Why We Hold Hard Assets II
Jim Grant is the publisher and editor of Grant’s Interest Rate Observer, a bi-monthly newsletter that he founded in 1983, around the time when bonds were considered some of the worst investments – when they yielded 13 to 15 percent.
Rick Rule, Chairman of Sprott US Holdings Inc., often quotes Jim Grant’s description of government bonds as ‘return-free risk.’ (Rick sees US Treasuries as the ‘anti-gold’).
Mr. Grant took my questions on interest rates and the bond market – including Bill Gross’ recent departure from PIMCO – via phone from his Manhattan office.
Mr. Grant, you argue that companies whose share prices are rising should be becoming more efficient – hence driving down the costs of consumer goods and services.
The Fed is succeeding in keeping both stock market prices and consumer goods prices moving higher – which look like contradictory goals. Do you think this situation is sustainable going forward?
Many years ago, falling prices were a sign of improved efficiency and expanding wealth, and of widening consumer choice. Thanks to the spread of electricity and other such wonders in the final quarter of the 19th century, prices dwindled year by year at a rate of 1.5% to 2% per year. People didn’t call it deflation – they called it progress. Similarly, in the 1920’s there were advances in production techniques. The prices didn’t decline and didn’t rise. They were stable. Looking back on the 20’s from the vantage point of the 30’s, many people wondered why prices had not fallen. They concluded that it was because the central banks were emitting too much credit, and that credit had served to inflate asset values. It had also pushed the world into a very imbalanced credit and monetary situation towards the close of the 20’s.
Fast forward many generations and here we are today with a world-wide labor market linked through digital technology. We are the beneficiaries of Moore’s law. Nearly every day we see new, wonderful, labor-enhancing machinery coming into the workplace – including new software. And yet, prices don’t fall. They tend to rise, albeit by 1% or 2% per year. Central banks seem to want more than that. You do wonder – I wonder – what would be wrong with what Wall Mart calls ‘everyday low and lower prices.’ People seem to rather relish that – certainly when shopping on the weekends. Central banks want no part of it. So, I see that as a contradiction. What central banking policy has done is to inflate consumer prices that, if the laws of supply and demand were properly functioning, would have tended to fall. At the same time, central bank policy has tended to inflate the prices of stocks, bonds, and income-producing real-estate. Why it is that these immense emissions of new credit by the central banks have not been inflationary? Well, it seems to me that they have been inflationary, because prices are rising not falling.
Do you think that the situation will continue going forward – rising consumer prices along with rising stock prices?
What I don’t know about the future, we don’t have the time to go into. I dare say that stock prices will not continue to rise uninterrupted at the same pace. That’s not a very interesting prediction, but the stock market is certainly a cyclical thing. Stock prices will pull back in the fullness of time, whether it starts 5 minutes, 5 months, or 5 years from now. I think it’s fair to observe that today’s ultra-low interest rates flatter stock market valuations. Stock prices are partly valued based on a discounted flow of dividend income. To the extent that the discount rate you use to value that stream of dividend income, which depends on interest rates, is artificially low, stock prices are artificially high. I think that the burden of proof is on anyone who would assert that we are in a new age of persistently and steadily rising stock prices.
On the subject of bond markets, you’ve said: “does it not seem incongruous to chase low-yielding fixed-income securities denominated in a currency that the central bank is vowing to inflate?” Why do you think that investors go into bonds despite the Fed’s intention to devalue them over time?
Well, I can’t explain it. I can try to piece together what might be driving people to do that, but, to me, it’s a mystery. One thing to bear in mind is that bond prices have been rising and yields have been falling since fall of 1981. That’s a long time and there’s something in financial markets that we might call ‘muscle memory.’ Long-running trends tend to gather force, just as a rock rolling down a hill tends to pick up speed. There’s something about the persistence and age of this bull market that leads more people to think that it will continue. That said, fixed-income investors are intelligent and reasoning people. That can’t be the entire explanation. I see that in Europe money market interest rates are trending below zero. You have to search long and hard over the globe to find government securities in developed countries yielding more than 2%. In Ireland, some short-term securities are yielding less than 0%. Why would people buy them? I simply don’t know – I can’t fathom it –, but they certainly are, hand over fist.
