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.
In the final calendar quarter of 2013, the 30-year Treasury bond yield increased from 3.69% to 3.97%. On an encouraging note, the rise in yields in the fourth quarter was less than in the third. For the year, the gain in this key barometer of the bond market was just over one percentage point.
Details of the Quarter
The Wasatch-Hoisington U.S. Treasury Fund returned -3.92% in the fourth quarter compared to a return of -0.14% for the Barclays Capital U.S. Aggregate Bond Index. For the full year, the Fund’s return was -16.71% versus -2.02% for the Index. However, for the past three years, on an annualized basis, the Fund gained 6.53% and outperformed the Index, which rose 3.26%. For the last 10 years, the Fund’s average annual total return was 6.63% versus 4.55% for the Index. Since inception, the Fund’s average annual total return was 7.56% compared to 6.71% for the Index.
In his book The Theory of Interest, Irving Fisher, who Nobel Laureate Milton Friedman called America’s greatest economist, created the Fisher equation. This equation states that the nominal bond yield is equal to the real yield plus expected inflation. It serves as the pillar of all of macroeconomics and as the foundational relationship of the bond market. It has been reconfirmed many times by scholarly examination and by the sheer force of historical experience. Examining periods of both low and high inflation offers insight into how each variable in the Fisher equation affects the outcome.
From 1871 to 1948, a period of relatively low inflation, the Treasury bond yield averaged 2.9%, with the inflation rate 1.0% and the real yield 1.9%. From 1948 to 1989, a period of higher inflation, inflation jumped to 4.3% on average, the Treasury bond yield increased to 6.0%, but the real yield remained close to historical levels at 1.7%. In more recent times, the inflation rate has changed, but the real rate has remained close to historical averages. The significant point is that while average inflation and bond yields were volatile, the average real yield was far more stable, and over these longer stretches the real yield was never far from the post 1871 average of 2.2%. Thus, over long periods of time, bond yields fluctuated in response to rising and falling inflation. However, the real bond yield steadily reverted to its mean indicating that inflation was the driving force in determining the bond yield over time.
A host of different factors caused inflation to vary in the aforementioned periods, but two points of significance are identifiable. First, the 70-year span between 1871 and 1948 (excluding the World War years) was an extended global market era. It began about the time of uninterrupted transcontinental railroad travel and the completion of the Suez Canal and resulted in a period of rapidly expanding global trade. By 1871, 10% of U.S. railroad traffic carried goods that were traded globally. This era produced increasing returns to scale and minimized price pressures. Second, the 1871 to 1948 period encompassed two episodes of high indebtedness: the 1870s and then the 1920s until the mid-to-late 1940s. Both severely destabilized economic activity and produced minimal inflation, which in turn led to bond yields that eventually reached slightly less than 2%.
From 1871 to 1948, there were two 20-year periods when the total return on long-term Treasury bonds (maturities longer than 20 years) exceeded the total return on the S&P 500***: one from the 1870s to the 1890s and another from 1928 to 1948. Additionally, the traditional vibrancy in demographic trends in the United States ended during the 1930s as both the birth rate and total increase in population slowed dramatically.
The period from 1948 to 1989 differs markedly. By 1948, a global market did not exist, and the excessive indebtedness of the 1920s to1930s had been eliminated. In the late 1940s, the Iron and Bamboo Curtains imposed by Russia and China removed roughly 50% of the world’s population from global trade, reducing economies of scale. During the war years, from 1933 to 1948, the U.S. ratio of public and private debt-to-gross domestic product (GDP)† dropped from 295% to 139%, as the personal saving rate jumped from below zero to 28%. With normal and sustainable debt levels the U.S. entered the post-war boom, a period of rapidly rising prosperity that produced greater returns for the S&P 500 than for long-term Treasury bonds. Additionally, the abysmal demographics of the 1930s gave way to the post-war baby boom as households became more positive about their economic prospects.
Today, conditions resemble the 1871 to 1948 period. Global trade is once again less inhibited and public and private debt is high and rising. Additionally, the saving rate is greatly depressed. Demographics have also soured. The birth rate in 2013 fell to the lowest level on record, and the population increase was the slowest since the depression era year of 1937. Thus, fundamental conditions are now conducive for an inflation rate averaging 1% or less. Based on the Fisher equation, therefore, long-term bond yields should be comfortable at 3% or lower.
