2016 Second Quarter Report1 – Global Interest Rate Mania

If MCS clients’ investments were treated as one large portfolio including their cash, on average clients gained 3.67% after fees through June 30, 2016. The range of individual client returns was from 0.81% to 6.98%. For comparison purposes, the S&P 500 Total Return Stock index earned 3.84%, and the Barclays Aggregate Bond Index was up 5.31% through June 30th. Clients with the lowest returns were negatively impacted by more concentrated individual stock exposure (that was particularly hard-hit by the Brexit vote).The clients with the highest returns benefited from no equity exposure, a fully invested portfolio (due to portfolio drawdowns) or concentrated low-basis stock positions that outperformed. In general, client returns were lower than index returns because clients hold significant cash and one year bonds. Indexes used for comparison hold no cash.

Global Interest Rate Mania

Financial History is being made. Can you feel it? You and your life’s savings are part of it!

Long term US interest rates are nearing historical lows2; 30 year US Treasury bonds now yield a mere 2.18%, down from a high of 3.11%, over the past 12 months. The 10 year bond now yields 1.46%, down from a 12 month high of 2.34% (as of July 29,2016).

Today, toxic demand for bonds is creating a global mania, pushing interest rates to unprecedented lows. Nominal interest rates continue to plumb never-before seen lows (negative rates in some countries) while boosting the value of all types of investments. It is a bad, bad sign, and I do not know how long it will continue. For this report, I have created a ’Toxic Demand and Financial Manias’ table where I compare recent manias in real estate and tech stocks to current conditions.

The inputs and feedback mechanisms driving interest rates are numerous, complex, and interconnected, with both repelling and reinforcing characteristics. Demand becomes toxic when unfavorable changes in the demand outlook have a high probability of resulting in a vicious negative feedback loop with widespread financial repercussions. ‘Mania’ describes crowd psychology characterized by the adoption of beliefs that, while perhaps initially grounded in reality, ultimately devolve into destabilizing memes directing investor behavior.

What are negative interest rates?

Interest rates are negative when the lender pays the borrower interest on the loan. Here are some examples. The European Central Bank charges its bank customers 0.4% on their deposits. An investor buying 5 year Swiss, German, French, Swedish, Netherlands or Japanese bonds will receive less than they originally invested at maturity. A Danish homeowner, rather than paying interest on their mortgage, receives a payment from the bank.

Figure 1
Central Banks’ Holdings of Government Bonds as a Share of Outstanding Debt

Figure 1 | MCSA

Opportunities to lose money in highly dramatic fashion abound, while compensation for such risks evaporates. Industries that rely on interest earnings (like banking and insurance) are now threatened by the central banks’ economic policies and new regulations designed to reduce the risk of these institutions in a crisis.

Politically, more history is being written with the emergence of a populist uprising in both parties. Donald Trump pulled off a bloodless coup in the Republican Party. Hillary Clinton co-opted Bernie Sanders’ socialism. These events spring from a deep well of dissatisfaction. The American Dream – that hard work equals a better life – has not been realized by the majority of Americans, while income inequality has grown over the past three decades.

Three Examples of How Manias Stay Alive

The power of manias lies in their initially positive financial outcomes. Despite the evidence that low interest rates have lost their economy-boosting powers, they continue to propel the ascent of stock, bond and real estate values.

  1. Institutional investors fan the mania flames with relative value trades. To wit: Neil Dwayne, global strategist at Allianz Global Investors, is still buying. “Every piece of analysis we do on the bond market tells us they are structurally overvalued,” he said. But he is buying bonds anyway. “That’s what you have to do when you have the ludicrous valuations in Europe and Japan.” Source: This Bull is on Its Last Legs, WSJ, July 14 2016

    This quote perfectly captures why so many money managers are only secondarily focused on making money for clients. What managers are really focused on is beating their benchmark index. Beating an index encourages relative value trades, i.e. the manager is a ‘success’ if he loses 25% of client money when the index loses 28%. It is the same rationale offered during the tech bubble, when stock fund managers grossly overpaid for profit making tech companies. Back then, they compared profit making tech companies’ valuations to mania-driven valuations of new tech companies with no profits at all. At this point, whether the price offers a reasonable reward for the risk taken no longer matters.

  2. The decision to keep buying is also supported by the flow of funds rationale. For example, the European Central Bank (ECB) committed to spending $60 billion euro per month to buy sovereign European bonds. Knowing this, traders could comfortably buy these bonds ahead the ECB knowing that bond prices were supported by the ECB bond buying commitment. ECB bond buying allows investors to ignore the stupidity of Italian 10 year government bonds yielding 1.20% while comparable US Treasury bonds yield 1.51%. Italy is a much weaker credit and should yield more than similar US Treasury bonds.
  3. Many advisors are telling clients that you have to take more risk now because of TINA (There Is No Alternative). The problem with this line of thinking is that taking more risk does not assure you that you will get a higher return. Rather you could lose buckets of money because that’s what taking more risk also means.

The above examples just scratch the surface of what’s going on. To keep your head while all about you are losing theirs, it useful to recall Warren’s Buffet’s analogy that investing is like a baseball game with no called strikes. If you don’t like the odds (pitches), walk off the field and play some other day.

ECB Bond Buying Keeps Interest Rates Low

This chart shows the negative rates and maturities of European government bonds. The European Central Bank is prohibited from buying bonds below its negative 0.4% deposit rate. Therefore it must buy longer term bonds that yield more than -0.4%. This puts a floor under short term bond prices and drives up the prices of long-term bonds. The negative and low returns from European bonds encourage global investors to buy US Treasury bonds, which are ‘relatively’ (there’s that word again) inexpensive compared to European bonds. That’s why Neil Dwayne says US bonds are “structurally overvalued.” There is no intrinsic reason US bonds are so expensive, but they are relatively inexpensive compared to other assets.