You’ve also said that Treasury investors may ‘repent at their leisure’ for buying US Securities, and that corporate investors will one day wish they had not invested so heavily in corporate bonds. Do you see a bear market coming imminently for bonds?
Yes – starting about 2002…
Henry, now, that’s meant to be a laugh line.
I have wholly been way out of step with the bond market for a long time, and everything that I say with regards to the future of interest rates deserves to be written in something like invisible ink. You know, in a work entitled ‘Security Analysis,’ a work about value investing written by Benjamin Graham and David Dodd, this approximate phrase appears: “bond selection is a negative art.” Well, what Graham and Dodd meant by that is that, because the buyer of a bond at par can do no better than getting his money back and earning some interest along the way, the prospect for gain is inherently limited. Risk ought to be at the front of the mind of the creditor. There are no 2 or 3-baggers in investment-grade bond investing. You have to be mindful of what can go wrong, and it seems that the world over, thanks to these policies by central banks, bond investors are not looking at risk, or feel they can’t afford to look at risk. Rather, they are grasping at the few straws of yield that remain and I think that posterity will look back at this with wonder.
“Think of it” – I’m now putting words in posterity’s mouth. “Think of it, people were buying as if the supply were limited. They were buying government securities, which yielded practically nothing. They were buying bonds denominated in currencies that the central banks explicitly vowed to depreciate. Why did they do that?”
So, I think posterity will ask that question. Certainly I am asking that question now, and I can’t come up with a really persuasive answer.
What would a bear market in bonds look like? Would it be accompanied by a bear market in the stocks?
Well, we have a pretty good historical record of what a bear market in bonds would look like. We had one in modern history, from 1946 to 1981. We had 25 years’ worth of persistently – if not steadily – rising interest rates, and falling bond prices. It began with only around a quarter of a percent on long-dates US Treasuries, and ended with about 15% on long-dated US Treasuries. That’s one historical beacon. I think that the difference today might be that the movement up in yield, and down in price, might be more violent than it was during the first ten years of the bear market beginning in about 1946. Then, it took about ten years for yields to advance even 100 basis points, if I remember correctly. One difference today is the nature of the bond market. It is increasingly illiquid and it is a market in which investors – many investors – have the right to enter a sales ticket, and to expect their money within a day. So I’m not sure what a bear market would look like, but I think that it would be characterized at first by a lot of people rushing through a very narrow gate. I think problems with illiquidity would surface in the corporate debt markets. One of the unintended consequences of the financial reforms that followed the sorrows of 2007 to 2009 is that dealers who used to hold a lot of corporate debt in inventories no longer do so. If interest rates began to rise and people wanted out, I think that the corporate debt market would encounter a lot of ‘air pockets’ and a lot of very discontinuous action to the downside.
Is it possible for the Fed to ‘lose control’ of the bond market and yields?
Absolutely, it could. The Fed does not control events for the most part. Events certainly will end up controlling the Fed. To answer your question – yeah. I think the Fed can and will lose control of the bond market.
So no matter how many bonds the Fed buys, it eventually won’t be enough to keep yields low?
Well, let’s try to imagine a case where the Fed proposed to buy every single bond in existence. To do that, it would undertake to print more money than we – even us hardened veterans of the QE era – could imagine. If the Fed undertook to print the money necessary to buy all the bonds on offer, it would spook at least the more thoughtful investors, who would see that the Fed would certainly be undertaking a truly radical program of inflation.
It seems like the Fed is doing almost exactly that today – and we’re still waiting to see the adverse effects.
Well, yes indeed. I think this is a time where people will look back on us and see it as a period of practically central bank worship. The central bankers – Draghi, Yellen, Bernanke – have become almost celebrities in America. People have invested unreasonable hopes in what these central banks can know, and what they can do. I think that, sooner or later, the investing public will become disillusioned of these ideas.
