2016 Q3 Legacy Group Commentary

Interest Rates are Low?  Who Knew?  

The chart below shows the change in the interest rate of the 10 year Treasury bond over the last 34 years.  The early 1980’s were the tail end of a period of high inflation and interest rates.  Many of you probably remember having CD’s paying interest in the double digits.  In 1981 policies were enacted by the Federal Reserve that started a drop in interest rates that, as the chart below shows, has not really ended since.  Earlier this year the interest rate on the 10 year treasury hit a record low…the US has never seen interest rates this low.   In fact, if you put it in a broader historical context the current interest rate environment is the lowest the world has ever seen.  We won’t bore you with the details of Grecian, Roman, Byzantine and British Empire interest rates but it is true – interest rates have never been this low.  

The real effects of this on people’s lives are clearly visible.  On the positive side home, vehicle and unsecured financing is inexpensive.  This has allowed people to free up cash flow by reducing their interest costs and households have been slowly reducing their debt the last few years.  Total household debt relative to US Gross Domestic Product is the lowest it has been in over a decade. 

However, the negative consequences of low interest rates are starting to weigh heavily on investors and the economy.  Our economy is built upon a system of credit and interest and it is becoming apparent this system is impaired in a low rate environment.  Banks rely on the ability to lend money out for more interest than it costs them to hold it (net interest margin).  As interest rates entered into unprecedented lows their margins shrank and now depositors receive little to no interest while paying fees on their accounts.  Similarly, insurance carriers rely on interest payments from a bond portfolio to reduce premium costs and increase profits.  As income received from their investment portfolios have decreased insurance premiums have increased.  Pension funds who had generally counted on – foolishly in our opinion – an 8% annual rate of return to pay future liabilities are now facing a reality where 40% of their portfolio is only earning 2% – or less – interest.  That makes it kind of hard to earn the 8% they – and their pensioners – are counting on.  While low interest rates may have assisted in the avoidance of a total economic collapse if they continue too long our economic system may slowly break down.

What we think is more likely to happen is an attempt to return to normal via central bank raising interest rates. We have been waiting for this for a long time.  Admittedly, this low interest rate environment has lasted far longer and been more extensive, than we expected.  It could continue to go on longer than we expect.  But the commentary among the “economic and political elite” has begun to change.  The US Federal Reserve is receiving a lot of pressure to normalize rates and it appears they may resume that process soon.  

A World with Rising Interest Rates

This creates a very real risk to investors.  There is an inverse relationship between interest rates and the value of a bond.  If interest rates go down – like they steadily have for 30 years – then the value of a current bond goes up.  If interest rates go up then the value of a current bond goes down. Once this process of raising rates begins bond holders will be dealing with something they have not had to deal with in 30+ years – the value of their bonds going down.    

As Jack would remind us, the way people invested when he started as an investment manager 40 years ago this would not matter.   People would purchase a bond by directly lending the US Government or a company $10,000, for example, collect interest for 10 years and then at the end 10 years the entity would give them back their $10,000.  Whatever happened to the price of the bond along the way did not matter.  The investor got their $10,000 back at maturity no matter what the value of the bond did.  

But it does not really work like that anymore.  30 years of decreasing interest rates, an industry “scaling” their business models to maximize profits, and the creation and adoption of Modern Portfolio Theory (the en-vogue investment management theory of the day) have essentially changed how individual investors access the bond market.  Investment products have been designed and built around a bond market that steadily increases in value. The principal protection element of bonds (you get your $10,000 back the end of 10 years) has been at best limited and at worst eliminated through the management style of bond funds.  Bond fund managers rarely (very rarely) hold a bond till maturity.  In fact, the execution of a portfolio following Modern Portfolio Theory results in the creation of divided bond classes grouped by the maturity date of the bond.  This grouping forces the manager to sell their bond holdings prior to maturity, even it has to be sold at a loss. 

With the winds of change upon us we are being forward thinking in how to manage a bond portfolio in a rising interest rate environment.  There are methods to mitigate this risk.  Some strategies have already been implemented in portfolios and others will be implemented as conditions warrant. 

