Portfolio manager’s Letter November 2002
Bond Guru Bill Gross says “Stocks Stink”. Buy bonds, because stocks are still to expensive. So if they stink now what did they smell like two and a half years ago when NASDAQ was at 5000, and why wasn’t he telling us to buy bonds then? But what about Bonds? They do not look cheap to me particularly Government bonds. Five Year Treasury notes are paying 2.93%, and 10 year Treasuries are yielding 3.91%, the lowest yield in over forty years. The question is how much lower can interest rates go? Or to make the question more interesting how much risk is there, if you sell treasuries short?
Despite the meager returns now available from government bonds, money is pouring into debt. Bond funds experienced a record 28 billion inflow of funds in July. Almost always when you sell money flowing into sector funds it is a sign that the sector is getting overpriced. One is tempted to ask if buying 10 years government bonds 4% is any more rational than buying tech stocks with PE’s above 100.
It is difficult to understand how investors can rationally expect any sort of decent return on the capital invested when they are buying ten year treasuries bonds with a 3.9% coupon. Even a low level of inflation and a moderate tax burden would make it difficult to get any sort of real return from this investment.
The emergence of any sort of substantial inflation it the next ten years will mean these bonds will render a negative return in real dollars, and a potential capital loss if the bonds have to be sold prior to maturity. So is flight to fixed income a rational refection of the economic conditions we can expect in the near future, or is it just Mr. Market scared to death by what he sees in the rear view mirror.
Mr. Gross says that bonds are not over-priced assuming that the economy is moving into a period of slow economic growth and with or non-existent inflation. But are these rational assumptions? Does it matter that we have not experienced these conditions in last sixty years? We have not had a period like Gross describes that lasted more than a few months since the end of World War II. But, “this time it is different.” – Right!
Are we entering into a new period were economic growth will muddle along at two or three percent for ten years? Or will the future be like the past; consist of nasty cycles with short periods of recovery followed by periods of contraction? This is a critical distinction for the bond market because if there is a rapid improvement in the economy it could lead to a return of inflationary forces. This in turn would mean higher interest rates and falling bond prices.
It seems to me that the odds favor cycles over slow and steady for a number of reasons. Maybe because I enjoy being perverse, I think that the current bond market offers an opportunity to make money by selling bonds short. Barclays introduced a series of fixed income iShares in July that make it very easy to short treasuries. These new instruments to can be used to profit from any reversal of the current trend toward lower interest rates. They are traded on the American Stock Exchange and can be shorted as easily as any liquid common stock.
The conventional wisdom says shorting bonds, now, is s bad bet, the economy is tanking, and will recover slowly or maybe even suffer a double dip. There is a general suspicion that perhaps we heading into a post bubble experience similar to what Japan has suffered for the last ten years. However, since no one has ever made any money in the market following the conventional wisdom. I consider it my duty to look at the other side of this economic wisdom. To gain insight into the direction of inflation and interest rates, it is interesting to compare the growth of the money supply post bubble in Japan to present situation in this country.
So why do I think we will not share the Japanese fate? The answer is in the two charts shown on these pages. The first chart shows the rate of growth of the Japanese money supply from 1984 to 2000. You can see a spike in 1987 & 1988, which helped to inflate the Japanese bubble, and then you can see another spike in 1990 and 1991 as the Bank of Japan lowered interest rates in response to the crash in the Japanese market.
This lowering of rates helped increase the money supply initially but within a couple of years the money supply growth had gone negative. Since then their money supply has shown very little real growth. If you adjust the above chart to include changes in the velocity of money the Japanese growth of money has spent a good share of the Last ten years in the red.
The second is on the next page and it shows the rate of growth of the US money supply since 1990. Notice the slow growth in the early nineties, and the much more rapid growth after 1995. Of particular interest is the fact that despite all the squiggles in the red line the black line has continued upward for the last three years at about the same pace as the late 1990’s.
You can see a sharp upward spike toward the end of 2001. This we can assume was result of the fed adding liquidity after 9/11; also it appears that much of that liquidity was withdrawn early this year as the FED saw the economy recovering in the first quarter. This may help to explain the rapid expansion in the first quarter of this year and the slower growth of the last two quarters Lately however the red line has turned back upward with M2 showing rapid growth of 12.8% in the 13 weeks ended July 29.
The Bottom line is that two years after the tightening that popped the Japanese bubble the growth of their money supply had dropped to next to nothing; whereas two years after the explosion of our tech bubble our money supply is growing at almost 13%. We have a whole different equation and so should expect a quite different result.
The Fed has three tools that it can use to influence the money supply. They can lower interest rates; they can lower bank reserve requirements. Or they can engage in the open market purchase bonds or bond repos. This last method is much more effective in a weak economy, because at some point lowering interest rates becomes “pushing on a string”.
In a weak economy banks typically get nervous and stop lending, so lower rates will not increase the amount of money in the system, but with open market activity the FED can continue to pump up the money supply no matter what the banks are doing. My guess that is exactly what the FED has been doing for the last three months.
In addition to the rapid expansion in our money supply we have the War on Terror, and the return to budget deficits that accompanied it. The last time we had a war and a rapidly expanding money supply was in the 1970’s. Do I think we will see a return to the kind of inflation that we saw in the seventies? No, I do not. The deficits are not anywhere near as big now as they were in the late 1960’s and early 1970’s, as a percent of GDP, and Greenspan is not likely to let the money supply get completely out of hand. But the inclination of central bankers is always to error on the side of easy money.
While I do not see conditions similar to the seventies, I think that there is a substantial chance that we will see inflation return to levels we have not experienced for awhile. In addition to the factors listed above. There is a serious drought in the Midwest and this is starting to raise prices of agricultural commodities. When Gross predicts continued low inflation, I think he is doing so with his eyes firm fixed on the past. Bill Gross knows a lot more about bonds than I do, but the FED is the FED and with Greenspan in the saddle it seems to me that their response to the current economic queasiness will be stimulate, stimulate, stimulate.
I am confident that there is now a lot of pressure on Greenspan to pump up the money supply. The Federal Reserve is theatrically independent of political influence, but experience has shown that this independence has never prevented the FED from simulating the economy when the politicians want it stimulated.
This is, after all, an election year and politicians do not like tight money, it raises hell with their reelection campaigns. It seems likely to me that because of its history, the FED will ease too much and too long. With the result that one year from now we are going to be a lot more worried about inflation than we are about deflation. And People holding Long bonds will have learned something about interest rate risk.