The Bond Calamity

This hurts: since early 2020 the value of a twenty-year U.S. Treasury bond has fallen by half. For months now, we’ve been at a crossroads. Will the world’s central banks continue to raise interest rates in an effort to contain inflation? If they do that, bonds will continue to sink and heavily indebted governments, corporations and consumers will struggle. Most likely a severe economic crash will unfold. But what about the opposite scenario? What if central banks decide not to risk a recession and do what they’ve done almost every time in modern monetary history—kick a recession and do what they’ve done almost every time in modern monetary history—kick the can further down the road by lowering rates? Many analysts believe that would vastly improve the bond market’s prospects, a bet I’m still uncomfortable with.

Here is why. Yes, falling interest rates typically boost debt securities. However, if falling rates coincide with an increase in inflation, the opposite can happen. Through much of the 1970s, for example, bonds steadily underperformed cash, while cash lost in value due to inflation. To be sure, the world has changed a lot during the past half-century, but at least to me the 8% or so average inflation rate that dominated the decade of the 1970s is not unimaginable in today’s context.

Still, I remain far more non-committal than most financial strategists. The primary reason I’m agnostic on what central bankers will do or what the consequences of their actions will be, is that things have been allowed to move in the wrong direction for so long that the concept of a “correct” or “incorrect” monetary response is no longer realistic.

So, the bottom line on the most talked about asset class of the moment: remain cautious. In our April 02, 2020 update I wrote, “Arguably the worst asset class at the moment is that of bonds.” We’ve been mostly out of fixed income markets since then, except for small positions in very high-quality short-term selections, which served as cash-like holdings with superior yields. By now, by far the largest part of such holdings is in maturity-staggered, deposit-insurance guaranteed American CDs and Canadian GICs, which currently yield between 5.5% and 6%. Will bonds stage a come-back soon? It’s possible, but for now I believe that a defensive position remains the most prudent choice.

Unfortunately, the performance of other asset classes is equally difficult to predict. The elevated rate environment not only hurts segments of the economy, but also enhances the possibility of a “financial accident”. Another factor of concern in today’s interconnected global economy is that the U.S. status quo can easily be derailed by external events.

With much of Europe’s economy struggling and China in the midst of a real estate collapse, contagion risks are high. All of this weighs on an already overvalued stock market.

The value of currencies is determined by much the same factors. I’ve been warning for months that the widespread calls for a dollar collapse are premature. My sentiment is still the same: yes, the replacement of the U.S. currency as the world’s reserve currency is inevitable, but the process will take longer than most people predict. For the moment, the dollar offers higher nominal rates than other major currencies, which makes it an attractive parking spot. That reality is also affecting gold, whose progress has for the moment been halted.

The Recent Past…

The past weeks have been fascinating. Colourful narratives of what exactly would happen abounded, but most were dashed. We were told that the G-20 would adopt its draft resolution condemning Russia over its invasion of Ukraine, but India and other Global South nations didn’t go along with it. Equally, countless analysts predicted that the BRICS nations at their late August summit would announce the birth of a new currency, possibly backed by gold. Another call that didn’t manifest. Oh, and all along there were forecasts of a U.S. dollar collapse; instead the greenback made new highs.

Here is what did come out of the summit theatrics. The G-20 announced that they stood united in their desire to implement digital currencies and IDs, which virtually guarantees even greater government overreach. And as to the BRICs, while they didn’t stand united on all issues, they did significantly advance their key ambition: expansion. The addition of Iran, Saudi Arabia, the UAE, Argentina, Egypt and Ethiopia will boost the clout of the BRICs block significantly—at the expense of North America, Europe and Japan.

Other valuable insights could be obtained by listening to people who, unlike our professional and mostly incompetent politicians, actually run economic and social enterprises. The most interesting corporate perspective was that offered by Jamie Dimon, the CEO of JPMorgan Chase, the world’s largest bank. In a presentation to a New York banking conference he offered an economic outlook that differed sharply from the government narrative. “To say that the consumer is strong…is a huge mistake,” he warned, adding cautionary remarks about other weaknesses, such as debt levels and dependence on government handouts.

