Be Careful What You Wish For
With that provocative title, you’re probably wondering what you or we wished for that has now gone sideways. Like, did we wish for higher inflation, as the Federal Reserve did, from 2008 all the way up until March, 2022? Did we wish that the private sector would be allowed to set wages without interference from government mandates and minimums? Did we wish for an independent Fed, which would enact monetary policy without kowtowing to Washington?
It wasn’t that long ago these were just wishes. From 2009 – 2019, there was almost no inflation. That all changed by late 2020. While the Fed’s “transitory” tagline was naïve from the get-go, we thought at least we could finally witness the long-awaited shift out of bonds and into stocks, and ultimately decent bond yields. [More on that wish in a bit.]
Remember when blue states and cities passed minimum wage laws at the… gasp… $15/hour level? The ink hardly had a chance to dry before that level was usurped in the free market, set by employers and employees. That even hasn’t been enough for most fast-food franchisees, who also offer signing bonuses, benefits, and drug test waivers.
Presidents often try to sway Fed Chairs into not raising interest rates, especially in re-election years. President Trump took “sway” and turned it into “browbeat,” as he blatantly made his feelings about Fed Chair Powell known, even publicly threatening to fire him as Powell raised rates in 2018. Biden kept Powell on the hot seat throughout 2021 as he deliberated on whether to re-nominate him to another term. I wonder if that had any effect on monetary policy in 2021? Now we have a fully re-energized Fed, with Powell warning that he will bring pain to the economy as he fights the war against inflation.
For those of us who invest money for a living, one simple request of God and/or Santa Claus since 2009 has been bonds that offer decent yields, like they once did. I think I hear the angels singing, “Be careful what you wish for.” Good news: bond yields are higher now! [See below: 10-year treasury yield since 1990.] Bad news… those bonds that you already own? Not worth as much anymore.
Trying to explain bond prices in a newsletter is always perilous, but maybe this attempt will be the exception. Let’s say a year ago you bought a bond with a 1% coupon that matures in 5 years. You bought it at a price of $100, and when it matures in 5 years, you’ll get $100 back. Those terms are still valid even now that interest rates are higher. Your bond still sends you 1% annually and will pay you back $100 at maturity. The problem is that your bond is tradeable on the bond market (I’m actually kidding—the fact that you can sell your bond is a good thing, unlike, say, bank CDs or annuities). Now that 5-year bonds yield 4.1%, bond buyers can buy a new 5-year bond with a 4.1% coupon at $100. Under what circumstances would they want a 1% coupon bond? Only if the price were lower to account for the 3.1% missing annual interest. That price should work out to something like $87. Now you can see why the bond market has lost 14.6%, in aggregate, since 2022 began. Thankfully, most of our bond holdings have lost far less value.
Is TINA dead?
First of all, whoever is asking the question, welcome to the newsletter. I don’t remember a Q&A session on the agenda, but good question. More on TINA shortly—we’re still talking bonds. Investors buy bonds and stocks for different purposes, of course, and the two are connected in that they both pay you income. They are competitors of a sort, but in what sporting event? Our submission: a long-distance trail race. What form will our two challengers take? The tortoise and the hare, of course.
The hare, running fast, represents stocks; the tortoise, slow and steady bonds. Why a trail race? I have never understood how it is even remotely possible that the hare could lose to the tortoise over a long distance, even if it does take a nap (as in Aesop’s fable). The only possibilities would be if it gets injured, sick, or maimed, but those unfortunate events are never mentioned by Aesop. Our theory: a big chunk of the trail goes through a marsh or a lake. The tortoise would seem to have an advantage over this terrain, much as bonds normally do when stocks sink into bear markets. That said, 2022 has been anything but a normal year…seems the trail was ambushed by a mudslide that took them both out.
So is Tina in the race? No silly (wait, is Elmo asking the questions?). TINA is an acronym for There Is No Alternative. TINA was born in 1980, thanks to Margaret Thatcher as she was, coincidentally, battling inflation in the U.K., and insisted that there was no economic system that had the potential to solve the woes of the day other than free market capitalism. TINA received a second life in 2009 at the dawn of the age of 0% interest rates.
Dividend yields were higher than (safe) bond yields, which earned stocks the moniker of TINA. If you wanted to earn something north of 0%, there was no alternative to stocks. Since bond yields have made such a comeback this year, rumors abound that TINA has been spotted six feet under.
What SHOULD stocks yield if bonds yield 4%?
