The Vanishing Treasury Yield

Thursday, August 2nd, 2012

by Neuberger Berman Research

July 2012 – Investment Strategy Group

Despite hitting record lows earlier in the year, the yields on U.S. Treasury bonds continue to tumble. The 10-year rate ended last month at 1.62%, materially below the long-time monthly record low of 1.95% set in January 1941. Yields for 10-year Treasury Inflation-Protected Securities (TIPS) have been persistently negative since the fourth quarter of 2011 and continue to trend lower, implying that investors are paying increasingly higher prices for the relative safety these investments are supposed to provide. In this edition of Strategic Spotlight, we consider why yields continue to decline and the implications for investors.

Download PDF

A Mystery, But Is It?
Yields on long-term Treasuries have been declining since the 1980s, when they peaked along with inflation. Since the financial crisis of 2008, the continued reduction in Treasury yields has at times perplexed even the most astute investors. One prominent bond guru famously avoided them in 2010 to the detriment of his portfolio, and pundits who prematurely declared the imminent “death” of bonds couldn’t have been more wrong. In recent years, yields have moved even lower even though inflation has held fairly steady.

Over the longer term, nominal yields for long-term Treasuries generally follow inflation levels and growth expectations. When inflation rises, nominal yields typically rise to compensate for the erosion in purchasing power and, similarly, if growth expectations rise, the increase in attractive investment opportunities in the economy tends to result in rising real (after inflation) interest rates (see Figure 1). Oddly enough, inflation expectations (as implied by the difference between the nominal 10-year Treasury yield and TIPS yield) have held steady at around 2% and the decline in nominal rates has been driven mostly by declining real yields—all in the face of a positive, albeit slow, growth environment.

REAL YIELDS AND GDP TEND TO MOVE TOGETHER

Source: Factset.

So, what explains this somewhat unusual phenomenon? Since the onset of the financial crisis, bond purchases by the Federal Reserve have increased as it has implemented unconventional monetary policies, specifically quantitative easing and maturity extension programs (known to most as Operation Twist). Through these measures, which have tended to lower long-term interest rates, the Fed has sought to stimulate the economy and reduce unemployment at a time of low inflation. Another pressure on rates has come from foreign demand for Treasuries, which has generally been very strong, especially during periods of heightened market anxiety. In recent months, slowing purchases by emerging market central banks have been offset by flight-to-quality demand from European investors, who have also driven the nominal rates on certain German, Dutch and Danish bonds to negative levels. Meanwhile, U.S. investors have shown a lack of appetite for risk as flows to bond mutual funds have outpaced those into equities.

How Low Can Rates Go?

In theory, there is no bottom for bond yields. Declining inflation and continued risk aversion have historically caused nominal rates to fall. Real yields have been significantly negative in certain time periods, although admittedly when inflation was higher than today. Figure 2 shows that there have been two key periods since the 1920s in which real rates where very negative—during the Great Depression and World War II era, and in the 1970s when inflation spiked along with oil prices. Should global economies falter in the coming months, it’s possible that interest rates could move In theory, there is no bottom for bond yields. Real yields have even been significantly negative in certain time periods. lower (even turning negative on the short end), especially if the Fed engages in another round of asset purchases.

REAL RATES HAVE ‘GONE NEGATIVE’ IN THE PAST

Source: Factset.

Better Opportunities Elsewhere

It should be noted, however, that there are major risks in holding Treasuries with little to no yield. An end to the continued bull run in Treasuries would imply a reversal of some factors supporting it now, such as low inflation, deteriorating growth expectations and worsening prospects for the eurozone debt crisis. With global central banks launching unprecedented levels of monetary easing, potentially higher levels of inflation could hamstring the Fed’s ability to continue asset purchases – causing both inflation expectations and real yields to go higher. In addition, investors may realize that Treasuries might not be as “risk-free” as they assumed, particularly as the debate over the U.S. federal budget deficit intensifies later this year.

While interest rates could still move lower in the short term, we believe that the return profile for the asset class is skewed to the downside, especially given our base-case assumption of low but positive growth. We advise caution in holding excess levels of Treasuries and believe that other assets, such as high yield fixed income and high-quality U.S. equities, could be more attractive in this environment. Similar to buying tech stocks in the late 1990s with no sales and earnings, buying today’s Treasuries with minimal yields could prove hazardous for investors.

*Source: Factset

This material is presented solely for informational purposes and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. The views expressed herein are generally those of Neuberger Berman’s Investment Strategy Group (ISG), which analyzes market and economic indicators to develop asset allocation strategies. ISG consists of five investment professionals who consult regularly with portfolio managers and investment officers across the firm. Information is obtained from sources deemed reliable, but there is no representation or warranty as to its accuracy, completeness or reliability. All information is current as of the date of this material and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole. Third-party economic or market estimates discussed herein may or may not be realized and no opinion or representation is being given regarding such estimates. This material may include estimates, outlooks, projections and other “forward-looking statements.” Due to a variety of factors, actual events may differ significantly from those presented. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.

This document is issued for use in Europe and the Middle East by Neuberger Berman Europe Limited which is authorised and regulated by the UK Financial Services Authority (“FSA”) and is registered in England and Wales, Lansdowne House, 57 Berkeley Square, London, W1J 6ER. Neuberger Berman is a registered trademark.