The global inflation rate is influenced by many factors, but the current bout of low inflation and the insufficiency of demand are both symptoms of extreme over-indebtedness. Weakness in prices is evident in numerous different measures. Over the last 12 months, the price of goods in the Consumer Price Index (CPI)†† actually decreased 0.5%, while the more accurately measured durable and nondurable components of the U.S. personal consumption expenditures deflator††† fell by 2.0% and 0.6%, respectively. Prices of imported goods fell 1.5% over the same period; excluding oil the decline was nearly as large. Facing weak domestic demand, foreign producers cut prices on goods headed toward the U.S. market, and this forced domestic producers in the U.S. to match those lower prices.
A lack of pricing power is likely to continue in 2014. First, the global economy continues to incur more indebtedness. Both public and private debt in the major economies of the world continues to move further above the levels that create a sustained negative impact on economic activity. Second, monetary conditions moved in the wrong direction last year, partly as a result of misguided policy efforts at quantitative manipulation of reserves. Third, although the sequestration‡ of government expenditures will be less in 2014 than in 2013, fiscal policy in the broadest sense is not supportive of economic growth.
Academic research has shown that a public and private debt-to-GDP ratio above the range of 260% to 275% has a depressing impact on economic growth. In 2000, the U.S. debt level exceeded this range. Since then, the bond yield has averaged 4.6%, with inflation 2.1% and the real yield 2.5%. By comparing growth and debt figures prior to 2000 with those afterward, the magnitude of the problem and likelihood of its persistence can be assessed. From 1871 to 1999, private and public debt averaged less than 165% of GDP (well below the 260% to 275% critical level), and the trend growth in real GDP was 3.8%. From 2000 through 2013, growth has faltered to just 1.9%. Based on the latest 2013 figures, total private and public debt amounted to $58.2 trillion or 344% of GDP. If the debt-to-GDP ratio were currently the same as the average from 1871 to 1999, total debt should only amount to $30.5 trillion, or almost half of the existing level. The debt-to-GDP ratio declined since peaking in 2009 but not sufficiently to re-enter the normal range. Moreover, the ratio resumed its upward trend in 2013. Thus, the U.S. appears to be following Japan’s example of trying to cure an indebtedness problem by accumulating more debt.
Scholarly research conducted in the U.S. and Europe over the past three years indicates that existing levels of government debt relative to GDP have reached the point that historically has produced a deleterious effect on economic growth. This effect has historically lasted two decades or longer. As termed by European researchers, the current levels have reached the “non-linear zone.” This means that the negative effects on growth are likely to intensify as this debt ratio moves higher. Ignoring this research is ill advised, especially since the debt levels are advancing. Although the U.S. budget deficit was smaller last year, the more critical debt ratio continued to rise.
According to the Organisation for Economic Co-operation and Development (OECD), General U.S. Government Gross Financial Liabilities as a percent of GDP reached 104.1% in 2013, the highest level since the early 1950s. (Gross, rather than net, government debt is the appropriate measure; netting out the government debt held in other government accounts is not appropriate since the social insurance trusts have far greater liabilities than they have government securities to fund those future commitments.) By the end of 2015, the OECD projects that this figure will jump to 106.5%. Over the next 25 years government debt-to-GDP is projected to move dramatically higher, according to the Congressional Budget Office.
Since European fiscal policies mirror those in the U.S., it is not surprising that growth prospects there remain dismal. According to the OECD, General Government Gross Financial Liabilities in Europe reached 106.4% of GDP in 2013, up from 95.6% in 2011, an even faster rise than in the United States. New research shows that the world average of total public debt, expressed as a percent of global GDP, is approximating its highest level since 1826 (IMF Working Paper WP/13/266, “Financial and Sovereign Debt Crises: Some Lessons Learned and Those Forgotten,” December 2013, by Carmen M. Reinhart and Kenneth S. Rogoff). Private debt to GDP in the Euro currency zone and the United Kingdom (and interestingly, in Japan) are all higher than in the U.S. and even further above the levels that research has identified as being detrimental to growth.
Monetary policy continues to be a negative for growth. As discussed in our last quarterly letter, three academic papers presented at the Jackson Hole conference determined that the present approach of quantitative easing‡‡ by the Federal Reserve has actually slowed economic activity. Three considerations show that monetary policy is working against economic growth.
First, monetary policy works primarily through price effects. The level of real interest rates determines the price of credit. In 2013, long-term Treasury bond yields rose one percentage point. The inflation rate, measured by the year-over-year change in the Fed’s targeted core personal consumption expenditure deflator, dropped one-half of a percentage point. This pushed the real yield on the 30-year bond to nearly 3% at the close of 2013. Thus, real yields currently carry a significant premium to the long-term average. The effects of this rising price of credit are visible in the high frequency housing data. Pending and existing home sales in November were below the levels of a year ago. Mortgage applications for home purchases in December were at their lowest level in more than a decade.