Great question; it’s almost like we planted you in the audience. In theory, dividend yields should go up if bond yields go up. There are two ways for a dividend yield to go up: for the dividend to rise, or the stock price to fall. Yes, dividends are still growing, but not enough to move the needle that much. The 10-year treasury bond yield now yields 4%. It was 1.5% at the beginning of the year. For the S&P 500 to yield 4%, stocks would need to drop another 54%, because its current dividend yield is 1.8% (for reference, the average yield for Monarch’s core stocks is 2.7%).
In actuality, stock and bond yields don’t always trade in lockstep, as this chart shows:
In the 1990s and 2000s, bond yields traded considerably higher than dividend yields, and only slightly higher, on average, in the 2010s. The better question might be: is there predictability in stock returns based on any of this? Sadly, the answer is not much. It is a much debated, and thoroughly researched topic. Markets go through long periods when stock prices and bond prices are positively correlated, and also long periods when they are negatively correlated. The correlation since 1990 is positive 33%, but 0% since 2009.
If you’re a bond bull, you would rightly point out that when bond yields go from 1.5% to 4%, bonds lose only 14%. Stocks have lost 24% this year, but the dividend yield has risen by only 0.5%. This is because bonds have a shorter, finite term; stocks do not.
Stock bulls would point out that dividends grow over time, whereas bond coupons are fixed until the bonds mature. That stock that yields 3% now, if the dividend grows at 7% annually, will have 6% “yield-on-cost” in 10 years. If you buy a 10-year bond now at 4% yield, your payout will remain 4% for the 10 years. You’ll actually earn more income from the stock. Even if the stock treads water for 10 years, it outperforms the 10-year bond. Are you wondering whether dividends will grow at 7%? Note that dividends grew 8% annually during the 1970s, a period of high inflation and poorly-performing stocks…stocks appreciated only 4% annually, but including dividends, they returned +8.5% annually.
We can’t predict exactly how fast dividends will grow, but there are reasons to be optimistic. First, if we are entering an era of stagflation (sustained high inflation + stagnation in the economy), dividends should grow at high rates in “nominal” terms (including inflation), as they did in the 1970s. This is because corporate revenues and cash flow grow in nominal terms. Another support for dividends could come from the new tax on share buybacks. As part of Joe Manchin’s “Inflation Reduction Act” (editor’s fact check: this bill has been scored by multiple nonpartisan agencies as not inflation-reducing over any time period, and more likely to increase inflation in the short-term), companies buying back stock will be taxed at 1% of the value of their share buybacks. This should sway more companies to repurchase fewer shares, and spend more cash flow on dividends instead. Side note: the buyback tax goes into effect 1/1/23, so companies are likely to buy back stock in the remaining days of 2022, which could provide a big tailwind for stocks.
Why are higher-yielding “value” stocks outperforming as bond yields rise?
The questions seem to have taken a decidedly wonky turn. In theory, it makes more sense that the kind of stocks that are more relevant competitors to bonds, like those that investors buy for the yield instead of the growth, should be suffering more this year than growthy growth stocks. Like, is anyone seriously flipping their portfolio of unprofitable startup IPOs and SPACs into bonds?
Instead, utility and drug stocks are the best-performing sectors in 2022, after energy and defense stocks (for obvious reasons). Two stronger forces are at work in favor of utilities and Big Pharma. First, they are safety sectors, bulwarks that will continue to grow revenues and profits regardless of the economy. Second, they were relatively cheap compared to no-yielding, faster-growing tech. A large proportion of publicly-traded tech stocks (and an even higher proportion of tech companies owned by private equity) have never turned a profit.
We have written in the past about “blue sky markets,” during which investors love companies that are growing on bean stalks to the sky, and are unconcerned with any risk factor, or even that growth will someday slow down. A nervous market, on the other hand, is not willing to pay for earnings that will begin in 2028. Compounding the problem for a lot of tech companies in 2022 is that growth has dramatically slowed, predictably lapping the covid-fueled growth of 2020-21.
Is this bear market different?
Oooooh, now we’re getting into salacious territory. This bear market in stocks is different in that it also coincides with a bear market in bonds. A more typical bear market in stocks is caused by fears of a recession in the economy, which will drag down earnings and make stocks seem more risky (which is a mirage…only risky companies actually become riskier in a recession). Simultaneous with falling stock prices would be rising bond prices, as investors seek a flight to safety in safe bonds, pushing up demand for bonds. Plus, the Fed is usually cutting short-term interest rates at such a time.
Pretty sure most of us could identify one difference between a typical recessionary bear market and the current bear market. Instead of bond prices rising because of recession fears, bond prices are falling because of inflation fears. Instead of an economy that’s looking too weak, our economy has been too hot. There has been a flight to safety, but it hasn’t been into bonds, rather it’s been into cash and safe sectors like drug stocks and utilities. Thus we hear the phrase, “this time is different,” which are known to be the 4 most dangerous words in our business, because it can inflict irrational decisions upon disciples of the phrase.
