Contrary to most forecasts, recession, lower stock prices and lower government bond yields are likely to be in our future.
Let's look at the economy first.
Since the end of the Great Recession in June 2009, the U.S. has experienced the slowest recovery since World War II. During this recovery, personal disposable income has failed to regain its pre-recession peak despite government assistance at historically high levels. Nearly one in five U.S. citizens is on some type of assistance program. This is not the environment from which economic growth springs.
A good bit of capital has been spent during the recovery, but most of it came in the form of labor-saving productivity enhancements that have not benefited the consumer in the short run. The dollar's weakness has helped exports but (and there always seems to be a “but”) Europe is in a recession. Asia is experiencing a slowdown along with the rest of the world, and housing has been bumping along the bottom with a boom-created overhang likely to keep the market soft for quite some time.
Even the government sector, which is spending like a drunken sailor, is not adding to economic growth on a year-over-year basis.
So where is future growth going to come from? Probably nowhere. While the Wall Street consensus continues to be positive concerning growth possibilities for this year, the number of bears also has grown. There is confusion about the outlook for the global economy in general, and the U.S. economy in particular, largely because there is little agreement about which economic indicators are actually leading, coinciding with or lagging future economic events.
Wall Street, which most often is bullish, pays little attention to which is which, preferring to low-ball predictions and then buy on “better than expected” results.
MISLEADING INDICATORS
While the traditional leading indicators remain strong, they give a 45% weighting to financial indicators, which cannot work as they have in the past since the Federal Reserve is keeping short-term interest rates at near 0%. If one disregards these indicators, things look worrisome. (As an aside, the National Bureau of Economic Research created the leading indicators, which soon may be changed because they are so heavily financially oriented. Over the years, in fact, none of the leading indicators has been a reliable predictor of future economic activity.)
Based on the fundamentals, the economy is caught in a classic struggle between inflation and deflation. While the consensus maintains that inflation is in the cards, the greater likelihood is deflation because the world is burdened with debt and debt is inherently deflationary.
In the U.S., the debt mountain started with Michael Milken's leveraging of corporate take-overs, then spread to the consumer and now, of course, to the federal government. While American consumers have started to deleverage, whatever pay-down has taken place has been more than offset by continued federal borrowing of massive proportions. As long as debt is handled in that fashion, expect slow to no real growth along with disinflation to deflation for as far into the future as the eye can see. One does not solve a debt problem by creating more debt; it's that simple.
HAIR OF THE DOG
At some point, debt — whether individual, corporate or national — can be repaid only by income. Rolling over debt is becoming more and more difficult. Witness how the eurozone is solving its debt problem by issuing more debt. This hair-of-the- dog approach is unlikely to solve the problem there, or here.
In the U.S., personal disposable income still is well below its peak in early 2009. To add insult to injury, approximately 7% of our disposable personal income comes from government transfers. Until such time as the consumer can get his or her balance sheet in shape, the U.S. economy will be in a slow- to no-growth mode. Higher food costs due to increasing worldwide demand, and rising oil prices due to excess liquidity created by the Fed, have fueled speculation about a comeback of inflation, but core inflation is as dead as a doornail. Thus, those who expect an imminent rise in interest rates are wrong.
Ironically, our firm has held this contrarian view for 30 years, and when it first broached the possibility of 3% long-term government rates in 1995, most people didn't believe such low rates were possible. In fact, for most of the past three decades, most “experts” held that yields were too low or sure to go higher. Ten years ago, they said that interest rates — then at 7% — had never stayed that low for so long and could not dip much lower. Well, history proved otherwise.
In 1981, when it started buying long bonds at 15% after having been out of the bond market for five years, our firm lost accounts because short-term rates were at 20%. Why in the world would anyone buy 30-year bonds at 15% when 20% Treasury bills were available? That's giving up 5 percentage points with no market risk. The answer, of course, is that investors cannot get capital gains with short-term Treasuries, and run a reinvestment risk if rates go down.
While the long-term bull market in bonds is coming to a close, the end is not here yet. With debt levels where they are, and the economy in such poor shape, all signs point to the low in the 30-year government yield's still being ahead of us. That's why it still makes sense to buy government bonds for total return, not just the coupon.
What's more, there is predictive value in a financial correlation that is in sync most of the time: the direction of yields on 10-year Treasury bonds and the S&P 500. They tend to go up and down in tandem. Over the past six months or so, however, that correlation has diverged, with stock prices going up and yields going down. Someone has it wrong. And we believe it is the stock market.
Don S. Peters, at dpeters @centralplainsadvisors.com, is founder of Central Plains Advisors LLC, , a division of Freestate Advisors LLC in Wichita, Kan.
