Quarterly Review and Outlook by Van Hoisington and Lacy Hunt
Below, I summarize my takeaways from the quarterly review by the Hoisington Investment Management Company. I like these letters because they take an extremely long view and have been reliably contrarian (e.g. predicting lower interest rates even after the Fed had brought down the ST interest rates near 0 after the financial crisis). Below, I summarize the letters that I have read. I have skipped the ones that didn’t contain any new lessons for me.
Treasuries are under-valued because of the 4 mis-perceptions:
- Recent downturn will give way to improving conditions and higher bond yields: Wicksell effect says that when market rate of interest (best estimated by Baa corporate yield) exceeds the natural rate of interest (best captured by nominal GDP), funds are drained from income/spending to pay the financial obligations of the debtors. This relationship tells us that the Wicksell effect is a constraint on growth as Baa corporate yield is 4.8% vs. GDP of 2.6%.
- Intensifying cost pressure will lead to higher inflation and this higher yield: Four reasons given and why they’re wrong below –
- Increases in cost of medical care will only lead to shift of earning from other discretionary items into healthcare.
- Labor market measures continue to show substantial slack. GAO study shows that up from 35.3% in 2006, 40.4% of the workforce is now doing temporary jobs, now having become a permanent category, with earnings roughly 1/2 of that of a person with steady full-time job. Plus, these hours puts an upward bias on average hourly earnings due to difference in hours worked between full-time and contingent workers.
- After peaking in Q313, Profits (after tax), adjusted for inventory gains/losses and over/under depreciation have fallen by 16% (sources from the BEA). Furthermore, productivity has hit the lowest point in decades. These, combined, suggests that firms are more likely to cut salaries, not raise them.
- Finally, inflationary cycles DO NOT typically start with rising cost pressures. Rather, inflationary cycles are characterized by “money, price and wage spiral” and in that order. This implies that money growth is accompanied by a stable/declining velocity of money, which will cause aggregate demand to pul prices higher, which will lead to wage inflation. This upturn leads to a spiral when this higher prices and wages by another even faster growth in money (I don’t understand how/why this would happen).
- Inevitable normalization of federal funds rate will work its way up along the yield curve: productivity of debt has a far more important influence on velocity of money, but nonetheless, higher interest rates will cause lower velocity and weaker growth and will give Fed a pause as they raise rates.
- The bond market is in bubble and will crash: In the past 145 years, real long bond yield has averaged 2.1%. With the recent nominal yield of 3.1% and inflation of 0.1%, real yield stands at 3%.
Falling productivity does not cause faster inflation. Weaker output/hr is as much a consequence of over-debtedness as other factors (e.g. downturns w/o cyclical factors). In an economy purely dominated by cyclical forces (vs. one that is highly leveraged), both productivity and inflation would not be depressed.
Earnings growth is difficult in deflationary times. Business must cut expenses faster than the price of their goods/services, and most businesses have no experience with this because deflationary episodes are infrequent.
Velocity of money and low inflation are both signaling recessionary environment. Lower inflation is as much a hallmark of a recession as is decreasing real GDP. As for velocity of money (GDP/M2), falling V is a symptom of over-debtedness–when debt is used for (a) consumption, (b) payment of interest, and (c) default. Once an economy reaches 250-275% of total debt/GDP, the economy begins to slow down (U.S. is 334%, EU is 460% and JP is 655%). Hoisington remains bullish on Treasuries and cites strength of USD because–price leader for several goods is a foreign producer, who is happy to lower prices with stronger USD, forcing domestic producers to lower prices, thus lowering inflation, which should be favorable to falling UST yields.
According to Knut Wicksell, the natural rate of interest, a level that does not tend to slow or accelerate economic activity, should approximate the nominal GDP growth rate. Wicksell preferred not a RFR such as T30 but a business rate of interest such as BAA corporates. Currently, the higher rate of interest (vs. GDP) is slowing the economy down, suggesting that the next move in the interest rate is lower.
FOMC uses the FRB/US econometric model, according to which household consumption behavior is expressed as a function of total wealth (among other variables), and predicts a 5-10c spending boost per $1 increase in wealth. We think that this wealth effect is much weaker than the FOMC presumes.
The flat yield curve is an opportunity for investors. In the 2004-05 federal funds rate cycle, once the federal funds rate began to rise, the long Treasury rates fell over the next 2 years (from 05/04 – 02/06: federal funds rate increased by 350 bps, 5-yr notes increased by 80 bps, yet 30-yr bonds fell by 84 bps, as inflation expectations fell). If the Fed follows through on the federal funds rate increase, inflation expectations will be tamed, which can lead to a fall in the long-term rates. Moderating economic activity should also dampen inflation expectations, so prospects for lower Treasury yields seems favorable.
From 1871-1948, Treasury bond yield averaged 2.9%, with inflation at about 1%, and real yield at 1.9%. From 1948-1989, bond yields averaged 6.0%, with inflation at about 4.3% and real yield at about 1.7%. Over the long stretches, the average real yield was not very far from post-1871 average of 2.2%, with inflation as the key driver of bond yields.
Inflation is driven by level of Debt (public and private) /GDP, prevalence of global trade (which creates economies of scale and allows for movement of goods across countries), and demographics. At the the current levels, inflation should remain low (<1%) and this long-term rates should be around 3%.