By Nick Fisher, Portfolio Manager
For the last 7 years the vast majority of economists and analysts alike have incorrectly forecasted rising interest rates and the possibility of rampant, out of control inflation. This stems from their lack of understanding in the differences between this business cycle and all other post-war era business cycles. Recently, however, these same soothsayers have flip-flopped and said that they now believe that interest rates will likely stay lower for longer. We have written extensively about the insignificance of short-term interest rate volatility to our bond holdings in the past, but it may be time to change our stance. The probability of inflation and rising rates over the next 5 years is much more significant than it has been in the recent past and it poses a real threat to investment portfolios. We need to be prepared.
For years investors have incorrectly assumed that the Federal Reserve (Fed) controls interest rates. In theory, the Federal Funds rate is a baseline. However, all other risk premiums on all assets in the world are determined by the "market" and in reality by investor participants, not the Fed. We are seeing signs that global investors are losing faith in US Federal Reserve Monetary Policy. The implication is that the Federal Reserve will either have to raise interest rates ignoring investor response and the market will sell off, or the Fed will hold rates near zero for way too long which increases the risk of inflation.
I believe investors are grossly mispricing the risks in the financial market.
To reiterate, we have recently touted the benefits of cash and bonds to offset the risks inherent in holding stocks. This served us very well in the volatility we experienced earlier in 2016 (after the first time the Fed raised rates). In recent daily volatility, we have not had this diversification benefit.
On Friday September 9th, Boston Fed President Eric Rosengren commented that, "...a reasonable case can be made," for raising rates to avoid overheating the economy. "A failure to continue on the path of gradual removal of accommodation could shorten, rather than lengthen, the duration of this recovery," he said. In response to Rosengren's comments, every major asset class, equity sector, bond sector and commodity was down in a significant way, except cash (ie. US Dollars). We call this correlation.
When markets are highly correlated they all move in the same direction at the same time and there is very little if any benefit from diversification and portfolio volatility increases. One day in the market is nothing to hang your hat on, but I believe this may be a harbinger of things to come. In this scenario, bonds will not provide nearly the diversification benefit that they have in the past.
As a result of this foresight, the exposure we have to bonds is significantly less susceptible to interest rate movements than the bond market averages. With a broad exposure to the short end of the maturity spectrum, both of our preferred bond managers at Doubleline and Janus have a conservative view of the lopsided risk/reward tradeoff available in the bond market currently. In summary, our bonds will lose less value from interest rate increases than the average portfolio (as identified by the major aggregate bond index).
Typically, rising rates and inflation go hand in hand and the stock market returns provide a reasonable tradeoff from inflation risk. In other words, the returns expected from stocks outweigh the drag on purchasing power from inflation. In a fair to overvalued stock market like we have now, the returns may not be sufficient to balance the inflation risk inherent in a diversified portfolio.
With bond values also suffering from higher interest rates and the purchasing power of cash declining, we are left with quite a dilemma. We have been diligently working on this issue for some time in preparation for the inevitable turning of the tide.
Natural Resource Equities as a Solution
In a recent white paper, GMO's Jeremy Grantham and Lucas White lay out the investment case for natural resource equities, which is well outside the favor of current market analysts. This is just the kind of thought leadership we look for.
Grantham and White write:
We believe the prices of many commodities will rise in the decades to come due to growing demand and the finite supply of cheap resources. Public equities are a great way to invest in commodities and allow investors to:
1. Gain commodity exposure in a cheap manner
2. Harvest the equity risk premium
3. Avoid negative yields associated with rolling some future contracts
Many analysts and investors over the years have proven the importance of direct commodity ownership in protecting a portfolio during inflationary times. Most of these studies use the direct ownership of commodities to represent the portfolio diversification benefits. Of course, direct ownership for investors is very difficult, given the impracticality of taking delivery and storing significant amounts of any natural resource. As a result, investors turn to futures markets, which become quite expensive typically negating the benefits almost entirely over long periods of time.
Owning the stock of commodity companies is a much more effective way of gaining the inflation fighting benefits of owning the commodities. We call this difference between the two the equity risk premium. In other words, you gain a premium of return for owning the stock compared to owning the futures contracts.
During periods of high inflation, where inflation was persistently above 5% for more than 1 year, commodity company stocks have performed much better than the S&P 500 as a whole.
Over short periods of time, resource companies can be volatile, similar to the broader stock market. Given the low correlations between the two however, over long periods of time the diversification benefits can be dramatic. Of course, the past performance of these asset classes does not guarantee performance will be the same this time. When you have an asset class as disliked as resources are currently, I believe the chances of success are significantly higher.
Why are resource stocks so disliked? The natural capital cycle and flow of investment has been waning given the recent plunge in commodity prices. When no one wants to own an asset class, prices naturally adjust lower until select value investors see prices low enough to justify the risk. Considering these lower valuations, this is precisely the type of scenario that excites us and creates opportunity for outperformance over long periods of time. In the meantime, volatility will naturally scare some investors and they will mistake short-term volatility with risk and they will miss out on long-term, lower risk opportunities in favor of the false sense of security and the erosion of their purchasing power from inflation.
In summary, the Fed has used all of its tools to stimulate the economy and it hasn't worked particularly well. The Fed runs the risk of encouraging mal investment and system instability in certain areas by keeping rates too low for too long. In the short-term the market doesn't appear accepting of the Fed raising rates. We are bound to see volatility as this scenario plays out. Over the long-term, natural resource stocks are an area that could provide a reasonable risk-adjusted return over the remainder of the interest rate cycle.