This document is being made available in Asia by Neuberger Berman Asia Limited (“NBAL”), a Hong Kong incorporated investment firm licensed and regulated by the Hong Kong Securities and Futures Commission (“SFC”) to carry on Types 1, 4 and 9 regulated activities, as defined under the Securities and Futures Ordinance of Hong Kong (Cap.571) (the “SFO”).

This document, and the information contained in it, is being made available in Australia by Neuberger Berman Australia Pty Ltd (CAN 146 033 801), holder of Australian Financial Services Licence No. 391401 (“NB Australia”), to a person defined as a “wholesale client” under section 761G of the Corporations Act 2001 (Cth) and applicable regulations, and other such persons to whom disclosure would not be required under chapter 6D and Part 7.9 of the Corporations Act 2001 (Cth) (“Wholesale Investor”), for informational and discussion purposes only. This document is intended only for the Wholesale Investor to which it has been provided, is strictly confidential and may not be reproduced or redistributed in whole or in part nor may its contents be disclosed to any other person (other than such Wholesale Investor’s agents or advisers) under any circumstances without the prior written consent of NB Australia.

This document, and the information contained herein, is not, and does not constitute, directly or indirectly, a public or retail offer to buy or sell, or a public or retail solicitation of an offer to buy or sell, any fund, units or shares of any fund, security or other instrument (“Securities”), or to participate in any investment strategy.

The Wholesale Investor who receives this document should not consider it as a recommendation to purchase any Securities mentioned in it. To the extent that information in this document constitutes financial product advice, it is general financial product advice only, and provided only by NB Australia to Wholesale Investors. This document does not take into account the Wholesale Investor’s investment objectives, financial situation and particular needs (including financial and tax issues) as an investor. Any Securities mentioned in this document will only be available to a Wholesale Investor to whom the provision of a disclosure document prepared in accordance with Australian law is not required. The Wholesale Investor to which this document is provided should not rely on the information contained in this document in making any future investment decision.

This document has been issued for use in Japan and Korea by Neuberger Berman East Asia Limited, which is authorized and regulated by the Financial Services Agency of Japan and the Financial Services Commission of Republic of Korea, respectively. Please visit https://www.nb.com/Japan/risk.html for additional disclosure items required under the Financial Instruments and Exchange Act of Japan.

The “Neuberger Berman” name and logo are registered service marks of Neuberger Berman Group LLC. Neuberger Berman LLC is a Registered Investment Advisor and Broker-Dealer. Member FINRA/SIPC.

Tags: Astute Investors, Attractive Investment Opportunities, Detriment, Financial Crisis, Growth Environment, Growth Expectations, Imminent Death, Inflation Expectations, Inflation Protected Securities, Investment Strategy, Neuberger Berman, Pundits, Purchasing Power, Record Lows, Relative Safety, Strategy Group, Treasuries, Treasury Inflation Protected Securities, Treasury Yields, U S Treasury, U S Treasury Bonds
Posted in Markets | Comments Off

Bill Gross: Investment Outlook (January 2012)

Friday, January 6th, 2012

Investment Outlook

Towards the Paranormal

by William H. Gross, PIMCO

January 2012

• The New Normal, previously believed to be bell-shaped and thin-tailed in its depiction of growth probability and financial market outcomes, appears to be morphing into a world of fat-tailed, almost bimodal outcomes.
• A new duality – credit and zero-bound interest rate risk – characterizes the financial markets of 2012, offering the fat left-tailed possibility of unforeseen policy delevering or the fat right-tailed possibility of central bank inflationary expansion.
• Until the outcome becomes clear, investors should consider ways to hedge their bets, including: maximizing durations, U.S. Treasury bonds that may potentially offer capital gains, long-term Treasury Inflation Protected Securities (TIPS), high quality corporates and senior bank debt, and select U.S. municipal bonds.

How many ways can you say “it’s different this time?” There’s “abnormal,” “subnormal,” “paranormal” and of course “new normal.” Mohamed El-Erian’s awakening phrase of several years past has virtually been adopted into the lexicon these days, but now it has an almost antiquated vapor to it that reflected calmer seas in 2011 as opposed to the possibility of a perfect storm in 2012. The New Normal as PIMCO and other economists would describe it was a world of muted western growth, high unemployment and relatively orderly delevering. Now we appear to be morphing into a world with much fatter tails, bordering on bimodal. It’s as if the Earth now has two moons instead of one and both are growing in size like a cancerous tumor that may threaten the financial tides, oceans and economic life as we have known it for the past half century. Welcome to 2012.

The Old/New Normal
But before ringing in the New Year with a rather grim foreboding, let me at least describe what financial markets came to know as the “old normal.” It actually began with early 20th century fractional reserve banking, but came into its adulthood in 1971 when the U.S. and the world departed from gold to a debt-based credit foundation. Some called it a dollar standard but it was really a credit standard based on dollars and unlike gold with its scarcity and hard money character, the new credit-based standard had no anchor – dollar or otherwise. All developed economies from 1971 and beyond learned to use credit and the expansion of debt to drive growth and prosperity. Almost all developed and some emerging economies became hooked on credit as a substitution for investment in tangible real things – plant, equipment and an educated labor force. They made paper, not things, so much of it it seems, that they debased it. Interest rates were lowered and assets securitized to the point where they could go no further and in the aftermath of Lehman 2008 markets substituted sovereign for private credit until it appears that that trend can go no further either. Now we are left with zero-bound yields and creditors that trust no one and very few countries. The financial markets are slowly imploding – delevering – because there’s too much paper and too little trust. Goodbye “Old Normal,” standby to redefine “New Normal,” and welcome to 2012’s “paranormal.”

