has generally been unsuccessful. The Bank of Japan held the discount rate for much of the 1990’s at 0.50% but deflation persisted. There are parallels with current Fed policy. The Fed Funds rate is targeted at a range of 0% to 0.25%. Where the current U.S. policy partially differs is that Japan spent its fiscal stimulus dollars on inefficient public works projects and failing businesses, while the U.S. appears to be letting the market (consumers) decide where the stimulus is best spent. Some recipients are buying expensive shoes and handbags, while others are trying their luck by investing in the financial markets. Another deviation is that the U.S. has been expanding the supply of money. A final material difference is that banks are still willing to lend, so there is not currently a credit crunch.
A possible “dark cloud” on the horizon for real estate and banks in the U.S. could be commercial/retail property in high-tax and high-rent urban areas and office towers more broadly. As mentioned last quarter, Americans are moving to more affordable locations. Since the start of the pandemic, commercial rents in San Francisco and New York City have fallen 22% and 16%, respectively (accounting for concessions). Regulatorily-imposed, non-economic dispensation of bank loan access could be an example of an unforeseen cause of a credit crunch in the U.S. It could put banks in some areas of the country in the position to strategically shrink, or if creditworthy borrowers had to increasingly subsidize other borrowers, the appeal of borrowing may decrease, and they may choose to fund large purchases from increased savings. The point is that although the U.S. is not Japan of the 1990’s we appear to be following the lesson of giving money straight to consumers, but we are only a policy misstep away from facing a similar scenario. The Fed has seemingly used most of the tools in its “deflationary” toolbox and they even crossed (briskly) many of the “red lines” established prior to facing the global pandemic. A genuine fear we have is that in the current political environment of “good versus evil,” “right versus wrong,” and “us versus them,” if we make a policy mistake, will we fix it, or will we leave it in place because it is “the right thing to do?”
Away from the “Lost Decade” scenario, we see the most probable outcome of the current landscape as involving a dutifully (and probably appropriately) stimulative Fed, a fiscal environment with a lot more spending to come, and some short-term signs of convincing growth. That sounds enjoyable. Unfortunately, at a point in every great adventure a bill of some kind must be paid. Ignoring “fairness” opinions, taxes will need to be paid and in simple terms, money will have to flow from the hands of above average producers, laborers, and savers to subsidize those who generate below average economic activity. A transfer of that type very likely results in diminished future economic growth at the aggregate level. The recently released Penn Wharton Budget Model surmises that the $2.5 trillion American Jobs Plan (the Biden administration’s first infrastructure plan) would result in GDP falling 0.9%, capital stock (stock values) would drop by 3%, hourly wages would decline by 0.7%, and government debt would increase by 1.7% over the next decade. The “positives” that model can’t quantify include the effect of carbon reduction, the value in helping the elderly, and the “X-factor” from government R&D (related to the plan’s $590 billion allocation to jobs training and R&D). It used to be the case that reasonable people could discuss the gap between what is economically “smart” and what is “right.” Is that conversation even possible anymore? The inevitable part where we “pay the tab” and experience diminished future growth will probably become a part of the market’s lowered expectations as the tax conversation becomes more real. Sometime between the current infrastructure plan and the next one, billed as a social investment, the tax picture will need to be more concrete (except for the semantic difference between a tax hike on the middle class and simply letting the Trump tax cuts roll off by 2027). That is not to suggest one political party is entirely virtuous. They appear to be a duopoly of half-truths and slight-of-hand in delivering to their respective bases.
Tax rates, regulatory pressures, an uncertain business/investment environment, legislative changes, and compassionate incentives that contort labor markets may serve to hurt those for whom much of the extraordinary stimulus plans and safety net expansions were designed to help. In an uncertain environment, business is more likely to invest in systems and automation, rather than human resources. Even if businesses want to hire, there are still many people who make more not working due to unemployment enhancements. The ride share companies Uber and Lyft are having a hard time finding enough drivers. We wonder if they make more being at home, rather than by working. Their human resource challenge is a bit shocking because for those who use these services, how much less are you spending on rides these days as compared to a couple of years ago? Perhaps it is a chicken and egg situation (not enough fares result in fewer drivers – making the services inconvenient with longer wait times and fewer ride choices). We run the legitimate risk of having a soft employment environment on both the supply and demand side of the equation. Employers will be cautious to hire, and workers may make more on unemployment, or the jobs that are out there do not equate to full employment. Work ethic may soften, and skill sets may become stale, causing longer-term economic difficulties for some workers. Independent of “quality of labor” issues, green energy pursuits may increase transportation fuel and home energy costs, which are meaningful influences on the disposable incomes of many middle class and low-income families. Stimulus dollars are pushing up prices for some goods and services, so those who are left behind in the labor market could lose even more purchasing power and quality of life. The risk of hurting those we are collectively seeking to help seems to be a probable outcome.
An extreme outlier of the current effort to reward work over wealth would be a scenario where we monetize debt to a level, and for unproductive purposes, that the value of the U.S. dollar and the economic engine that powers it becomes debased, effectively expunging debts. It could also serve to close the wealth gap as the dollar-based wealth of some people would become worth less on a global basis. Likely, some asset prices would inflate, especially income producing assets, so the wealth equity goals sought by some would not be fully realized. Long before then, people will move into non-dollar stores of value as a necessary wealth risk reduction tool. Crypto-currency, non-fungible tokens (NFTs), art, numismatic coins, bullion, collectables, and just about any store of value will gain in value long before the U.S. dollar sees a significant slide in value. Did you hear about the NFT from the artist Beeple that sold at Christie’s last month for $69 million? Perhaps the outlier scenario is not as far off as we might think.
The near-term end game that we are expecting is that Democrats push for the passage of a large, singular, mega infrastructure bill that will be on the order of $2.5 trillion to $3 trillion (combining the current broadly defined infrastructure bill with a social infrastructure bill). Voters of many political stripes understand the pandemic is nearly behind us, a lot of stimulus has been distributed and at a point, the reality of paying for it all does not fully escape most people even if we like to think “others” will pick up the tab. The political effort required to pass smaller bills will be herculean and it may be easier to make the political deals necessary to quickly get the infrastructure spending plan done before the questionable expenditures are brought into the public conversation.
The shock and awe of another spending plan on the order of $2 trillion to $3 trillion in the midst of GDP growth expectations exceeding 7%, could be what pushes the 10-year Treasury past the 2.0% level. We do not see a large risk that the high side of a spike in yields would go as high as 2.50%. Our basis is that the Fed’s dot plot shows that the neutral rate (the point where policy is neither accommodative nor restrictive) is 2.5% on a long-term basis. Since the dot plot was first released in 2012, it has been rare that longer-term bonds have exceeded that guidance. In the second half of the year, we expect that tax realities, workforce quality issues, safety net programs that have extended past their useful lives, and a lot of spending for consumption rather than productive purposes will result in diminished future economic expectations, driving yields lower.