What are ‘safe haven assets’ if you believe that a bear market in bonds is inevitable?
Well, if we believe that financial markets are cyclical, then bear markets are inevitable — just as bull markets are inevitable. I wish I could tell you when these will happen – I can’t. I think that the nature of a safe haven will depend on the type of bear market and the reason for that bear market. You can imagine a bear market in bonds where the reason was an unscripted burst of prosperity. Let’s say that the indestructible American economy, for whatever reason, got back its mojo, and the Fed seemed to be way behind the curve. Interest rates would go up for the wholesome reason that things were looking better. At that point, you could make a very good case for common stocks.
If the bond market sold off because of a sudden and unscripted loss of confidence in the currency, that would be a different matter altogether. I think that ‘safety’ is not inherent to any asset – rather, ‘safety’ is a function in large part of valuation. Towards the tail end of the great bond bear market of 1946 to 1981, people were fed up with fixed-income securities. They only seemed to go down in price –investors were always disappointed. They slapped various labels of scorn on the entire asset class. That was when people first called them ‘certificates of confiscation’ – and that was when they yielded 13%, 14%, or 15%. They certainly were not certificates of confiscation as events revealed. Today, when bonds yield a great deal less than 13, 14, or 15%, most investors regard them as intrinsically safe assets. Well, they are not intrinsically safe. They are popular – that’s a very different matter.
At Grant’s, we try to look for assets that are castoff, unpopular, out-of-favor, and value-laden. We have been looking at common stocks in, for example, Argentina and Russia. These are places that would appear to be inherently unsafe. We’ve of course been looking at gold and gold mining shares for a long time too. What gold, Argentina, and Russia have in common is that people are, by and large, going from them rather than towards them. If you asked the average person on the street whether securities relating to those three areas were safe or unsafe, I think that 99 out of 100 would say ‘unsafe.’ There is a great deal to be said for the ultimate safety that low valuations afford. That’s how we approach the situation. A little bit less exotically, we’ve been looking at business development companies generating attractive cash flows in this time of ‘yield famine.’ ‘Safety’ is a tricky and paradoxical concept. The safe assets are often the ones that people regard as hopelessly risky.
One more question – Bill Gross recently announced his departure from PIMCO. Is this a trivial event, or a sign of something more fundamental happening in the bond market?
I don’t know how to read it. Maybe after 40-odd years in the same place, Bill Gross deserved a change of scenery? I think he has enough money to retire – I dare say he could scrape by on a billion or so. He seems to want to continue to work – that’s laudable. Insofar as his exit having a deeper meaning, it may be to underscore the new illiquidity of the bond market. On news of his exit, a lot of different classes of fixed-income securities sold off, and I wouldn’t have expected Treasuries and mortgages to move the way they did. We at Grant’s think that the illiquidity of fixed-income securities might be one of the important themes of the coming autumn for the bond market.
By ‘illiquidity,’ you mean that investors are unable to buy and sell bonds easily?
It’s not difficult to buy them.
So it’s difficult to sell them.
Correct. What you want is a ‘greater optimist’ and it’s not clear that a ‘greater optimist’ will be available when you want to get out.
James Grant founded Grant’s Interest Rate Observer in 1983 following a stint at Barron’s, where he originated the “Current Yield” column.
His books include works of financial history, finance and biography. They are: “Bernard M. Baruch: The Adventures of a Wall Street Legend” (Simon & Schuster, 1983); “Money of the Mind: Borrowing and Lending from the Civil War to Michael Milken” (Farrar, Straus & Giroux, 1992); “Minding Mr. Market” (Farrar, Straus & Giroux, 1993); “The Trouble with Prosperity” (Times Books, 1996); “John Adams: Party of One” (Farrar, Straus & Giroux, 2005); “Mr. Market Miscalculates” (Axios Press, 2008); and “Mr. Speaker! The Life and Times of Thomas B. Reed, the Man Who Broke the Filibuster” (Simon & Schuster, 2011).