2012 Paranormal
This process of delevering has consistently been a part of PIMCO’s secular thesis but “implosion” and “bimodal fat tailed” outcomes are New Age and very “2012ish.” Perhaps the first observation to be made is that most developed economies have not, in fact, delevered since 2008. Certain portions of them – yes: U.S. and Euroland households; southern peripheral Euroland countries. But credit as a whole remains resilient or at least static because of a multitude of quantitative easings (QEs) in the U.S., U.K., and Japan. Now it seems a gigantic tidal wave of QE is being generated in Euroland, thinly disguised as an LTRO (three-year long term refinancing operation) which in effect can and will be used by banks to support sovereign bond issuance. Amazingly, Italian banks are now issuing state guaranteed paper to obtain funds from the European Central Bank (ECB) and then reinvesting the proceeds into Italian bonds, which is QE by any definition and near Ponzi by another.

So global economies and their credit markets instead of delevering and contracting, continue to mildly expand. Yet there is bimodal fat-tailed risk in early 2012 that was seemingly invisible in 2008. Granted, the fat right tail of economic expansion and potentially higher inflation has existed for the 3+ year duration. QEs and 500 billion euro LTROs can do that. At the other tail, however, is the potential for “implosion” and actual delevering. To the extent that most sovereign debt is now viewed as “credit” in addition to “interest rate” risk, then its integration into private markets cannot be assured. If only Italian banks buy Italian bonds, then Italian yields are artificially supported – even at 7%. If so, then private bond markets and non-peripheral banks in particular may refuse to play ball the way ball has been played since 1971– purchasing government debt, repoing the paper at their respective central banks and using the proceeds to aid and assist private economic expansion. Instead, fearing default from their sovereign holdings, any overnight or term financing begins to accumulate in the safe haven vaults of the ECB, Bank of England (BOE) and Federal Reserve. Sovereign credit risk reintroduces “liquidity trap” and “pushing on a string” fears that seemed to have been long buried and forgotten since the Great Depression in the 1930s.

But delevering now has a new spectre to deal with. Not just credit default but “zero-bound” interest rates may be eating away like invisible termites at our 40-year global credit expansion. Historically, central banks have comfortably relied on a model which dictates that lower and lower yields will stimulate aggregate demand and, in the case of financial markets, drive asset purchases outward on the risk spectrum as investors seek to maintain higher returns. Near zero policy rates and a series of “quantitative easings” have temporarily succeeded in keeping asset markets and real economies afloat in the U.S., Europe and even Japan. Now, with policy rates at or approaching zero yields and QE facing political limits in almost all developed economies, it is appropriate to question not only the effectiveness of historical conceptual models but entertain the possibility that they may, counterintuitively, be hazardous to an economy’s health.

Importantly, this is not another name for “pushing on a string” or a “liquidity trap.” Both of these concepts depend significantly on perception of increasing risk in credit markets which in turn reduces the incentive of lenders to expand credit. Rates at the zero bound do something more. Zero-bound money – credit quality aside – creates no incentive to expand it. Will Rogers once fondly said in the Depression that he was more concerned about the return of his money than the return on his money. But from a system-wide perspective, when the return on money becomes close to zero in nominal terms and substantially negative in real terms, then normal functionality may breakdown. We all start to resemble Will Rogers.

A good example would be the reversal of the money market fund business model where operating expenses make it perpetually unprofitable at current yields. As money market assets then decline, system-wide leverage is reduced even if clients transfer holdings to banks, which themselves reinvest proceeds in Fed reserves as opposed to private market commercial paper. Additionally, at the zero bound, banks no longer aggressively pursue deposits because of the difficulty in profiting from their deployment. It is one thing to pursue deposits that can be reinvested risk-free at a term premium spread – two/three/even five-year Treasuries being good examples. But when those front end Treasuries yield only 20 to 90 basis points, a bank’s expensive infrastructure reduces profit potential. It is no coincidence that tens of thousands of layoffs are occurring in the banking industry, and that branch expansion is reversing industry-wide.

Tags: Bank Debt, Bill Gross, Bimodal, Cancerous Tumor, Different This Time, Fractional Reserve Banking, Gross Investment, Inflation Protected Securities, Inflationary Expansion, Interest Rate Risk, Investment Outlook, Market Outcomes, Mohamed El Erian, Municipal Bonds, New Duality, PIMCO, Ringing In The New Year, Treasury Inflation Protected Securities, Two Moons, U S Treasury, U S Treasury Bonds, William H Gross
Posted in Markets | Comments Off

The Real Story Behind Bond Yields (Nairne)

Tuesday, July 5th, 2011

Since peaking in 1981, yields on the government bonds of most developed nations have fallen almost continuously, as illustrated in the following graph.

This decline is due, in large measure, to the success of central bankers in reigning in inflation from the heated double-digit numbers of three decades ago. Also, oil prices fell precipitously in the 1980′s while deregulation and globalization fuelled competition and exerted downward pressure on prices.