China

In the 2016 Quarter 1 commentary we wrote the following:

The Chinese market and economy have made a lot of headlines over the past year.  The Shanghai Exchange experienced massive volatility in 2015 and the resultant conversation of the financial pundits was that the Chinese economy was headed for a hard landing.  We have never quite understood the general consensus of the financial world towards China.  They have painted a picture of a country laden with debt, lower economic growth prospects, and highly overpriced stock markets (sounds familiar).  But to every one of these arguments there exists fundamental misunderstandings about China.  In the interest of brevity, let’s examine just one…overpriced stock markets.

In the Quarter 1 commentary we addressed the overpriced stock market.  In the Quarter 2 commentary we addressed lower economic growth prospects.  And this quarter we will wrap this up by addressing the misconceptions of China being overextended in debt.  

Wait a minute…there’s actually two sides to a balance sheet?  

During the last decade total debt in China – consisting of corporate, household, government and bank debt – has increased from roughly 150% of China’s Gross Domestic Product (GDP) to over 250% of China’s GDP.  That’s a lot of debt. In fact, when you take into consideration that the denominator in the equation has also increased significantly during that time period the increase in debt gets really big: total debt has gone up 465% in the last decade.  

Our recent experiences in western culture make these numbers very worrisome.  In the US, we have witnessed the danger of an over-leveraged economy: the 2006 housing crisis and the subsequent Great Recession beginning in December 2007.  But to every balance sheet there are two sides: assets (what you own) and liabilities (what you owe).  What is being largely ignored in the case of China is the asset side of the balance sheet.  

Let’s take a look at the household debt burden in China within the context of the real estate market.  In the last few years many pundits have expressed concern of a growing bubble in Chinese home prices.  Home prices have increased roughly 9% – on average – every year for the last 10 years.   In our economy those high increases would be troubling.  But Asian cultures tend to look at savings and debt differently than western culture.  In short, they save more and they go into less debt. A few statistics to consider:

  • Wage increases have averaged roughly 13% per annum for the last 10 years, which outpaces the home price increases.
  • In order to buy a home in China a 20% down payment is required.  That is not a banking standard.  It is a law.  That is if it is your first home.  If you are buying an investment property (second home) 30% is required. 
  • A 2014 study showed that 15% of all real estate purchases were paid with 100% cash.
  • According to a China Household Finance Survey in 2012, average household debt amounted to only 11% of home value; the median household debt was 0%.   
  • The same 2012 survey indicated that if home values fell 50% only 14% of mortgages would be underwater.  

Those stats paint a very different picture than an over-extended, over-leveraged consumer.  And a similar picture could be painted for corporate and government debt: there are assets to support their level of debt.  Even the structure of the debt (state financed in a closed system) makes the debt level more palatable.  While Chinese debt has grown excessively during the last several years it appears to be at manageable levels. 

That is not to say there is no risk here.  In our opinion this increase in debt is going to continue for some time.  China has aspirations for their currency (Yuan) to be used more heavily in international transactions and as a reserve currency.  In order for that to happen there needs to be more volume of Yuan in the market.  In a fiat currency system, money is created and put into circulation through debt.  If China wants more Yuan in circulation then more debt will be required.  Continuing to fuel this debt may put more strain on the Chinese economy.  While we do see long term value in investing in China we will be closely monitoring the situation watching for meaningful economic deterioration. 

As we examine the global landscape, China – and other select Emerging Markets – continue to have the greatest potential for long term growth.  We believe patient investors who endure the volatility often experienced in these markets will see long term gains.  We also see developed markets – such as the US and Europe – struggling to obtain meaningful economic growth.  As central banks and governments make more decisions and businesses and individuals continue to adjust to an economic environment very different than it was a decade ago we believe markets will continue to be volatile.  Throughout these developments we will continue to invest in areas where we see value and the greatest potential for long-term growth.

Blake

Past performance is not a guarantee of future earnings.  Asset allocation does not assure a profit or protect against loss in a declining market.  Blake A. Stanley, CFP® is an Investment Advisor Representative of Legacy Advisory Group, LLC a Registered Investment Advisory Firm.

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