The views expressed in this commentary are those of Hoisington Investment Management Company, the sub-advisor to the Fund, and may differ from the views of Wasatch Advisors.
The Wasatch Hoisington Treasury Fund registered a return of 11.21% for the quarter ended December 31, 2014, compared to just 1.79% for the Barclays Capital U.S. Aggregate Bond Index. For the 12 months of 2014, the Fund returned 32.58%, more than five times the 5.97% return of the Barclays.
The Fund’s substantial returns for the quarter and year were made possible by the long-duration investment posture we have taken during this time of sharply falling long-term U.S. Treasury bond yields. The 30-year U.S. Treasury bond yield closed calendar year 2014 at 2.75%, down from 3.20% on September 30, and dramatically below the 3.95% yield at year-end 2013.
Details of the Quarter
All measures of inflation fell substantially both in the United States and globally. Moreover, indicators of future inflation declined even more steeply. Commodity prices at year-end 2014 were 40% to 70% lower than at their peaks in 2011. At year-end, eight to 10 of the world’s 20 largest economies were either in or near recessions. The main cause for these depressed conditions has been the over-accumulation of debt used, in too many cases, to fund consumable and non-productive assets that fail to generate a future stream of revenue to repay this debt.
Outlook for the Year
“No stock market crash announced bad times. The depression rather made its presence felt with serial crashes in dozens of commodity markets. To the affected producers and consumers, the declines were immediate and newsworthy, but they failed to seize the national attention. Certainly they made no deep impression at the Federal Reserve.” Thus wrote author James Grant in his latest thoroughly researched and well-penned book The Forgotten Depression.
Commodity price declines were a symptom of sharply deteriorating economic conditions prior to the 1920-21 depression. To be sure, today’s economic environment is different. The world’s economies are not emerging from a destructive war, nor are we on the gold standard, nor is U.S. employment centered in agriculture and factories (over 50% in the U.S. in 1920), yet the fact remains—global commodity prices are in noticeable retreat. Since the commodity indices peaked in 2011, prices have plummeted. The Reuters/Jefferies/CRB Index† has dropped 39%. The S&P GSCI®†† is down 48%, energy (-56%), metals (-36%), copper (-40%), cotton (-73%), West Texas Intermediate (WTI) crude (-57%), rubber (-72%), and the list goes on. This broad-based retreat reflects, in some cases increased supply, but more clearly it indicates weakening global demand.
The proximate cause for the current economic maladies and continuing downshift of economic activity has been the over-accumulation of debt to fund, in many cases, consumable and non-productive assets that fail to create a future stream of revenue to repay the debt. This circumstance means that existing and future income has to pay not only current outlays, but past expenditures as well, in the form of interest and repayment of debt. Efforts to spur spending through relaxed credit standards, i.e. lower interest rates, minimal down payments, etc., to boost current consumption merely adds to the total indebtedness. According to Deleveraging? What Deleveraging? (Geneva Reports on the World Economy, Report 16) total debt-to-gross domestic product (GDP) ratios‡ are 35% higher today than they were when the 2008 crisis began. The increase since 2008 has been primarily in the underdeveloped world. Since debt is the acceleration of current spending in lieu of future spending, falling commodity prices (similar to 1920) may be the key leading indicator of more difficult times ahead for world economic growth as current overspending is reversed.
Recognizing the economic malaise, various economies, including the U.S., have instituted policies to take an increasing “market share” from the world’s competitive, slow-growing marketplace. The U.S. fired an early shot in this economic war instituting quantitative easing‡‡ (QE) 1, 2 and 3. Each episode of bond purchases weakened the dollar. However in each case, the cessation of the Fed’s balance sheet expansion reversed the dollar weakness.
Subsequently, Japan and Europe have joined the competitive devaluation race and have managed to devalue their currencies by 61% and 21%, respectively, relative to the dollar. Last year, the dollar appreciated against the currencies of all 31 of the next largest economies. Since 2011, the dollar has advanced 19%, 15% and 62%, respectively, against the Mexican peso, the Canadian dollar and the Brazilian real. Latin America’s third largest economy, Argentina, and the 15th largest nation in the world, and Russia, have depreciated their currencies by 213% and 82%, respectively, since 2011.