Recent research has highlighted other causes. A McKinsey Global Institute study found that a dramatic fall-off in the level of global investment in physical assets such as infrastructure, plant and equipment since 1980 reduced the demand for capital relative to previous decades and hence, depressed interest rates. Some economists including Fed Chairman Bernanke have suggested that a worldwide shortage of safe assets, particularly in the emerging markets, reduced Treasury yields over the past decade. According to this view, this shortage has been exacerbated by the recent financial crisis.

Although many investors are aware of the challenge lower bond yields present to achieving adequate long-term portfolio returns, a focus on nominal yields (which include both a real and an expected inflation component) conceals the scope of the problem. For investors, it is real (i.e. net of inflation) bond yields that matter. The inflationary component of bond yields only offsets expected price increases. As illustrated in the following graph, real government bond yields on both short-term (in dark) and long-term (in light) Treasury Inflation Protected Securities (TIPS), the principal value of which increases with inflation, have also fallen precipitously.

Interest rates today are so depressed by the Fed’s monetary policy that investors now receive a negative real yield on short-term TIPS. Like fearful savers in the Middle Ages who paid goldsmiths to safeguard their gold, anxious investors today are prepared to pay in the form of certain real losses for the perceived safety of short-term TIPS. Meanwhile, investors in long-term TIPS who earned real returns in excess of 4% per annum just a decade ago now accept a modest real annual yield in the 1.5% range.

Tags: Bond Yields, Developed Nations, Double Digit Numbers, Downward Pressure, Dramatic Fall, Fed Chairman, Global Investment, Government Bond, Government Bonds, Inflation Component, Inflation Protected Securities, Infrastructure, Mckinsey Global Institute, Oil Prices, Physical Assets, Principal Value, Term Portfolio, Three Decades, Treasury Inflation Protected Securities, Treasury Yields, Worldwide Shortage
Posted in Infrastructure, Markets | Comments Off

QE = Wealth Redistribution

Wednesday, December 22nd, 2010

This post is a guest contribution by Dian Chu, market analyst, trader and author of the Economic Forecasts and Opinions blog.

James Bullard, President of the Federal Reserve Bank of St. Louis was on CNBC Monday, December 20, 2010 mostly defending the Fed’s controversial $600 billion Treasury purchasing program (QE2) announced in Nov.

What struck me as totally self-contradictory were Bullard’s statements regarding the QE2, treasury yield, inflation expectations, and inflation, which I will outline and rebuff below.

Bullard – Higher Treasury yield = QE2 success
During the interview, aside from the usual Fed PR spin that QE2 has been ‘modestly successful so far’, he also states:

“People who see the rise in Treasury yields as a sign the Fed’s purchases were not having their desired effect should look at other measures, especially the improvement in the economic outlook and the rise in inflation expectations in the market for Treasury Inflation-Protected Securities (TIPS). These are the ultimate goals of the Fed’s policy.”

Bullard – QE2 unrelated to rising commodity prices
But when Fred Smith, Chairman, President and CEO of FedEx asked whether QE2 was related to the run-up in commodity prices, fuel prices in particular, which has been up 15% in the last 90 days and acted as a tax on American consumers, Bullard had this to say:

“…Is there some independent effect coming from monetary policy other than supply and demand conditions globally…I haven’t seen very much evidence of that, but would like to keep an eye on that.”

So, basically Bullard touts QE2 as building up inflation expectations, driving up treasury yields (thus averting a potential deflationary cycle), which was the goal of the Fed QE2 initiative.  Furthermore, Bullard contends that global demand and supply factors are behind the record high prices across almost all commodities, which he believes is unrelated to QE2.

Higher Treasury yields – kills housing et al
First of all, the ultimate goal of the Fed’s securities purchases (QE2), as outlined by Chairman Bernanke in his speech at Frankfurt, Germany on Nov. 19, is to “lower interest rates on securities of longer maturities” to support household and business spending.

On that measure, QE2 has failed miserably. Interest rates, instead of declining, are rising rapidly driven by the bond markets and the bond vigilantes. The 10-year yield was at a low for the year of 2.4% in early October, and has shot up to a seven-month high of 3.56% the week of Dec. 12, before easing back to around 3.34% on Monday Dec. 20. (Fig. 1)

The yield on the U.S. Treasury is used as a benchmark to set interest rates on many kinds of loans including mortgages, and business borrowing rates in the capital market. So, the sharp rise in yields on Treasurys since the QE2 announcement in early November not only kills any flickering recovery sparks in the housing and other related sectors, but also raises the borrowing costs and interest payments of Uncle Sam.

Higher borrowing costs for Uncle Sam
The Congressional Budget Office (CBO) on Dec. 14 projects that under current law, debt held by the public will exceed $16 trillion by 2020, reaching nearly 70% of GDP. The CBO also projects the combination of rising debt and rising interest rates to cause net interest payments to balloon to nearly $800 billion, or 3.4% of GDP, by 2020 (Fig. 2).

U.S. debt downgrade – more than a warning
Now, the U.S. is at a stage where the downgrade of U.S. sovereign debt rating seems closer to reality than ever before. Although most have dismissed the downgrade initiated by China’s Dagong Credit Agency back in July, CNBC reported that this time around the U.S. Treasury Dept. is going to meet with Moody’s and other agencies in January, 2011 to make its case to prevent a downgrade from the current AAA status.