Figure 1
Slim Pickings

Figure 2 | MCS

There is no ‘Global Interest Rate Mania’; the Counter Arguments

interest rates. Here are their counter arguments.

Interest rates are not historically low in real terms, therefore, this period is actually not unprecedented when measured by the real rate.

This statement is true – real rates (nominal rate minus inflation = the real rate) have been more negative in the past. It is also true that investors have different perceptions of the same negative real rate depending on the nominal rate. Investors earning 5% when inflation is 6% feel better about the situation than investors earning 1% when inflation is 2%. While both situations have the same negative rate of 1%, ‘feeling better’ in one situation vs. another does influence spending.

Professional investors are embracing Secular Stagnation Theory as the best explanation for what is happening today

Secular Stagnation Theory was put forth by Alvin Hansen in 1938, and describes a condition of stalled or meager economic growth in a market-based economy. ‘Stagnation’ results from a lack of consumer demand for goods and services. Secular refers changes in consumer demand that have become permanent (rather than cyclical). Secular Stagnation as an explanation for today’s environment is supported by:

  • demographics (older people spend less on stuff except healthcare),
  • losses of high paying jobs due to technology and the globalization of manufacturing,
  • the inability or desire of consumers to take on more debt, and
  • income inequality (the middleclass, having made no wage gains for decades, cannot fuel economic growth, and the small number of rich people don’t spend enough to make up the difference). To put this in stark perspective: 47% of American households could not come up with $400 to meet an emergency – so how can they spend more? http://www.theatlantic.com/magazine/archive/2016/05/my-secret-shame/476415/

The Japanese economy provides evidence of how an economy that once demonstrated significant growth can go sideways for decades, resulting in both low economic growth and ultralow interest rates. The Japanese 10 year government bond has yielded less than 2% since 2000 (Hard to believe – that’s 16 years ago!). It now yields a negative 0.23%. In other words, if you invest $100,000 today and wait ten years, you will end up with $97,700!

In the secular stagnation story, interest rates stay low for a long, long time because economic growth stagnates. Absent economic growth, the demand for money (borrowing) falls. When demand falls, the price (interest rates) for using other peoples’ money falls with it.

You can find a more detailed discussion of secular stagnation by Dr. Lawrence Summers, President Emeritus of Harvard University. http://larrysummers.com/2016/02/17/the-age-of-secular-stagnation/

At the end of Summers’ article, he notes there are fairly simple solutions to the problem. He advocates for global infrastructure investment and notes that the key to alleviating secular stagnation is to raise demand (although the article stops shy of suggesting how to do so). Hint: increased pay will enable increasing consumption and inflation.


The interest rate mania and counter arguments are cut from the same cloth. The response function to low rates is already in play in higher prices across all asset classes. Triggers that expose investors to losses include higher interest rates due to continued economic growth, higher than expected inflation, and higher taxes and government spending. Investors are not prepared for inflation reaching the Fed’s goal of 2%, much less a higher number. Nor are they prepared for interest rates to increase to 3 to 4% on the 10 year Treasury bond. Should this occur, stock, bond and real estate prices will fall. Furthermore, continued economic growth does not necessarily mean sufficiently higher earnings for US companies in the near term. The prospect of higher interest rates, higher labor costs and taxes coupled with weak corporate earnings growth, makes stocks just as vulnerable as bonds.

What I’m Doing About It

Here are some of the actions I have taken on behalf of our clients:

  • Reduced portfolio risk by building cash and investing in bonds due in 2017.
  • For the past few years, I purchased high coupon (7 %+) bonds which are highly likely to get called between 2019 and 2021. These bonds will be less impacted by higher interest rates and are now very difficult to find.
  • Reviewing and (when appropriate) consolidating client investments with substitution trades into lower cost funds, including indexes. In other words, we are selling funds with higher expense ratios and replacing them with index funds and ETFs that have lower expense ratios.

What You Should Expect

If I am correct about some major shifts in the offing, I will not be able to shield clients from all the potential pain. My goal is to make it bearable. I could be wrong about the outcome; the world could shift in unexpected ways. My analysis is evolving as new information is available. I believe that a higher emphasis on capital preservation is now prudent, but we’re not getting out of markets entirely. My track record of avoiding major economic upheavals has been very good, although I’ve tended to be early. Should markets keep rising, our performance will lag the indexes. I recognize that some clients may grow impatient and disengage my services, however, I’d rather lose clients than lose their money.

1 MCS Family Wealth Advisors (MCS) consolidated client returns are dollar-weighted, net of investment management fees unless stated otherwise, include reinvestment of dividends and capital gains and represent all clients with fully discretionary accounts under management for at least one full month in 2016. Individual client returns represent client discretionary accounts under management for the entire period – starting on 12/31/2015 and ending on 06/30/2016. These accounts represent 100% of MCS’s discretionary assets under management as of 06/30/2016 and were invested primarily in US stocks and bonds (18% of client assets on 06/30/2016 were invested in tax-exempt municipal bonds). The Stock Index values are based on the S&P 500 Total Return Index, which measures the large-capitalization US equity market. The Bond Index values are based on the Barclays Capital US Aggregate Bond Index, which measures the US investment-grade bond market. Index values are for comparison purposes only. The report is for information purposes only and does not consider the specific investment objective, financial situation, or particular needs of any recipient, nor is it to be construed as an offer to sell or solicit investment management or any other services. Past performance is not indicative of future results.