Have US Treasuries become a dangerous asset class?
In this environment of rising interest rates, and rising budget deficits, a small minority of money managers believe that US Treasuries may no longer be the safe haven that we think they are, and could in fact become a dangerous asset class in the not too distant future. This is obviously a very controversial, non-conventional view of the world. However, it does seem to merit consideration, whether we agree with it or not.
When we say that such pessimistic view is non-conventional, we mean that it defies the most basic rules of asset allocation, namely that diversification between stocks and bonds works most of the time. It works for the simple reason that most investors, individuals or institutional, follow or maintain certain asset allocation percentages. Such percentages may be altered depending on market dynamics, but a minimum bond allocation is always, or should always, be maintained by any investor. So when investors dump equities, some of that money has to go to bonds, and that makes bond yields go down, and bond prices go up. This has been the conventional view adopted by most asset allocation models. So what makes some people think that such inverse relationship between stocks and bonds is breaking down?
Their reasoning is simple: US fiscal policy is currently highly inflationary. And there is more to it than inflation being inherently bad for bonds. US aggressive tax cuts and military spending are causing the US budget deficit to balloon. It is now forecast to reach 5% of GDP, some time between 2019 and 2020. That's already a high number. Problem is, we are currently nearing the end of the boom cycle. If the budget reaches 5% of GDP at the peak of the economic boom cycle, what will it do when we get into the next recession? Will it hit 7%, 8%, or even 10% of GDP?
The above percentages are clearly unsustainable. In any event, all economists seem to agree that US debt has now reached a point where it has become impossible to repay. What makes investors buy US Treasuries is not the debt repayment capacity of the US government. It is the status of the US Dollar as an international reserve currency, to which there is no alternative. Having said that, the US Government will need to issue more bonds to finance its enormous funding needs. This will significantly add to an already huge supply of bonds in the market.
Which takes us to the other side of the equation, i.e. the demand side, where the picture is hardly reassuring. For starters, the US Federal Reserve has stopped buying, and is now selling bonds in order to normalize its balance sheet. The European Central Bank, another major source of global liquidity, has now stopped buying, and will start selling assets next year. That will be another liquidity drain. So we have an unfavourable environment of increasing supply of bonds against shrinking demand.
Adding insult to injury, there is another important variable to consider: China. Over the years, China has become a major buyer of US bonds. The way things have worked has been fairly simple: The US buys Chinese goods, paid for in US Dollars, hence the trade deficit with China. On the other hand, China uses the surplus dollars to buy US bonds, thus financing the US budget deficit, something that US investors cannot do because they spend their savings on Chinese goods. If this sounds similar to what happened between Greece and the rest of Europe, it is. Greeks kept buying German and other European goods with borrowed money, which Europeans kept financing by buying Greek bonds, until Europe said: we can lend you no more.
Obviously the US is not Greece, far from that. But the US is now telling China it has to reduce its trade surplus with it. It means the US will buy less Chinese goods, and China will have less Dollars to buy US bonds. Obviously, we are using China as a proxy for other countries that have trade surpluses with the US, because China is the largest one, but the idea is the same: if this trade war continues, the world will have less dollars to buy US bonds.
On top of that, the US is picking trade fights with everybody and the political environment, particularly between the US and China, is worsening. So can we really expect China to bail out the US Government when bond prices collapse? If not, who will fill the US governments's enormous funding gap when every body rushes for the exits?
That kind of scenario may sound very alarmist, but one has to consider it as a possibility. Obviously, there is always one buyer of last resort, and that is the US Federal Reserve (The Fed). If we get to such critical point as described in the previous paragraph, the Fed may have no choice but to step in and start buying bonds again. Such return to quantitative easing sounds like a non-orthodox scenario, but could very well become inevitable. In Japan, despite various pledges not to do it again, the Central Bank has reneged on its promise and resumed buying bonds several times already. It continues to do so. The US Federal Reserve, and the ECB, may not have a choice but to do the same thing, in order to prevent an economic meltdown 2008-2009 style. That said, they can do it up to a certain point because quantitative easing is inflationary, so it will be a tough balancing act.
All this is highly speculative for a very simple reason: we are in a totally uncharted territory, experiencing economic conditions that we have never seen before. Quantititive easing and trade wars/tariffs are new dynamics that have disrupted the normal functioning of markets, whether we are talking about credit markets, stocks or simply international trade markets. How things will all pan out is a big question mark. But there is one thing for sure: the level of Government debt, whether in the US or elsewhere, has reached astronomical proportions that make it impossible to repay: the only way to manage such mountains of debt is to debase. In other words, to make the debt more affordable and easier to manage, you reduce the value of money, by creating inflation. Among all the uncertainties, the only sure thing that one can predict is higher inflation, because all roads now seem to lead to it: US fiscal policy, unsurmountable debt levels, trade barriers and, when it comes back, quantitative easing.
What should one make of all this in terms of portfolio positioning? Well, if the main concern now is to fight inflation, and if the US fiscal picture is that gloomy, then adding to long-term bonds may not be the best choice at this point in time. This may explain why yields continue to creep up (and bond prices continue to drop) despite the stock market correction. However, we at FundScope are not (at least not yet) embracing the dooms day scenario of US Treasuries losing their safe haven status. Even if this is bound to happen, it's still probably decades away, although current US behaviour is accelerating the process. Thus we continue to believe that, in the intermediate term, cool heads will prevail and some sort of a balancing act will be found. China might put some pressure on the US, but only to a certain limit. Everybody has too much at stake and nobody can afford a full US meltdown. Therefore, we continue to believe in our base case prediction that, even though Government bonds will continue to get beaten in the short-term, the inverse relationship between stocks and bonds will prevail in the long term.
And while we wait for an equilibrium to be found, we continue to advocate overweighting defensive equities. We have previously argued that high yield equities like utilities, pipelines and even REITs have an inflation-hedged business model by definition, because their pricing structure is indexed to inflation. So even though such sectors will suffer in the short term, in line with increasing interest rates, the long-term returns should remain acceptable because they have the capacity to increase their selling prices and adjust their dividends to rising inflation. Other defensive sectors include consumer staples and health care, because they sell necessities and thus have a bit more pricing power to pass on inflation than cyclical/industrial stocks.
As for inflation, the best hedge against it is a healthy weighting in commodity-based stocks (say 10-15%), particularly precious metals, although we feel that other sectors, like energy and base metals, can also provide adequate protection in an environment of rising inflation. But most importantly, in this environment of high uncertainty and rising interest rates, it would be wise to keep a high cash balance that you can use as dry powder when stock markets correct and when bond yields peak.
October 19, 2018