CBO’s debt and interest payment projection assumes that US borrowing cost will remain reasonable. However, a credit downgrade and/or further loose monetary policies along with continued over-spending will only prompt bond markets and bond vigilantes to demand even higher interest rates resulting in much higher interest payment than the current projections, reminiscent of the 80’s when bond yields were in double-digit.

Expectation drives inflationWhen it comes to inflation expectations, I’m actually in agreement with Bullard that the Fed has been successful in driving it up, which is reflected in the TIPS yield as well as the steepening yield curve (Fig. 3). However, as Bernanke himself puts it:

“The state of inflation expectations greatly influences actual inflation and thus the central bank’s ability to achieve price stability.”

Since the Fed hinted at QE2, commodity price inflation has surged at a record pace during the past six months (Fig. 4)  The manifestation of inflation is a combination of many factors including but not limited to expectations, which drives behavior, as well as supply and demand factors.

So, for Bullard to “take credit” for driving up inflation expectations, but ignore its inflationary effect on commodity prices is illogical as well as self-contradictory.

QE liquidity not flowing where it’s needed most
The bottom line is this: Unlike China where its central government can mandate banks to actually lend to business and individuals, Fed’s two rounds of QE liquidity did not go to where it’s intended; it is instead trapped on banks, and corporations’ balance sheets.

U.S. banks have been holding about $1 trillion of excess reserves for the last two years, while American corporations are flush with $3 trillion in cash.

What do they use this money for? Banks and institutions with access to the Fed’s cheap money are pumping up commodities and stocks to make their quarters, while corporations, facing higher input costs in the form of runaway commodity prices, are busy engaging in M&A’s (which typically means “job rationalization”), and share buybacks to juice up earnings per share.

Meanwhile, stagnant wage and hiring trends failing to keep pace with skyrocketing food and energy costs for consumers, coupled with higher input costs, such as fuel, hitting companies’ bottomline, will only further cut into growth prospects, and the purchasing power of consumers and even their overall standard of living.

QE = wealth redistribution
The concern of deflation is entirely overblown (thanks to Bullard’s research paper warning of a Japanese-style deflation in the U.S.) and the Fed jumped the gun. In a way, the Fed’s QEs are a form of wealth redistribution from taxpayers to banks, institutions and corporations.

The liquidity has created an artificial financial market where a disproportionate minority is benefitting through higher stock and commodity prices (without producing much output and benefit to the real economy); while the majority suffers higher input costs for essential items like food and energy.

Food and energy are some of the things that affect every consumer’s daily life and pocket book, but are excluded from the core inflation calculation, a key measure on Fed’s watch list.  This bias would only further misrepresent true inflation pressures, misguiding Fed’s future policies, and result in a net loss for the economy over the long haul.

Source: Dian Chu, Economic Forecasts and Opinions, December 21, 2010.

Tags: American Consumers, Cnbc, Commodities, Commodity Prices, Demand And Supply, Economic Forecasts, Economic Outlook, Federal Reserve Bank, Federal Reserve Bank Of St Louis, Fedex, Fred Smith, Fuel Prices, Global Demand, Inflation Expectations, Inflation Protected Securities, James Bullard, Market Analyst, Supply Factors, Treasury Inflation Protected Securities, Treasury Yields, Wealth Redistribution
Posted in Commodities, Credit Markets, Markets, Outlook | Comments Off

What to Expect When You’re Expecting … Returns

Wednesday, December 1st, 2010

Real Return Expectations

By Michael Nairne, Tacita Capital Inc.

There is nothing more important to long-term investors than real returns. Real returns – returns net of inflation – are what eventually fund consumption. The inflationary component of returns only offsets price increases.

Investors can lock in a certain real return through Treasury Inflation Protected Securities (TIPS). The principal value of TIPS increases with inflation (or decreases with deflation) and interest is paid bi-annually on the adjusted principal. At maturity, investors are paid the adjusted principal or original principal, whichever is greater. Unfortunately, the current yield on a 10-year TIP bond is a paltry 0.74%, far below its average since 2003 of 1.9%.

Unlike TIPS, the future real cash flow from stocks is uncertain. However, a number of academic studies have found that long-term real returns are somewhat predictable as stock market prices exhibit a tendency to revert to levels determined by fundamentals such as corporate earnings. In this regard, the following exhibit sets out the real earnings yield – the inflation-adjusted, 10-year smoothed earnings divided by price – of large company U.S. stocks since 1926.

Since earnings are the engine that drives both dividends and capital gains, the real earnings yield is a useful valuation measure of stocks. As illustrated, the real earnings yield as of September, 2010 is 4.9%. In essence, investors in U.S. large company stocks today are prepared to pay $1.00 for every 4.9 cents of real earnings. This is substantially higher than the record low yield of 2.3% in December, 1999 when euphoric investors pushed stock prices to delusional extremes during the technology boom. However, it is well below the long-term, average real yield of 6.7%.

Low real earnings yields historically have been associated with lower, real (i.e. inflation adjusted) stock returns in subsequent years. Conversely, high real yields have been associated with higher realized real returns. This is illustrated in the following scatter diagram which compares the monthly real earnings yields of large company U.S. stocks from January 1926 to October 2000 with the annualized real return actually earned over the subsequent ten years.

