"The crisis facing fixed-income investors"

Here's a link to an important article entitled "Bonds' future fortunes are flagging," by Simon A. Lack, who is also the author of a recently-published book entitled Bonds Are Not Forever: The Crisis Facing Fixed Income Investors.

In the article, the author points out the many daunting problems facing bond investors today.  Most investors are probably aware of the main problem: interest rates are at historic lows, as they have been for years, and have been held artificially low by the actions of central bankers (mainly the US Federal Reserve), and probably will remain artificially low in the foreseeable future.  This drives down the income return for bond investors, and makes their purchases subject to the possibility of loss in market value when interest rates finally do begin to rise.

However, Mr. Lack's article articulates aspects of the situation which many investors may not fully appreciate.  He explains that "Much of the return [for bond investors] of recent years has been fueled by capital gains through falling yields on long-term bonds" but that (as even the least-engaged bond investor should now realize) "Today's yields are close to, if not at, the point where further capital gain is not possible."

He then argues that bond investment returns from interest yields alone (without possibility of capital gains) "will turn out to be confiscatory" for three reasons:

1.  Transaction costs for the retail buyer are now (and have always been) too high, with investors paying a markup representing "an unacceptably big chunk of the possible return."

2.  Nominal yields on government and investment-grade credit will not stay ahead of inflation, let alone inflation plus taxes. 

3.  Even if yields were to stay ahead of inflation plus taxes, those planning retirement have to deal with costs which will rise faster than the measured "official" rate of inflation, and because they are generally on "fixed incomes" they will be even more vulnerable (unlike those who are still working and can hope to increase their incomes to keep up).

Again, these obstacles to bond investing are not new developments: the current situation has been building for over a decade, and many are aware of the general issue (although perhaps some of the nuances which Mr. Lack explains will reveal new sides to the problem for some readers).

The most significant aspect of his article, in our opinion, is the solution that Mr. Lack proposes for investors.  While many professional investors who have recognized these long-term problems with bond investing have turned to all kinds of structured vehicles engineered to try to address the problems described above, and while individual investors are being sold all sorts of "alternative" investments supposedly designed to create stable income streams with "less risk," the article actually proposes something which we think makes more sense.

Mr. Lack asks: "So where should investors go in their search for more-reliable ways to preserve the purchasing power of their savings?  The answer is equities.  US common stocks come in many flavors, provide growth opportunities and also offer an extremely fair deal to investors in terms of transaction costs."  Many stocks offer dividend yields that are much more attractive than the income possibilities of bonds, as well as offering attractive dividend growth rates.

To offset the greater potential for volatility (and even loss) which stocks present to the investor, Mr. Lack recommends holding greater percentages of cash than might otherwise be the case.

This strategy is actually one which we have been pursuing in our income strategy investing for some time, and we believe it is sound advice in the current environment.  We believe investors should clearly understand these issues, the serious problems facing bond investors, and the different courses of action which are available to them in the situation that has developed over the past several years.

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The importance of embracing risk

Economist and technology analyst Bret Swanson published an important essay earlier this year entitled "Long Live the Risk-Takers."  It examines the vitally important subject of "risk," particularly from the economic perspective. 

While acknowledging that seeking to identify and prevent (or at least avoid) future problems is a valuable and necessary endeavor, the essay then asks:

What happens, though, when we develop a hyperfocus on shortcomings and potential losses?  What happens when we seek a public policy remedy for every perceived problem?  This kind of obsession with [eliminating] risk, danger and downside may be counterproductive.  It may exacerbate known problems and unleash dangers never dreamed of.

The danger, Bret Swanson argues, stems from the fact that in the real world, "Entrepreneurship is more likely than centralized economic management to produce innovation and wealth."  Entrepreneurship requires conditions which allow decentralized citizens, acting on their own initiative, to pursue their own goals, dreams, and creative impulses.  This kind of decentralization can be scary and unpredictable, and it will necessarily entail some failure.  In short, it is risky.

However, the article goes on to say that such risk is not merely a byproduct of innovation and growth -- it is a key component of innovation and growth, and it is in fact a beneficial part of the process.  Mr. Swanson writes:

Wealth is about creating new ideas.  New ideas can only emerge through experiments of science, technology, and enterprise, all of which must be capable of failure in order to generate newness.  Failure flushes away bad ideas and points us toward good ones.  The failures may at times harm individuals and waste resources -- people lose jobs and investments can be lost.  The larger effect, however, is to lift the economy to a higher plane of knowledge, efficiency, and resilience.

