There has certainly been some improvement in various indicators of economic activity. As strange as this may sound, given my criticism of the Fed, I would attribute much of this improvement to a sentiment effect in response Fed's policy of quantitative easing. While long-term Treasury yields are significantly higher than before QE2 was announced, and though I continue to believe that the main effect of QE2 has been to encourage ultimately short-sighted speculation, the Emperor's-clothes enthusiasm about QE2 has had at least the short-term effect of buoying short-term spending and hiring plans. Unfortunately, this sort of sentiment-dependent bounce in activity is not very robust to shocks.
So while the surface activity of the U.S. economy has observably improved, it is in the context of an overvalued, overbought, overbullish, rising-yields market that is vulnerable to abrupt losses, a global financial system that remains subject to strains from sovereign default, a housing market where one-in-seven mortgages is delinquent or in foreclosure, and nearly one-in-four is already underwater with a huge overhang of unliquidated foreclosure inventory still in the pipeline, and a domestic financial system that lacks transparency and may still be slouching toward insolvency. The U.S. economy is progressing on the surface, but it remains a house built on a ledge of ice.
6) The U.S. fiscal position is far worse than our present $1.3 trillion deficit and nearly 100% debt/GDP ratio would suggest.
On the deficit side, there is certainly a "counter-cyclical" pattern to the U.S. federal deficit. As I noted a few weeks ago, every 1% shortfall of real GDP from potential (as estimated by the CBO) tends to be associated with a roughly 0.67% increase in the deficit as a percentage of potential GDP. So it is certainly true that part of the existing deficit reflects normal "automatic stabilizers." Unfortunately, this only explains about half the present deficit. Moreover, in order to adequately evaluate the existing deficit, it is essential to recognize that this figure reflects interest costs that are dramatically less than we can expect as a long-term norm. Consider the chart below. The blue line represents interest on the gross Federal debt at the average of prevailing 10-year Treasury yields and 3-month Treasury yields. Presently, this figure is comfortably low, thanks to the depressed level of interest rates. In contrast, the red line shows what the interest service would be at a 5.2% interest rate, which is the post-war norm.
Even if we restrict the analysis to publicly-held debt, the interest service at a 5.2% rate would still easily approach $500 billion annually. Investors and policy-makers risk an unpleasant surprise if they do not factor the unusually low level of interest rates into their evaluation of present fiscal conditions.
7) A long period of generally rising interest rates will not negate the ability of flexible investment strategies to achieve returns, provided that the increase in rates is not diagonal, and the strategy has the ability to vary its exposure to interest rate risk.
One of the most frequent questions received by shareholder services is what investors should expect if the "great bond bull" is now over. From my perspective, the answer is straightforward - we can't squeeze water from a stone if interest rates advance diagonally and persistently, but they rarely do. Provided that we observe natural cyclical fluctuation in yields, I expect that we'll have sufficient opportunities to vary our exposure in the event that yields advance over time.
Without detailing our own investment approach, which classifies Market Climates based on the level and pressure on bond yields, even a very simple model will suffice to demonstrate the point. Below, I've charted the total return of buy-and-hold strategy using 10-year Treasury debt, compared with the total return from a variant of a simple switching method described by Mark Boucher. The model is long when the 10-year Treasury yield is below its 10-week average and either the Dow Utility average is above its 10-week average or the 3-month Treasury yield is below its 50-week average.
The chart shows the period from 1963 to 1983 which captures the steepest interest rate increase in U.S. history. It isn't a performance claim, and the model is overly simplistic to follow in practice - it's too binary (i.e. either in or out) and trades too frequently to be effective as a stand-alone strategy. Still, the signal itself is clearly a useful indicator. Again, the basic point is that as long as yields don't rise in a perpetual diagonal line, strategies with the flexibility to vary interest rate exposure can perform admirably over time.
8) Stocks are a poor inflation hedge until high and persistent inflation becomes fully priced into investor expectations. At the same time, short-dated money market debt has historically been a very effective inflation hedge.
Investors sometimes make the mistake of believing that since nominal earnings can be expected to grow during periods of inflation, stocks should be a good inflation hedge. Straightforward reasoning, but unfortunately, it's not true. Sustained periods of inflation are disruptive, so even during the period between 1960 and 1980, S&P 500 nominal earnings still did not accelerate from their normal 6% peak-to-peak long-term growth rate. Moreover, stocks only behave as a good inflation hedge after high inflation is already fully anticipated. During the transition from low inflation to high inflation, stock prices have historically provided awful returns.
In contrast, short-term Treasury securities have historically been quite good inflation hedges. This is because short-term interest rates quickly adjust to reflect prevailing inflation rates, so unless you get a period of persistently negative real interest rates, the strategy of staying relatively liquid in interest-bearing securities has been fairly effective. It is certainly true that non-interest bearing cash is ineffective in preserving real purchasing power during a period of inflation, but the same is not true for short-dated money market securities.
9) It will be harder to inflate our way out of the Federal debt than investors seem to believe.
This is a corollary to 8). A significant portion of the U.S. Treasury debt is represented by short-duration paper, which makes the U.S. far more sensitive to rollover risk, and also makes the value of the debt less sensitive to inflation. See, if you borrow funds for 30 years, you can turn around and create a massive inflation to diminish the real value of that debt. But if you've borrowed funds for a year and then create a massive inflation, you'll find that investors will require a higher interest rate on the debt next year, which prevents the obligation from being diminished over time. This is good for the investors, but bad for the Federal government.