The upward slope of the graph clearly illustrates that as real earnings yields increase so does the real annualized return over the subsequent ten years. However, there is a dispersion of return outcomes related to most yield levels because market valuations can stay at extremes – either high or low – for protracted periods of time. Also, the return of any ten-year period is heavily influenced by the state of that market at the end of the 10 years. For example, negative real returns are most frequent when the ten-year period terminates in a bear market.

Tags: Academic Studies, Capital Gains, Company Stocks, Corporate Earnings, Current Yield, Deflation, Earnings Yields, Extremes, Inflation Protected Securities, Offsets, Price Increases, Principal Value, Return Expectations, Stock Market Prices, Stock Prices, Stock Returns, Tacita, Technology Boom, Term Investors, Treasury Inflation Protected Securities
Posted in Markets | Comments Off

Economy and Bond Market Diary (November 8, 2010)

Saturday, November 6th, 2010

The Economy and Bond Market Diary (November 8, 2010)

The Federal Reserve implemented phase two of its quantitative easing program this week, announcing an additional $600 billion of Treasury bond purchases. The surprise to the market is what the Federal Reserve will be buying. The Fed is focusing its purchases primarily in the 2 to 10-year Treasury range and less on the long end of the market. The bond market reacted accordingly with 5 to 10-year Treasuries rallying as yields fell as much as 12 basis points. Meanwhile the 30-year bond sold off, pushing yields up by 14 basis points.

Strengths

• The Federal Reserve followed through on the much anticipated quantitative easing program, more or less meeting investor’s expectations.
• The October employment report was much better than expected. The economy created 151,000 jobs and the prior two months were revised higher as well.
• The ISM Manufacturing Index unexpectedly rose to its highest level since May.

Weaknesses

• Retailer’s same store sales for October were generally disappointing, rising a modest 1.5 percent.
• The housing crisis continues as Standard & Poor’s estimated that the total cost for the bailout of Fannie Mae and Freddie Mac could be $685 billion. Standard & Poor’s also reported that large U.S. banks could experience losses of up to $31 billion if forced to buy back mortgage securities.
• Central bankers around the world are taking a different approach than the Federal Reserve as the Bank of England and the European Central Bank both kept monetary policy unchanged. In addition, Australia raised interest rates this week.

Opportunities

• Inflation is unlikely to be a problem for some time and this gives central bankers and other policy makers around the world room for expansive policies.

Threats

• Inflation expectations as measured by Treasury Inflation-Protected Securities (TIPS) spreads have risen sharply this month. Inflation expectations will be key data points to drive Fed policy changes going forward.

Tags: 10 Year Treasury, 30 Year Bond, Bailout, Bank Of England, Basis Points, Bond Market, Employment Report, Fannie Mae, Fannie Mae And Freddie Mac, Fed Policy, Freddie Mac, Inflation Expectations, Inflation Protected Securities, Ism Manufacturing Index, Key Data, Market Diary, Mortgage Securities, Phase Two, Treasury Bond, Treasury Inflation Protected Securities
Posted in Markets | Comments Off

Rob Arnott: Tried and True Strategies (Transcript)

Sunday, October 24th, 2010

Consuelo Mack WealthTrack – October 15, 2010

CONSUELO MACK: This week on WealthTrack, Financial Thought Leader and Great Investor Rob Arnott created fundamental indexing plus the first global funds to actively invest in all asset classes. What is this financial innovator cooking up now for better investment returns? Research Affiliates’ Rob Arnott is next on Consuelo Mack WealthTrack.
Hello and welcome to this edition of WealthTrack. I’m Consuelo Mack. Can you really create a better mousetrap as an investor so you will have enough proverbial cheese to see you through a lifetime? Well, that is a question we try to answer every week on WealthTrack, and it turns out there are some old-fashioned solutions and there are some intriguing new ones, which we will discuss with this week’s guest.
The years 1999 to 2009 were financially devastating to many investors. They were called “the lost decade” because the benchmark U.S. stock market, the S&P 500, lost money over the period, and widely followed global stock indexes barely made money, averaging under 1% annualized returns. So much, we thought, for the notion of stocks for the long run, and therein lies the problem. Too many of us relied too heavily on stocks. Had we truly diversified across many asset classes and countries, we would have made money.
Emerging market bonds delivered nearly 11% annualized returns; Treasury inflation protected securities or TIPS nearly 8%; long Treasury bonds delivered 7.6% a year; high-yield bonds 6.7%; real estate investment trusts or REITs more than 10%; and commodities a little over 7%.
But this week’s guest says investors made another costly mistake: investing in capitalization-weighted indexes. Now, these are the very popular index funds based on the market prices of the stocks, bonds or other securities that make up the index. Rob Arnott and his firm Research Affiliates have created an alternative. They were recently awarded the patent for “fundamental index” methodology. It replaces market value with four fundamental financial measures. Instead of stock price, the companies are valued on sales, cash flow, dividends and book value. And when Arnott back-tested the Research Affiliates Fundamental Indexes, RAFI for short, in different asset classes, they outperformed the old cap-weighted indexes over the decade.
For example, the large company U.S. Fundamental Index delivered nearly 5% annualized returns, the Global Fundamental Index nearly 8% returns on average, and the Emerging Market Fundamental Index came in with 19% annualized returns over the decade.
Research Affiliates is one of WealthTrack’s sponsors, but its chairman and founder, Rob Arnott, is considered to be one of the industry’s financial thought leaders. Editor of several highly respected financial journals with more than 70 published articles, he is also an industry innovator, creating several widely used products. I asked him what led him to fundamental indexing.