Central planners may be tempted to try to protect citizens from risk by implementing public policies that make it next to impossible for people to lose their jobs, but doing so can lead to a situation in which entrepreneurship is stifled and new businesses, new innovations, and new jobs are never created, all of which might have been created if conditions had been less stifling.  

As Bret Swanson's essay points out, this scenario is not hypothetical: many European economies have tried to do away with "risk" over the past several decades, only to throttle the ability of decentralized citizens, acting on their own initiative, to pursue the risky path of innovation and growth.  By trying to eliminate risk, danger, and downside, these countries have made their economies less diverse, creative, and resilient -- and now their citizens are suffering because of it.

In his most recent book, Knowledge and Power, visionary author George Gilder takes this observation even further, arguing that the expansion of wealth comes "through the conduct of the falsifiable experiments of free enterprises".  He explains: "Crucial to this learning process is the possibility of failure and bankruptcy." 

His book explores the importance of information and knowledge, and the fact that information is inherently decentralized -- meaning that dispersed individuals will always possess more information about certain subjects than even the most efficient central planners, and that therefore decentralized citizens must be allowed to act on their own initiative, and pursue their own goals and dreams using the information at their disposal.  In fact, in his book, he defines information at its most basic level as "surprise," which goes a long way towards explaining why central planners, even at their most efficient, can never corner the market on information and knowledge.

This subject, of course, has profound implications for the investor.  For one thing, we have long argued that investors should view their investing activities as the allocation of capital to businesses, and there are many ways that they can use the insights of George Gilder and Bret Swanson discussed above to seek out businesses that are creating "surprise" in their field.

Investors should become concerned when they see central planners moving in a direction that inhibits the ability of businesses and individuals to create surprise and (in Bret Swanson's words) "generate newness" -- a process which can only happen when there is a possibility of failure.  There are signs that, for a variety of reasons, central planners in many parts of the world (including the United States) are implementing policies that try to eliminate risk, even though such policies in reality only create bigger problems in the long run.

While investors may not have much control over the direction taken by policy-makers, they can and should consider the above discussion on the subject of risk, and realize that the temptation to try to eliminate risk can actually be more hazardous than embracing risk.  We have written on this subject in the past, such as in our article from June of this year discussing the dangers of municipal bonds (which many investors consider a sort of nearly "risk-free" investment), or this reflection from four years ago this month examining the reason investors think of venture capital investing as inherently more "risky" than real-estate lending, when in fact the opposite may be true.

In short, we believe that both Mr. Swanson's article and Mr. Gilder's book deal with an extremely important subject for investors to ponder deeply, and that both should be considered "required reading."  It may be understandable that at this point in history, elected officials and the investing public at large are reluctant to embrace risk.  Nevertheless, we believe that a correct understanding of the concept of embracing risk has never been so important.

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Don't Get Caught Up in the Fray!

As the calendar turns from summer to autumn the dreaded months of September and October, historically the weakest months for the stock market, are facing investors, there is plenty of outside news to make even the most steely market veterans queasy.  On the minds of most citizens in the United States, let alone investors, is the question of whether or not there will be an escalation of U.S. military involvement in the Middle East.  As of this writing, the Obama Administration is heavily lobbying the U.S. Congress to approve a strike against the Assad Government in Syria, apparently as "punishment" for the regime's use of chemical weapons against its own population.  We have no expertise in handicapping what the response of the Congress will be, and even less with respect to what the Obama Administration will ultimately choose to do, irrespective of the vote in Congress.   We will also not opine on the merits of such an "activity".

What we can say is that history is fraught with military endeavors and the market has either initially sold off only to recover shortly (1991 Iraqi invasion of Kuwait, Afghanistan War in 2001, Iraq War 2003), or it has ignored the actions altogether (U.S. and British bombing of Libya in 2011, NATO bombing of Yugoslavia in 1999).  For sure, the more prolonged a military conflict becomes, the more likely the market will react sluggishly, at best, or negatively, at worst.  It seems likely that any action taken by the U.S. against Syria will be short-lived and limited in consequences, at least in the short to intermediate term.  Therefore, we would expect the effect of any action on the market will also be short-lived.

