We have maintained on this site that although 2012 looks to be another repeat of 2010 and 2011 there are major differences. Global central banks are lowering interest rates instead of tightening them. Oil prices are the lowest that I can recall heading into the summer driving season. U.S. banks are better capitalized than they were a few years ago, and housing isn’t acting as a drag on the economy in the way it did when the credit crisis imploded. In southern California we’re seeing both new track and custom homes being built for the first time in years. Is this the bottom? I don’t know but at least we’re seeing new construction as potential homebuyers are able to buy homes at the lowest mortgage rates in half a century.
Despite these differences investors are suffering from a case of déjà vu; it must be 2010 and 2011 all over again. After a strong first start, the economic data shows an economy that is decelerating again from the regional PMI’s to the LEI’s; they have all headed south with the financial markets not far behind. As of this day the major indexes have given back all or most of their gains for the year. The worries that plagued the market over the last two years still remain: Europe’s debt difficulties, a hard landing in China, turmoil in the Middle East, and the U.S. fiscal cliff. All of those problems still hang over the market.
However, stimulus is being poured into the economy from multiple sources. On the U.S. side motorists are being treated to a pleasant surprise. Regular unleaded gasoline prices have fallen nationally from their high of $3.936 on April 4th to today’s price of $3.585. Doesn’t sound like much but that is an extra $8-$10 a week. Food inflation has also been coming down. Consumers will have a few extra shekels to spend each week that isn’t being poured into their gas tank.
National Average Price of Gas
Source: Bloomberg
The problem lies elsewhere in Europe, possibly China, and parts of Latin America. Europe is in a recession, China’s economy is slowing down, and many of the BRIC countries are seeing economic growth soften as we are now seeing in the U.S. To make matters worse Bloomberg is reporting that their Financial Conditions Index is negative, indicating the risk of financial stress is rising. There is the possibility that a financial shock in one country could spill over into other regions of the world leading to another financial contagion. That is unless the current stress points lead to a coordinated intervention as we saw last November.
Financial Conditions Tightening
Source: Bloomberg
Comparative 10-Year Yields
Source: Bloomberg
The markets are hoping that the Keystone cops running Europe will come up with some sort of intervention that will alleviate the stress points in Europe’s banking system and in the process kick the can down the road to allow for a gradual deleveraging in the same way it has played out here in the U.S. If there is action that needs to be taken the bulk of the heavy lifting will have to come from Europe, the epicenter du jour.
As far as the Fed is concerned there isn’t much it can do other than to continue “Operation Twist”, but instead of Treasuries the Fed could announce the purchase of mortgage securities. As the graph below indicates, mortgage rates have not come down to the full extent as treasuries. Treasury yields have fallen almost 100 basis points since their peak in March compared to only a drop of 30 basis points on 30-year fixed mortgages.
10 and 30 Year Rates
Source: Bloomberg
If the purpose of QE is to lower long-term treasury yields the market has already done the Fed’s work. The “risk off” trade has prompted a flood of investor money into bond funds at record levels driving down treasury yields lower in the process. With ten year notes at 1.54% there isn’t much the Fed could accomplish at this point in announcing QE3. If any of their actions were to have impact it would be in the mortgage market or in the swap markets with Europe. The dichotomy in sovereign debt spreads has never been this great. In the U.S., yields on ten year notes are at levels last seen during the Great Depression. In Germany, we have negative short-term rates and in the U.S. one year T-bills are less than 20bps.
Investors are now faced with a dilemma. Where do they place money in an era of financial repression? Do they chase Treasury yields which are now in bubble territory? Or are there safe havens still available in the stock market? I thought I would never see the day where the yield on the Dow Industrials would exceed the yield on a thirty year Treasury bond. The current stock market correction has brought the PE multiple down to 12 on the Dow Industrials and raised the dividend yield up to 2.8%. Treasuries may be seen as a safe haven but they are also fraught with risk. What happens to the price on bond funds when yields eventually rise?
Stocks may fluctuate more than bonds but it is hard for me to want to tie up my own money or that of my clients in a bond that pays 1.5% when the inflation rate is twice that amount. I’ll take a blue chip staple like PG that yields 3.7%, Chevron yielding 3.7%, AT&T paying 5.2%, or Dow utilities yielding over 4%, with the chance to get a high single digit or double digit pay raise each year.
I’m not sure in the current environment that we live in where governments are running major deficits, debasing their currency, and central banks are monetizing debt how much that 1.5% is going to buy me ten years from now. It is a difficult dilemma that all investors have to face. How will pension plans meet their future obligations? How will private sector employees be able to retire, and how will current retirees remained retired without having to go back to work again?
As I look at my own circumstances over the last decade just about everything I need to live—food, water, electricity, gasoline—is far higher today than where it was ten years ago. The things that I don’t need to buy have become a whole lot cheaper. I can get a brand new LED TV at Costco for a lot less money than when I first bought mine. However, I don’t need to buy a new TV, a laptop, or a new cell phone every year. I do need to eat, heat and cool my home, and put gas in my car. These items have more than doubled over the last ten years and are likely to double again in this decade. I must choose as must you. The decisions we make today will determine the lifestyles we will enjoy in the future. If I had to make a bet and could not change that bet for the next ten years I believe that today’s low Treasury yields will be much higher by the time this decade ends and that PG, AT&T, and companies like Chevron will still be around paying higher dividends and sporting higher stock prices than they do today. We all must choose. What will your choice be?