ROB ARNOTT: Well, the genesis for this actually goes back to a friend of mine, George Cain, who used to run the Common Fund, commingled university endowments, and he sat on a number of state boards and was horrified in the year 2000 as he saw more and more money being pushed into the ultra-high multiple growth stocks, the Ciscos of the world, even the Pets.com of the world, these companies that had no plausible way to earn enough money in the future to justify the then-current prices. And they became a larger and larger part of the portfolio, only because they were so expensive. He thought there had to be a better way. Why on earth should a popularity-weighted index be a good idea?
So why don’t we use company sizes and anchor to contra trade, bring the growth stocks down to their economic size, take the value stocks up to their economic size and just use that as an anchor for rebalancing. It seemed to us at the time that this is something that probably ought to work, as in probably ought to add some value. It never occurred to us how much value would be added.

CONSUELO MACK: As you’ve written to your clients, the lost decade from 1999, from 2000 to 2010 was not a lost decade at all, depending on how you had invested.

ROB ARNOTT: Right. And so cap weighting was one very big problem, especially in that decade because that decade was book-ended by two crises: one, what’s called the TMT bubble, the technology-media-telecom bubble and crash, and then the 2009 financial services, industrials, consumer discretionary anti-bubble, where they were collectively priced as if they might all disappear as industries. Well, how is that going to happen? Then, the snapback for the survivors. True, there were some that didn’t make it, but the snapback for the survivors was so vigorous that buying in at the bottom, when everyone was terrified, was actually a very profitable thing to do. Fundamental index gives you an objective basis to do the uncomfortable- to trim the popular, the comfort stocks, the safe havens, the growth stocks and to buy into whatever is most deeply out of favor.

CONSUELO MACK: Now the market capitalization indexes, and a lot of our viewers I’m sure have owned market capitalization index funds.

ROB ARNOTT: Of course they do.

CONSUELO MACK: And certainly some legendary individuals in the investment sphere, Jack Bogle comes to mind.

ROB ARNOTT: One of my heroes.

CONSUELO MACK: Vanguard has been a huge proponent of market cap indexes. Number one, do you know how Jack Bogle feels about fundamental indexation, and number two, do you think that the market capitalization is so flawed that it should actually be a disservice for investors to be invested in them?

ROB ARNOTT: I don’t think it’s a disservice at all. Firstly, Jack Bogle is one of my heroes. I started Research Affiliates a few months after having dinner with him knowing that he’d started Vanguard at roughly the age I was when we had dinner. So in many ways he’s my inspiration.
Jack was a pioneer. He is absolutely right that if you’re not invested at the market weight, you’re making a bet relative to the market, and for me to make a bet, somebody has to be on the other side of that bet. So for me to win, there has to be a loser. Okay. Who is that loser? It’s a zero sum game in terms of value added. But if you can identify who the loser is, maybe you’d have some more confidence in your ability to add value. The loser is the trend-chasing, comfort-seeking investor. Are there trend-chasing, comfort-seeking investors out there? Yes, legions of them. The market doesn’t reward comfort. It rewards discomfort.
One of the fascinating nuances of fundamental index is that while it has a value tilt, it makes most of its money not from a value tilt but from contra trading against the markets’ constantly changing opinions. And the value tilt, while it’s a little bit uncomfortable- you’re investing in companies that are out of favor and are cheap, and some of them deserve to be cheap- the uncomfortable part of fundamental index is what makes the most money, and that’s the trading.

CONSUELO MACK: What were some of the lessons that you learned and that we should take away from that crisis and the crisis itself and this very fast recovery as far as the markets are concerned afterwards?

ROB ARNOTT: The main lessons I think are ones that the markets teach us again and again and again. Warren Buffett says we should be greedy when others are terrified, terrified when others are greedy. Early 2009, the investment community was terrified. I was terrified. But I knew it was a great time to take risk because people were terrified of risk. A year after this the market recovers, heroically. I almost said handsomely. It was better than that. And you have so many investors, professional investors, who think, oh, thank goodness the financial crisis is behind us.

CONSUELO MACK: You don’t think so?

Tags: Asset Classes, China, Commodities, Consuelo Mack, Costly Mistake, Emerging Market Bonds, Fundamental Indexing, Global Funds, Global Stock, High Yield Bonds, Inflation Protected Securities, Real Estate Investment, Real Estate Investment Trusts, Real Return Bonds, Research Affiliates, Rob Arnott, Stock Indexes, Stocks Bonds, Thought Leader, Treasury Bonds, Treasury Inflation Protected Securities, U S Stock Market, Wealthtrack
Posted in China, Markets | Comments Off

The Economy and Bond Market Diary (October 25, 2010)

Saturday, October 23rd, 2010

The Economy and Bond Market Diary (October 25, 2010)

Treasury bond yields were little changed this week as the market focus shifted to corporate earnings releases instead of economic data. Expectations continue to build for the Fed Reserve to announce some form of quantitative easing (QE) on November 3 and two Fed officials commented on the likely path the Fed would take. Both speakers indicated a QE program of roughly $100 billion per month or, possibly, the amount could be decided at each Federal Open Market Committee (FOMC) meeting, which occur roughly every six weeks. This incremental approach has pros and cons but may disappoint market participants who favor a “shock and awe” approach of a large upfront commitment of $500 billion to $1 trillion.