The problem that this current pending military engagement presents is that it comes after a dozen years of prolonged conflict that the U.S. has been involved in both in Afghanistan and Iraq; and the citizenry, including the "investor", is weary of the danger that another prolonged conflict could be in store if action in Syria should go poorly.  It is very important that we make the point here that we believe war is NOT good for the economy, which is contrary to what many often believe.  Besides the obvious human tragedy that war encompasses, it strains the economy in that resources which would normally go towards investment in productive, entrepreneurial activity are instead redirected towards destroying things and killing people.  Sure, the defense industry may benefit, but this is the ultimate "zero-sum game".  We would argue that much of the reason that the market has struggled over the last dozen years is at least partially due to the enormous economic AND emotional cost of the wars in which the U.S. has been embroiled.

This is not an indictment of the defense industry.  Yes, there have been many technologies that have emanated from research and development in defense and have ultimately been commercialized, thereby aiding economic growth.  However, the most valuable of scalable technological advancements have come from private investment in areas such as microprocessors, software, and bio-pharmaceuticals.

What is most important to recognize is that while war may well have served to suppress the economy and market in recent years, the economy has managed to grow in spite and many more advances in technology have occurred in mobile, 3-D printing, biotechnology, etc.  And while the market has made little progress over the past dozen years, it is that very fact that likely means any significant downturn is less likely to happen, or to last long if it were to occur at all.  Therefore, as events unfold in the Middle East in coming weeks, regardless of what transpires, it would be wise not to get caught up the the "fray"!

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The boy who cried wolf: Economy growing in spite of monetary policy, not because of it

                                                                                                                                                             

Recently, the Federal Reserve issued a statement in which the members of the committee downgraded their description of the expansion of economic activity in the US from "moderate" to "modest" and reiterated their intention of keeping the zero interest-rate policy in effect for "a considerable time."  They also kept in place their ongoing quantitative easing policy, known as QE3 (sometimes nicknamed "Q-Eternity").

While the stock market response to this ongoing dovish sentiment from the Fed has been generally positive, we believe that the continuation of what were originally billed as "emergency measures" to address the 2008-2009 financial panic is unhealthy for the economy and the markets.  

We have written many times previously that the Fed should not be attempting to "steer" the economy.  Most recently, we discussed this problem in a blog post published towards the end of June, which contained links to the many previous posts which warn against the dangers of Fed "over-steering."

Even if the Fed does not decide to get out of the business of trying to steer the economy, we also believe that continuing to steer the economy as if it is in the middle of a major financial panic is inappropriate and potentially dangerous, just as it would be inappropriate and dangerous to drive your car as if you were always in the middle of an action movie car chase rather than simply going to work or going out to get coffee.

We have written about this problem before as well, such as in this post from last year entitled "Growing the economy, part 1: Get off a 'war footing' with monetary policy."  We know that central planners and policy-makers generally like to act as though we're always in the middle of an existential crisis (like a war): witness the "War on Poverty" and the "War on Drugs."  Such a mentality can induce the people to accept greater levels of intrusion into their lives from the governing bodies.  However, if such behavior is used all the time, it becomes a serious distraction to the normal, healthy functioning of individuals and businesses who are just going about their business and leading their lives.

At the risk of adding one too many metaphors, it's like the story of the "Boy who cried wolf."  After a while, the farmers got tired of dropping whatever they were doing and running to save the little boy's sheep from a wolf that wasn't really there.  All that running around took them away from their own business of the day.

While some would argue that the US economy has been in need of life support since 2008-2009, and that in such dire straits an endless "emergency status" is appropriate, we believe that the economic numbers have shown and continue to show steady, if painfully slow, economic growth.  We would also point to the analysis of professional economists whom we respect, such as Brian Wesbury, who argue that monetary policy gimmicks are not the way to grow the economy, and don't address the real issues that have been stunting economic growth in the US.  

In a recent note published on July 31, Mr. Wesbury wrote:

As we have written many times before, QE3 is simply adding to the already enormous excess reserves in the banking system, not dealing with the underlying cause of economic weakness, including growth in government, excessive regulation, and expectations of higher future tax rates.

Mr. Wesbury has coined the term "plow-horse economy" for the slow but steady progress that the economy has been making since 2009, and recent economic data such as the latest ISM manufacturing number and data showing continued gains in employment rates appear to support such a description.  The main reason the "plow horse" is not moving faster is that government has been weighing it down with additional regulation and costs, and these cannot be addressed with monetary policy from the Fed.

