READY FOR D-DAY?

We should all care about what Bill Gross does.

  • Mr. Gross manages the largest bond fund in the world ($237 Billion), Pimco’s Total Return Fund.
  • During the last 25 years, his TRF has returned 8.42% annually, an amazing 115 basis points better than his benchmark. Over 25 years!
  • The TRF had an amazing year in 2009, beating the benchmark by 7.9%. It remains that Mr. Gross has outperformed his benchmark in 7 of the last 10 years. In the 3 years he underperformed, it was by a very narrow margin.

Mr. Gross explains why he sold completely out of US Treasuries, no small feat given that

  • His benchmark owns 40% Treasuries. Going to zero is a huge relative bet.
  • He sold out of the most liquid instrument while managing the largest fund;
  • He sold out of the safest bond instrument out there for capital preservation.

Treasuries are “mispriced relative to the inflationary environment and the growth we see ahead and there are better alternatives in order to capture yield.

In his March “Investment Outlook”, Gross shared his analysis of US Treasuries under QEII (my emphasis):

If on June 30, 2011 (the assumed termination date of QE II), the private sector cannot stand on its own two legs – issuing debt at low yields and narrow credit spreads, creating the jobs necessary to reduce unemployment and instilling global confidence in the sanctity and stability of the U.S. dollar – then the QEs will have been a colossal flop. (…)

Washington, Main Street – and importantly from an investment perspective – Wall Street await the outcome. Because QE has affected not only interest rates but stock prices and all risk spreads, the withdrawal of nearly $1.5 trillion in annualized check writing may have dramatic consequences in the reverse direction. To visualize the gaping hole that the Fed’s void might have, PIMCO has produced a set of three pie charts that attempt to point out (1) who owns what percentage of the existing stock of Treasuries, (2) who has been buying the annual supply(which closely parallels the Federal deficit) and (3) who might step up to the plate if and when the Fed and its QE bat are retired. The sequential charts 1, 2 and 3 are illuminating, but not necessarily comforting.

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Chart 2 points out that nearly 70% of the annualized issuance since the beginning of QE II has been purchased by the Fed, with the balance absorbed by those old standbys – the Chinese, Japanese and other reserve surplus sovereigns. (…) The Treasury issues bonds and the Fed buys them. What could be simpler, and who’s to worry? (…) Who will buy Treasuries when the Fed doesn’t?

I don’t know. Reserve surplus sovereigns are likely good for their standard $500 billion annually but the banks are now making loans instead of buying Treasuries, and bond funds are not receiving generous inflows like they were as late as November of 2010. Who’s left? Well, let me not go too far. Temporary voids in demand are not exactly a buyers’ strike. Someone will buy them, and we at PIMCO may even be among them. The question really is at what yield and what are the price repercussions if the adjustments are significant. (…)

What I would point out is that Treasury yields are perhaps 150 basis points or 1½% too low when viewed on a historical context and when compared with expected nominal GDP growth of 5%. This conclusion can be validated with numerous examples: (1) 10-year Treasury yields, while volatile, typically mimic nominal GDP growth and by that standard are 150 basis points too low, (2) real 5-year Treasury interest rates over a century’s time have averaged 1½% and now rest at a negative 0.15%! (3) Fed funds policy rates for the past 40 years have averaged 75 basis points less than nominal GDP and now rest at 475 basis points under that historical waterline.

Hubert Marleau, CIO of Palos Management and an experienced observer of monetary policies, made similar observations in his Feb. 7, 2011 note, smartly concluding that

In this inexact science we draw some confidence from history that rules are better than forecasts.

In his Feb. 21st note, Hubert used the Misery Index as another indicator that US monetary policy was about to change:

The Misery Index, popularized during the 1970′s, is the sum of the headline inflation rate and the basic unemployment rate. The measure currently stands at 11.0% (9.4% for unemployment and 1.4% for inflation). The level is high but inflationary inflation represents only 12.5% of the measure. However, US consumer price inflation may have broken its downward inflation trend and inflation expectations may have broken out. (…)

Should the US economy continue to strengthen and international prices keep on rising, the FED will not be able or afford to ignore both a steady fall in the unemployment rate and surge in wholesale prices. In this connection, a dangerous increase in the representation of inflation in the misery index may force the FED to reconsider its monetary posture and present an ideal path on how and when to raise its key interest rates.

Since the official launch of QEII on August 25, 2010, things have changed significantly:

  • The US stock market has appreciated 22%.
  • 10-Yr Treasury yields have risen from 2.5% to 3.3%.
  • US GDP growth has reaccelerate from 1.7% in Q2 2010 (double dip scare) to 2.8% in Q4. The Philly Fed survey of professional forecasters sees steady growth averaging 3.2% in 2011, up markedly from 2.4% last November.
  • US employment has picked up and, in the last 3 months, the unemployment rate declined at the fastest rate since 1983.
  • US wages and salary have been growing at an annualized rate of 3.1% in the last 6 months and 3.6% in the last 2 months, right on cue with flattening transfer payments.
  • Growth in Personal Disposable Income has accelerated from 4.2% annualized (6 months) to 6.6% (2 months).
  • The personal savings rate has stabilized in the 5.5-6.0% range.
  • The YoY growth rate in Personal Consumption Expenditures troughed last August at 2.7%. It was 4.0% in February 2011.
  • US household debt is now 116% of disposable income, the lowest level since 2004.
  • S&P 500 companies profits are only 9% shy of their 2007 peak. Capital spending is picking up.
  • US corporations are the most liquid since 1963 with 7% of their assets in cash.
  • Even small businesses are getting more optimistic albeit at a low level.

