The ominous Chinese greeting, “may you live in interesting times,” has arrived in Canada. We face declining energy prices that are dragging down the entire economy to nearly zero growth. Canadian stocks are accordingly dismal. Our partner to the south, the U.S., has a soaring currency that will inhibit its exports. As a result, the U.S. major stock indices have a negative bias. In this glut of bad tidings, bond prices, which should fall in the face of rising interest rates, are headed up — the wrong way. But for investors seeking security rather than profit, it makes sense.
The Federal Reserve Board began to raise interest rates with a 0.25 per cent boost in the overnight rate on Dec. 17. By itself, that tiny boost means just about nothing, but as a portent of the successive interest rates increases to come, it is going to be tough medicine for any person or business with large debts, especially debts coming up for rollovers to new, higher rates.
The Fed’s mandate is to look after two factors in the U.S. economy — inflation and unemployment. Other central banks are tasked only to manage inflation. For the record, U.S. inflation is running at a bare 0.2 per cent and the unemployment rate is down to five per cent. From the viewpoint of the Fed, the great recession that began in 2008 is over. In 2016, the Fed’s Open Market Committee will meet eight times and, suggest a consensus of forecasters, it will probably raise short term rates four times. That would put the overnight rate, which is what the Fed charges banks that need to borrow money to maintain reserves, at perhaps 1.5 to two per cent, which is headed back to pre-2008 normality. Bond traders should be selling and going to cash or stocks.
If it were only that easy. At present, stocks are vastly overpriced. The Case-Shiller Cyclically Adjusted Price Earnings Ratio, the CAPE index for short, is 26.8. That is, the broad stock market is selling for an average of 26.8 times what stocks earn. The historical mean is 16.6. The implication is that stocks are eventually going to fall back to the average. But there is no actual clock. It could be in a month or six months or six years.
Stocks are high because bond returns have been low. Money fled fixed income, especially riskless government bonds, to the stock market where even modest dividends of two per cent a year or so looked good in comparison to five-year bonds that paid barely half a percent. In the see-saw of bond returns and stock returns, bond prices will drop as interest rates rise.
In this period of adjustment, investors have shown a strong preference for liquid assets. The more liquid, the better. Tough-to-trade emerging markets stocks lost 17.3 per cent in U.S. dollar terms in 2015 and the worst hit, Latin American stocks, lost 32 per cent in U.S. dollar terms.
Forecasts for the U.S. stock market for 2016 are downright gloomy. BlackRock Inc., which is the largest fund manager in the world with US$4.5 trillion of other people’s money in its coffers, says it expects only muted appreciation in the U.S. market in 2016 and a rising tide of bond defaults — chiefly among junk bonds.
In this market of low expected growth and rising interest rates, the most sensitive assets are junk bonds. Companies can suspend dividends on common stocks and investors can live with falling earnings. But bonds are a promise to pay interest on given dates and to return cash on specific dates. If an issuer fails to do either, the bond is in default and the vultures are likely to push the company into receivership. Then they descend to pick at the carcass.
Junk bonds are thus the canaries of capital markets. Several big junk bond funds shut their doors in 2015, each having to suspend redemptions of client funds. In early December, the New York-based Third Avenue Focused Credit Fund, a specialist in bonds rated CCC (“vulnerable in downturns” as bond rater Standard & Poor’s calls them) announced it would shut down its US$788 million portfolio and delay return of cash to investors rather than sell at fire sale prices. The fund told its investors that it would be months or even years before they could get their money back. Two other junk funds, Stone Lion Capital Partners L.P., based in Tennessee, suspended redemptions. Then on Dec. 14, Lucidus Capital Partners, a high yield bond specialist based in the U.K., announced that it had sold all of its US$900 million portfolio. It was returning money, reduced by the fall in junk bond asset prices, to its investors. The other two funds could not afford to pay off investors.
All investing is a game of musical chairs, but risk and illiquidity tend to go together. Some big coal companies’ lost as much as 90 per cent of their face value compared to what they sold for in mid-2014. Shares of Peabody Energy Corp, the largest coal producer in the U.S. saw its shares drop 93 per cent in 2015 and its bonds drop by 78 per cent. Coal was once a sure thing. It is no more.
What is next? Solid stocks with dividends they have historically raised every year or two or even several times on one year in industries that are here to stay — banking, insurance, public utilities, global retail (think Amazon on this one) or entrenched national retailers like Canadian Tire all have some control over their profits. They are price makers. They are not price receivers like miners unable to do more than take what prices the world market dishes out.
Oddly enough, government bonds, especially U.S. Treasuries, the most liquid asset in the world, are likely to hold value and even rise as investors seek safety. The wise strategy is to split one’s investment, half on long bonds, half on shorts. As with any foreign currency investment, there is the risk that the Loonie could rise and the greenback fall. But that is not likely to happen any time soon given expected, prolonged loonie weakness.
Trading in and out of a foreign currency can be expensive, as banks take a couple of per cent commission either side of the market. However, if you buy into a U.S. equity index fund with Canadian dollars, you usually get a conversion price at the true market centre. In the short run, foreign exchange rates rule. Over periods of a decade or two, it is the underlying index that rules.
Call it an article of faith, perhaps, but statistically, over long periods, buying and holding a broad index has usually been a winning strategy. It means accepting that idea that all broad indices eventually rise. Yet there are exceptions. It has been two and a half decades since the Japanese Nikkei 225 index hit its high at 38,916 on December, 29, 1989, then lost 89.9 per cent of its value by 2009. As 2015 drew to a close, the Nikkei was trading at 18,789, less than half of the historic high. Take off 30 years of inflation and buy and hold index Nikkei investors are pretty well wiped out. Japanese government bonds, however, with the guarantee of payment at maturity, have produced huge profits for their holders in yen and even more in dollars. And that is why, in times of overvalued stocks and a stagnant world economy, bond prices are going up.