Another relatively new element in recent public discussion is the growing popular disapproval of government support of Ukraine. In North America, criticism is still relatively muted, but in Europe tensions between individual EU member states and differences between political factions within them are rapidly escalating. Other media-assisted government campaigns are crumbling as well. Six months ago ESG initiatives, green targets and the determination to keep out nuclear power still received enthusiastic public support. That is no longer the case.

…And The Weeks Ahead

Looking at the remainder of the year makes for an interesting exercise. A great many economic, monetary, social and political issues will be coming to a head. Here is what I see:

The economy and monetary policy: As already discussed, the strength or weakness of the economy and inflation will determine how long central banks will keep interest rates high. Timing the Fed’s rate reversal remains extremely difficult. Personally, I feel quite strongly that the economy is far weaker than generally portrayed, especially in the hugely important consumer space. Let’s look at job creation and personal consumption data served up by the U.S. government. Month after month, the numbers surprise on the upside, but invariably they are later revised downward. The chart below illustrates it all perfectly.

Yet, while a weaker economy may force the Fed to stop raising rates, a continued rebound in inflation could convince it to keep rates at the current, high level. In short, we could be here for quite a while longer.

Social issues: As the pace of the economy weakens, which is already the case in several G10 nations, consumers will feel the pain. With governments under growing pressure to cut back on support programs and inflationary pressures rising (particularly on the food and energy front), social discontent may boil over.

Domestic politics: The focus here will increasingly turn to the United States, whose presidential race resembles the kind of charade we usually get to see in places like Pakistan or Nigeria—not an inspiring image for Americans or anyone still confident in the Washington-led “international rules-based order.” The odds of a hotly contested election outcome are growing by the day.

Geopolitics: I’m even more concerned about America’s international stratagems. Both the conflict with Russia and the deepening conflict with China usher in risks we haven’t seen for sixty years—risks that are further elevated by what a desperate Joe Biden may do in his pathetic quest to appear strong and gain re-election.

Our Portfolio

As I have repeatedly confessed in recent months, I have no idea how the fallout from decades of reckless policy will unfold. Which means that I’m closely watching developments, always prepared to make adjustments. Yet, curiously, our top-down allocations have been unchanged for quite some time—which is not to say that within each asset class we haven’t made changes. Let me summarize.

Overall, we continue to pursue a highly defensive strategy. Cash and cash-like instruments have made up 35% of our portfolio for some time—but a year ago, yields were far lower than they are now. Earning roughly the equivalent of the current inflation rate makes for a powerful justification of a meaningful cash hoard. As valuations in other asset classes become more compelling, we will be redeploying funds to attractive areas, hopefully at depressed levels.

Our bond holdings currently make up less than 10% of the portfolio; we’ve limited our exposure to high quality, short-duration choices. I’m giving a lot of thought to how we should respond when fundamentals for the fixed income sector improve. My current inclination is that “bond proxies” in the equity arena, especially quality consumer staples, utilities and pipelines, may have better recovery potential than bonds themselves—but we’ll deal with that when we get there.

Equities, at 40%, represent the largest part of our model portfolio, but here we have made modifications, as well. Roughly one quarter of our equities are now in commodity stocks. The reason: valuations are far more impressive than in the broad stock market and cash flow generation is impressive. Of course, in the event of a deflationary economic collapse commodities would suffer. But in the stagflation scenario which I believe is more likely, they will prosper. In many ways, the current situation is reminiscent of the 1970s, a decade during which the bond market tanked, most stocks were trapped in a nauseating sideways pattern and commodities prospered. Where are the other three quarters of our equity allocation invested? Mostly in companies with healthy balance-sheets, sustainable cash flow generation and, in most cases, attractive dividends.

Finally, a word on gold, which has not done well. As our chart shows, the setback in U.S. and Canadian dollars during the past 30 days has been around 4%, in Japanese yen 2%, and in terms of the European currencies below 1%. While this a clearly a technical setback, we remain encouraged by the metal’s fundamental position and its historical prowess as a portfolio stabilizer. That’s why we retain our 15% allocation to physical gold and look toward the November to February time window, historically the best period for appreciation.

Best regards,

Peter Cavelti