In fact, inappropriate "emergency" monetary policy actually acts as another load that weighs down the plow horse.  As another economist, Scott Grannis, writes in a post published on August 1 and entitled "A decent manufacturing report trumps QE," recent economic data:

casts serious doubt on the assumption that many observers have made that the Fed has been artificially lowering interest rates and in the process distorting the capital markets and artificially stimulating the economy.  As I've asserted for a long time, the Fed's QE program has been designed not to stimulate the economy but to accommodate the world's intense demand for money and cash equivalents.  And not only has monetary policy not been stimulative, but fiscal policy has been acting like a headwind to growth, since its emphasis has been on redistribution, huge new regulatory burdens (e.g., Dodd-Frank, Obamacare), and higher taxes.  In short, what we are seeing is that the economy has been growing in spite of monetary and fiscal policy, not because of it.

We believe these are very important insights from economists to whom investors should pay close attention.  Their analysis supports the assertions we make above that the Fed's continued zero-interest-rate policy and quantitative easing are inappropriate "oversteering" and that the sooner these policies end, the better.

Investors should also note that many stock market participants wrongly believe that the Fed's ongoing "emergency measures" are a good idea.  When those policies are finally removed, there may well be some serious negative reactions in the stock market.  However, we believe that any tantrums the market throws when the Fed finally ends these inappropriate policies will be outweighed by the longer-term benefits of getting these policies out of the way of real growth.

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Federal spending drops sharply in the US, leading to a budget surplus for June 2013



Recently, economist Scott Grannis published a post on his Calafia Beach Pundit blog entitled "Budget outlook improves dramatically."   In his post, he notes that:

especially in the last 12 months, there has been a dramatic improvement in the federal budget outlook.  Revenues have grown at double-digit rates of late, while spending has slumped.  As a result, the budget deficit has plunged, both in nominal terms and relative to GDP.  Almost two-thirds of the decline in the burden of the deficit since 2009 has come from the spending side, and that is good news since it leaves more room for the private sector -- the source of most productivity gains -- to expand.

His post contains some important charts which track the federal budget in terms of revenues (chiefly from taxes) and spending.  The charts show that while spending still exceeds receipts, the gap has narrowed significantly due to some recent spending cuts (including the government "sequester").  Other charts on his post show that federal spending has fallen as a percentage of GDP, from over 25% to 21.4%.  

The specific breakout of government spending outlays can be found in the US Treasury Department's most-recent Monthly Treasury Statement (MTS) which shows data through the end of June 2013.  The charts above, from the June MTS, show federal receipts in the top chart and federal outlays in the bottom chart.  While the outlays were generally higher than the receipts in most of the past twenty months, in June spending took a sharp turn lower and receipts took a sharp turn higher, leading to a surplus of $116.5 billion for the month.  Scott Grannis notes that the total spending for the twelve months ending this past June dropped 6% over the previous year -- "by far the biggest one-year decline in the past 43 years."

Brian Wesbury, another economist whose analysis like that of Scott Grannis we believe to be valuable, has commented on the June surplus in a recent piece entitled "Deficit?  What Deficit?"  There, he breaks down some of the components of the June spending drop (including some that are not really spending cuts but that the Treasury counts as spending cuts anyway), and notes that the overall federal budget deficit will probably drop to about 4% of GDP this year, down from over 10% in 2009.  Note that the deficit is the difference between spending and revenues -- that number is down to about 4% of GDP.  In contrast, spending by itself is a larger number than the deficit number -- that number is down to 21.4% of GDP.  It's important to keep those two different measurements straight, if you're not used to looking at these kinds of budget numbers.

We believe this development is actually very positive, and one that is not very well known by the general public or the investing community (Scott Grannis calls it the "most under-appreciated news that I am aware of today").  While there are of course aspects of the situation that could be much better, the fact that spending as a percentage of GDP has come down from over 25% in 2009 is very encouraging, since at that time it looked as though spending might continue to head towards an even higher percentage of GDP rather than coming down.  

It is also encouraging that the US economy (which drives tax revenues for the US government) has continued to grow, even if at a rate that is slower than we would like to see.  Brian Wesbury calls it a "plow-horse economy," as opposed to a race-horse economy.  At least it is still plodding forward.

In an environment in which many people are very nervous about the economy and in which positive economic news is not always widely reported in the media, we believe this development is extremely important and one of which investors should be aware.  

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