The answer to Bill Gross’ question whether the private sector can stand on its own two legs or not is therefore trivial … until we consider the housing sector and the mountain of underwater mortgages that remains as this chart from Calculated Risk depicts:

This is why Mr. Gross concluded his analysis with this:

As a counter, one would argue (and I would partially agree) that the U.S. and indeed developed global economies must keep yields artificially low for some time if post Lehman healing is to take place. But that of course is the point. By eliminating QE II, the Fed would be ripping a Band-Aid off a partially healed scab. Ouch! 25 basis point policy rates for an “extended period of time” may not be enough to entice arbitrage Treasury buyers, nor bond fund asset allocators to reenter a Treasury market at today’s artificially low yields. Yields may have to go higher, maybe even much higher to attract buying interest.

If Bill Gross is right, there is a pretty major change in the investment landscape just around the corner. A jump of 100-150 bps on Treasury yields during the summer would send tremor throughout the investment spectrum. Even more so if expectations for a more neutral monetary policy (i.e. higher short term rates) develop at the same time. Before debating the outcome, we must acknowledge the increasing risk for most asset classes as we approach D-Day. Risk premia are likely to increase across the board. Bill Gross again:

Investors should view June 30th, 2011 not as political historians view November 11th, 1918 (Armistice Day – a day of reconciliation and healing) but more like June 6th, 1944 (D-Day – a day fraught with hope for victory, but fueled with immediate uncertainty and fear as to what would happen in the short term). Bond yields and stock prices are resting on an artificial foundation of QE II credit that may or may not lead to a successful private market handoff and stability in currency and financial markets. (…)

The critical point in the Fed’s strategy has to be employment: if, by June,  the Fed concludes that US employment is in a sustainable recovery path, extraordinary monetary stimulus will no longer be necessary, even more so in the face of a ballooning fiscal deficit. The charts below, courtesy of NBF Economy & Strategy Group, are very encouraging on employment although not definitive:

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Same with Doug Short’s chart on weekly unemployment claims:

Most recent economic data on the US economy have been positive. Even housing and construction, two of the three remaining drags on employment (the third being state and local governments) are giving signs of stabilizing. Retail sales, including automobiles, have been quite strong in recent months, providing a solid background for employment in the spring.

To sum up, it looks like the Fed’s strategy is working, one way or the other. The recent run-up in longer term interest rates in the US constitutes the initial steps towards normalization which Bill Gross estimates needs another 150 bps to the 4.5-5.0% range on the 10 years.

Three caveats to consider:

  1. Sharply rising oil and food prices could meaningfully eat into disposable income and reduce discretionary spending globally in coming months. Expectations of slower GDP growth would likely keep inflation expectations lower and weigh on interest rates.
  2. The Arab uprisings are a significant known unknown.
  3. Japan’s calamities will likely negatively impact global GDP growth over the shorter term, only to boost it later on. Japanese buying of Treasuries will, if anything, disappear for a while.

IMPLICATIONS FOR EQUITIES

The Rule of 20 equity valuation method provides a time-tested, dispassionate way to assess fair value for equity indices like the S&P 500 Index.

At the present time, the Rule of 20 sets fair PE at 20 minus inflation of 2%, or 18x trailing EPS of $83.78 for a fair value of 1500 on the S&P 500 Index. At 1295, upside to fair value is 15%, still reasonable but nowhere near its readings of 24 (41%) and 7 months (24%) ago.

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What if 10-Yr Treasury yields rise 100-150 bps to 4.5-5.0%? A quick look at Doug Short’s chart below would suggest that equities should rise right to the Rule of 20 fair value of 1500. (See also WILL RISING BOND YIELDS DERAIL EQUITIES?)

Real, inflation-adjusted, 10-yr Treasury yields generally range between 1.5% and 2.5%. For equity valuation currently based on 2% inflation, Treasury yields upwards to 4.5% would be within reason as they would not signal higher inflation expectations, but rather nominal rates normalization post QE2.

Yet, we can expect that all long term rates will follow upwards, including mortgage rates. This would inflict additional harm to the moribund housing market and construction trade.

We can also expect that the Fed will then begin normalizing Fed funds rates. If Bill Gross is right, that is pretty scary:

Fed funds policy rates for the past 40 years have averaged 75 basis points less than nominal GDP and now rest at 475 basis points under that historical waterline.

Now, of course, we could also experience QE3, QE4 … up until the time the Fed is comfortable letting the economy on its own. That would mean pretty weak GDP numbers by the summer. With the Fed seemingly pushing on a string, earnings and earnings expectations could diminish rapidly.

In all, equities, being significantly less undervalued than during the last 2 years, and facing highly unpredictable events (Middle East turmoil, high oil, food and most other commodity prices) and uncharted monetary strategies, are entering a period of particularly high uncertainty. If Gross is right, the improved economic landscape will also mean sharply higher interest rates, long and short. This new and rising competition from fixed income investments, coupled with much more muted earnings growth rates will make the road to fair value much steeper and pretty bumpy.

If Gross is wrong and long rates stay unusually low, it likely will be because the economy remains in need of artificial support. How will earnings behave in such an environment in which productivity gains have peaked and input costs challenge operating margins?

PE ratios are discount factors which, in the best of times discount inflation rates. Needless to say, these are not the best of times. We should expect PE ratios to discount a lot more.

“Sell in May and go away!” they say. With only 6 weeks to go, we should at least start packing.

 

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