The competitive export advantages gained by these and other countries will have adverse repercussions for the U.S. economy in 2015 and beyond. Historical experience in the period from 1926 to the start of World War II (WWII) indicates this process of competitive devaluations impairs global activity, spurs disinflationary or deflationary trends and engenders instability in financial world markets. As a reminder of the pernicious impact of unilateral currency manipulation a brief review of the last episode is enlightening.
The return of the French franc to the gold standard at a considerably depreciated level in 1926 was a seminal event in the process of actual and de facto currency devaluations, which lasted from that time until World War II. Legally, the franc’s value was not set until 1928, but effectively the franc was stabilized in 1926.
France had never been able to resolve the debt overhang accumulated during World War I and, as a result, had been beset by a series of serious economic problems. The devalued franc allowed economic conditions in France to improve as a result of rising trade surplus. This resulted in a considerable gold inflow from other countries into France. Moreover, the French central bank did not allow the gold to boost the money supply, in contradiction to the rules of the game of the old gold standard. A debate ensued as to whether this policy was accidental or intentional, but that misses the point. France wanted and needed the trade account to continue to boost the domestic economy, and this served to adversely affect economic growth in the United Kingdom and Germany. The world was lenient to a degree toward the French, whose economic problems were well-known at the time.
In the aftermath of the French devaluation, economic conditions began to deteriorate in other countries between late 1927 and mid-1929. Australia, which had become extremely indebted during the 1920s, exhibited increasingly serious problems by late 1927. Signs of distress then appeared in the Dutch East Indies (now Indonesia), Germany, Finland, Brazil, Poland, Canada and Argentina. By the fall of 1929, economic conditions had begun to erode in the United States, and the stock market crashed in October.
In 1929, Uruguay, Argentina and Brazil devalued their currencies and left the gold standard. Australia, New Zealand and Venezuela followed in 1930. Through the turmoil of the late 1920s and early 1930s, the U.S. stayed on the gold standard. As a result, the dollar’s value was rising, and the trade account was serving to depress economic activity and transmit deflationary forces from the global economy into the United States.
By 1930, the pain in the U.S. had become so great that a de facto devaluation of the dollar occurred in the form of the Smoot-Hawley Tariff of 1930, even as the U.S. remained on the gold standard. By shrinking imports to the U.S., this tariff had the same effect as the earlier currency devaluations. Over this period, other countries raised tariffs and/or imposed import quotas, also effectively equivalent to currency depreciation. These events had consequences.
In 1931, 17 countries left the gold standard and/or substantially devalued their currencies. The most important of these was the United Kingdom (September 19, 1931). Germany did not devalue, but did default on its debt and imposed severe currency controls, both of which served to contract imports while impairing the finances of other countries. Germany’s action was undeniably more harmful than if it had significantly devalued its currency. In 1932 and early 1933, 11 more countries followed. From April 1933 to January 1934, the U.S. finally devalued the dollar by 59%. This, along with a reversal of the inventory cycle, led to a recovery of the U.S. economy but at the expense of trade losses and less economic growth for others.
One of the first casualties of this action was China. China, on a silver standard, was forced to exit that link in September 1934, and a sharp depreciation of the yuan resulted. Then, in March 1935, Belgium, a member of the Gold Bloc countries, devalued its currency. In 1936, France, due to massive trade deficits and a large gold outflow, was forced to once again devalue the franc. This was a tough blow for the French because of the draconian anti-growth measures taken to support the franc. Later that year, Italy, another Gold Bloc member, devalued the gold content of the lira by the identical amount of the U.S. devaluation. Benito Mussolini’s long forgotten finance minister said that the U.S. devaluation was economic warfare, a highly accurate statement. By late 1936, Holland and Switzerland, also members of the Gold Bloc, had also devalued. Those devaluations were just as bitter since the Dutch and Swiss used strong anti-growth measures to try to reverse their trade deficits and the resultant gold outflow. The process came to end, when Germany invaded Poland in September 1939, as WWII began.
It is interesting to ponder the ultimate outcome of this process, which ended with WWII. The extreme over-indebtedness, which precipitated the process, had not been reversed. Thus, without WWII, this so-called “race to the bottom” could have continued on for years.
For the United States, the war permitted the debt overhang of the 1920s to be corrected. Unlike the 1920s, the U.S. could export whatever it was physically able to produce to its war torn allies. The gains from huge net trade surpluses were not spent as a result of mandatory rationing, which the public tolerated because of almost universal support for the war effort. The personal saving rate rose as high as 28%, and by the end of the war U.S. households and businesses had clean balance sheets that propelled a postwar economic boom.