Strengths

• Fed officials reiterated views that additional quantitative easing was likely and an announcement could come as soon as November 3.
• China’s economy grew 9.6 percent in the third quarter and continues to be a bright spot for world economic growth.
• Housing starts hit the highest level in five months in a sign of possible housing market stability.

Weaknesses

• U.S. economic data was mixed this week with industrial production declining for the first time since June 2009.
• China raised interest rates for the first time since 2007, largely in an attempt to offset some of the loose monetary policy that is being imported into the country.
• Brazil and Thailand increased taxes on fixed income securities for foreign investors to dampen inflows into the country as the so-called “currency war” heats up.

Opportunities

• Inflation is unlikely to be a problem for some time and this gives central bankers and other policy makers around the world room for expansive policies.

Threats

• Inflation expectations as measured by Treasury Inflation-Protected Securities (TIPS) spreads have risen sharply this month. Inflation expectations will be key data points driving Fed policy changes going forward.

Tags: Brazil, China, China Raised Interest Rates, Corporate Earnings, Country Brazil, Currency War, Fed Officials, Fed Policy Changes, Fed Reserve, Federal Open Market Committee, Fomc Meeting, Foreign Investors, Incremental Approach, Inflation Expectations, Inflation Protected Securities, Market Diary, Market Participants, Market Stability, Open Market Committee, Shock And Awe, Treasury Bond Yields, Treasury Inflation Protected Securities
Posted in Brazil, China, Markets | Comments Off

Back to Zero: Deflation Fears Emerge (Sonders)

Wednesday, August 4th, 2010

This article is a guest contribution by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.

Key points

• Deflation now, inflation later?
• Double-dip fears are subsiding … will that ease deflation fears?
• Investors need to understand deflation risk’s impact on markets.

Although the fears about inflation have unquestionably subsided, I’m still surprised how often I get questions about its perceived inevitability … regardless of any actual evidence that it’s here or near.

Deflation, a scarier prospect, frankly, than even hyper-inflation, has emerged as a key worry. It may help to explain the market’s bouts with indigestion this year, as well as valuations that are not keeping pace with stellar earnings growth.

Fortunately, deflation is fairly rare, and is typically associated with a Depression-like plunge in demand of all stripes. Prices not only fall during deflationary periods but, typically, so do asset prices and incomes. In response, interest rates tend to fall to rock-bottom levels, which on the surface may seem like a good thing.

But here’s the rub: Even though the Federal Reserve has typically lowered rates aggressively, the cost of servicing debt for many remains elevated given that the plunge in asset prices disallows refinancings. Does this all sound familiar?

(click play to listen)

Liz Ann talks about deflation fears
August 2, 2010

Inflation fears plummet

As you can see in the chart below, inflation expectations, as measured by the yield on five-year Treasury Inflation-Protected Securities (TIPS), have plummeted from the peak in late-2008 when inflation fears were full-blown thanks to the Fed’s stimulus.

Low inflation expectations

Click to enlarge
Source: FactSet and Federal Reserve, as of July 29, 2010.

TIPS’ yields are clearly not negative, but for some they’re too close for comfort.

Why buy/invest now?

Deflation halts every variety of activity as consumers, business and investors go into postpone mode due to the expectation that prices/costs will be lower in the future—that’s why it’s so toxic to economic growth. Add to that rates typically already at rock-bottom levels, and the Fed is left in a bind without its traditional policy lever to pull.

Tags: Asset Prices, Bouts, Brazil, Charles Schwab, Chief Investment Strategist, Deflation, Double Dip, Earnings Growth, Factset, Federal Reserve, India, Indigestion, Inevitability, Inflation Expectations, Inflation Fears, Inflation Protected Securities, Keeping Pace, Liz Ann, Senior Vice President, Stellar Earnings, Treasury Inflation Protected Securities, Valuations
Posted in Bonds, Brazil, China, India, Markets | Comments Off

Inflation expectations are jointly falling?

Wednesday, July 14th, 2010

As a global economic slowdown is very likely underway, inflation expectations are being watched closely.

David Beckworth comments on inflation expectations in the US using the Treasury Inflation-Protected Securities (TIPS) market (he commented previously on an alternate measure of inflation expectations at the Federal Reserve Bank of Cleveland). He argues that the aggregate demand effect is the dominant factor dragging US inflation expectations.

However, inflation expectations are falling globally. The chart above illustrates the 10-yr break-even expected inflation rates for the UK, Germany, Canada, Italy, and the US using their respective inflation-indexed bond markets (TIPS in the US). Notably, declining inflation expectations is not specific to the US.

Of interest, the onset of the downward trend across break-even inflation rates coincides with policy announcements in Europe:

1. the bailout of Greece, and
2. the European Financial Stability Facility (EFSF)

Tags: Aggregate Demand, Austerity Measures, David Beckworth, Dominant Factor, Export Income, Federal Reserve Bank, Federal Reserve Bank Of Cleveland, Fiscal Austerity, Germany Canada, Global Economic Slowdown, Indirect Impact, Inflation Expectations, Inflation Indexed Bond, Inflation Protected Securities, Inflation Rates, Market Participants, Policy Announcements, Treasury Inflation Protected Securities, Uk Germany, Uk Inflation
Posted in Bonds, Canadian Market, Markets | Comments Off