We don’t have an easy solution to how the economy works itself out of this inflationary jam, nor are we counting on an immediate Fed “pivot” from tightening money supply to loosening it and calling an end to their interest rate hikes. But this day will come at some point. To think that the Fed will raise rates forever is the epitome of irrational thinking. Still, it is easy to see the pessimistic view that the Fed does not have our back. They will not step in and stop raising rates simply because stock prices are falling. Ever since the Greenspan Fed era began, the market has believed in the existence of a “Fed put,” or a line in the sand that, if crossed, they would start up the dovish talk, en route to cutting rates. The Fed put is currently in the same grave with TINA. Still, every bear market is built on an unprecedented event, and on fears that it will cause untold collateral damage, and won’t end any time soon. Bear markets always eventually end.
The Fed has needed to talk tough about inflation all year long for two reasons. First, they botched policy in 2021 so badly that they feel the need to make up for all the time they didn’t take inflation seriously. Second, they believe that by talking tough, that alone will do some of the dirty work for them, of slowing the economy and thus slowing inflation. We would agree. We would advise the Fed, however, to give their newfound tough talk and their higher interest rates some time to actually show they are working. Remember that it was just 6 months ago that the Fed started raising rates from 0%, and the first hike was a meager 0.25%. The 0.75% bazooka didn’t deploy until June. The Fed was still buying bonds for its quantitative easing program into May!? It is utterly ridiculous to expect these sharp rate increases to flow through in only 3 months all the way through the supply chain and labor market to CPI.
Should the Fed be looking at earlier-stage inflation measures than CPI?
Amen! If they did, they would see a lot of evidence that inflation is starting to come down. Commodity prices are down across the board. This is the CRB Index, the broadest measure of commodity prices, going back to 2000:
The CRB peaked in early May and has dropped 14% since. Aluminum is off 45%, steel 55%, copper 30%, and lumber 70%. Crude oil is 33% lower than the June high, and even European natural gas has quickly dropped 35% in the last month. Shipping costs are down 60% since last September. This deflation does take time to work through the system. Crude PPI, a measure of manufacturers’ prices, peaked in June and has dropped 6% since, although it remains up 33% year-to-date. CPI will take longer to come down, but we believe it will thanks to input costs coming down, and the eventual destruction of demand, which should raise the incentives of competitors to compete on price.
The wild card is energy. Does Putin have any cards left to play in trying to cripple the West? It seems he has played his final card by shutting down Nord Stream, the natural gas pipeline that supplies Europe. Now that Europe is getting no natural gas from Russia, and working to acclimate to their new world of conserving energy and buying a lot of LNG (liquefied natural gas), it would seem he has no economic leverage anymore unless he convinces OPEC to stop producing oil, which seems unlikely to say the least.
Back to the Fed, you might be wondering what is their track record on provoking a demand response vis a vis raising the Fed Funds rate? Are they successful in getting the economy, and inflation, to retrench? In fact, the Fed is 11-0 since 1961. One of those “wins” was its campaign to raise rates in 2018-19, and the subsequent covid recession in spring, 2020. Clearly, covid and the lockdowns caused the recession, not the Fed, so if you want to remove that one, that’s okay. Let’s just say the Fed has never failed to rein in the economy and inflation. And let’s give a shout-out to Milton Friedman, and all monetarists who believe that monetary policy is the best route to help regulate the economy, not government spending. True that in the 1970s, twice, inflation came roaring back a couple years after the tightening, which may have been caused by the Fed cutting rates too quickly after they raised them, or there were plenty of bad, protectionist economic policies that contributed.
You might also be wondering what is the Fed’s record on inducing a “soft landing” to the economy, causing the economy to soften but not fall into recession, and yet still kill inflation? That record would be 3-8, although the covid recession is the 8th “failure.” It is a sensible belief that this time, the Fed is far more interested in killing demand growth than usual, so a recession would seem to be more likely than the 70% historical odds. That said, does it have to be deep? What if, as we expect, real GDP falls only a couple percent? Consumers, companies, and banks are in far better financial condition than they have been historically. Wage growth is strong. What if we see real GDP contract 2%, but inflation over the recession averages 5%, maybe 8% at the start and 2% at the end? That means the economy grows 3% in nominal terms. This doesn’t sound like the Great Depression to us.
Finally, we send our hopes and prayers to anyone impacted by Hurricane Ian. Southwest Florida is like a second home for Fort Wayne.
–Written by John Meyer