The U.S., in turn, served as the engine of growth for the global economy. Gradually, countries began to recover from the effects of the Great Depression and World War II. During the late 1950s and 1960s, recessions did occur but they were of the simple garden-variety kind, mainly inventory corrections, and they did not sidetrack the steady advance of global standards of living.
As noted above, economic conditions, framework and circumstances today are different. The gold standard in place in the 1920s has been replaced by the fiat currency regime of today. Additionally, imbalances from World War I that were present in the 1920s are not present today, and the composition of the economy is different.
Unfortunately, there are parallels to that earlier period. First, there is a global problem with debt and slow growth, and no country is immune. Second, the economic problems then, like now, were more serious and more quickly apparent outside than inside the United States. However, due to negative income and price effects on our trade balance, foreign problems are transmitting into the U.S. and interacting with underlying structural problems. Third, over-indebtedness was rampant in the 1920s as it is today. Fourth, many countries were involved in competitive devaluations. Today, currency devaluations are also taking place. These may be a consequence of monetary and/or fiscal policy actions or in some cases the assessments of private participants in the markets.
Clearly the policies of yesteryear and the present are a form of a “beggar-my-nation” policy, which the following passage from The MIT Dictionary of Modern Economics explains as follows: “Economic measures taken by one country to improve its domestic economic conditions … have adverse effects on other economies. A country may increase domestic employment by increasing exports or reducing imports by … devaluing its currency or applying tariffs, quotas, or export subsidies. The benefit which it attains is at the expense of some other country which experiences lower exports or increased imports … Such a country may then be forced to retaliate by a similar type of measure.”
The existence of over-indebtedness and its resulting restraint on growth and inflation has forced governments today, as in the past, to attempt to escape these poor economic conditions by spurring their exports or taking market share from other economies. As shown above, it is a fruitless exercise with harmful side effects.
The downward pressure on global economic growth rates will remain in place in 2015. Therefore, record low inflation and interest rates will continue to be made around the world in the New Year, as governments utilize policies to spur growth at the expense of other regions. The U.S. will not escape these forces of deflationary commodity prices, a worsening trade balance and other foreign government actions. Therefore, nominal GDP, which slowed from 4.6% in 2013 to 3.8% in 2014 on a fourth quarter to fourth quarter basis, will slow even further in 2015 to around 3%. The Consumer Price Index§ will subside from the 0.8% level reported in 2014 displaying negative year-over-year prints for many months and registering only a minimal positive change for 2015. Conditions will be sufficiently lackluster that the Federal Reserve will have little to choose from in its overused bag of tricks, but will have to stand pat and watch previous mistakes filter through to worsening economic conditions. Interest rates will of course be volatile during the year as expectations shift, yet the low inflationary environment will bring about new lows in yields in 2015 in U.S. Treasury securities with intermediate- and long-term maturities.
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**The Barclays Capital U.S. Aggregate Bond Index covers the U.S. investment grade fixed rate bond market, including government and corporate securities, agency mortgage pass-through securities, and asset-backed securities. You cannot invest directly in this or any index.
†The Thomson Reuters/Jefferies/CRB Index is a commodity futures price index. It was first calculated by Commodity Research Bureau (CRB) in 1957 and made its inaugural appearance in the 1958 CRB Commodity Year Book. The CRB Index periodically adjusts its weights to ensure that it remains representative of the current market environment. It is designed to provide a liquid and economically relevant benchmark that will provide a timely and accurate representation of commodities as an asset class.
††The S&P GSCI is widely recognized as a leading measure of general price movements and inflation in the world economy. It provides investors with a reliable and publicly available benchmark for investment performance in the commodity markets.
‡Gross domestic product (GDP) is a basic measure of a country’s economic performance and is the market value of all final goods and services made within the borders of a country in a year. Debt-to-GDP ratio is a measure of a country’s federal debt in relation to its GDP. The higher the debt-to-GDP ratio, the less likely the country will be to pay back its debt, and the higher its risk of default.
‡‡Quantitative easing is a government monetary policy used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.
§The Consumer Price Index (CPI), also called the cost-of-living index, is an inflationary indicator that measures the change in the cost of a fixed basket of products and services, including housing, electricity, food, and transportation. The CPI is published monthly.