Second, the money multiplier‡‡‡ that reflects the conversion of bank reserves into deposits (money) by the banking system fell to a new 100 year low of less than three in late December 2013. This is an indication that the Fed’s Large Scale Asset Purchases (LSAP) are not currently producing real, tangible economic effects and are not likely to in the future. Since 1913, $1 of high-powered money has, on average, resulted in an increase of $8.20 of M2.§ The current multiplier constitutes an unprecedented historical gap. To begin the process of accelerating economic growth from a monetary perspective, an increase in the multiplier would be necessary. The best indicator of whether this process is working would be the expansion of bank credit, which includes bank investments and bank loans. Unfortunately, for the past 12 months the expansion of total bank credit is only 2.0% higher than one year ago, and bank loans have expanded by only 1.9%. In spite of the Fed’s massive LSAP, M2 expanded at a slightly slower pace in the latest 12 months versus a year ago.
Third, the even more important velocity of money (V) rejects the argument that monetary policies are gaining traction. Velocity, or the speed at which money turns over in an economy, links M2 to the level of nominal economic activity. With the money supply expanding at 5.6% in the latest year, it would be reasonable to expect the same growth rate in nominal GDP if V were stable. Unfortunately, since 1997 velocity has been falling, and in the last 12 months it has dropped by 3.0% to 1.57, the lowest level in six decades. While velocity is influenced by a myriad of factors, the rate of change of financial innovation and lending for productive purposes affect its direction. If debt generates an income stream that repays principal and interest and creates other activities, it will tend to expand economic activity and cause V to rise. Student, auto and other loans for consumption (which represent the bulk of the increase in consumer credit in 2013) do not meet the necessary criteria, so debt is merely an acceleration of future consumption. This will tend to inhibit the borrower’s ability to increase consumption in the future. Further, new regulations on our financial industries are discouraging financial innovation, and this will bring further downward pressure on velocity. In 2014, if velocity continues to erode at a 3% pace and the money supply continues to grow around 6%, it is reasonable to anticipate that nominal GDP will grow at about a 3% rate.
Based on scholarly research, only half of the negative economic impact emanating from the $275 billion 2013 tax increase has been registered. Due to the recognition and implementation lags, the remaining drag on growth from the tax increase will occur this year and again in 2015. Carrying a negative multiplier of 2 to 3, this impact far outweighs the sequester (which is expected to be slightly less in 2014 than in 2013) since the multiplier for government expenditures is zero, if not slightly negative.
An important fiscal policy event for 2014 is the Affordable Care Act (ACA).§§ Health care is the largest sector in the U.S., comprising 17.2% of the economy in 2012. This is more than twice as large as the residential construction, oil and gas exploration and the automotive industries combined. The scope and scale of ACA may divert energy and activity away from more productive endeavors. The ACA’s employer mandate was waived in 2013, as were similar obligations of labor unions and others, but these wavers expire this year. Firms may have to cut full time employees to part time, reduce total employment or cut benefits since they lack the pricing power to cover these costs. As such, this will place the burden of adjustment on consumers. On January 1, 2014, health insurance premiums that target small businesses and individuals were raised. These groups create jobs and are vital for growth, so although the amount of the increase is small, this is not a positive development for the economy. While the ACA is an unprecedented event for which no historical point of comparison exists, history does confirm that substantial increases in government regulation are not a springboard for innovation, the lifeblood of economic activity.
The slow nominal growth rate anticipated for 2014 should continue to put downward pressure on the inflation rate as insufficiency of demand continues to create highly competitive markets. With slower inflation, lower long-term interest rates are a probable outcome.
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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. To be included in the index the security must meet the following criteria: must have at least one year to final maturity, regardless of call features; must have at least $100 million par amount outstanding; must be rated investment grade or better by Moody’s Investors Service, Standard & Poor’s, or Fitch Investor’s Service; must be fixed rate, although it can carry a coupon that steps up or changes to a predetermined schedule; must be dollar-denominated and must be nonconvertible. All corporate and asset-backed securities must be registered with the SEC; and must be publicly issued. You cannot invest directly in this or any index.
***The S&P 500 Index includes 500 of the United States’ largest stocks from a broad variety of industries. The Index is unmanaged but is a commonly used measure of common stock total return performance.
†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 gross domestic product (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.
††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.
†††The Personal Consumption Expenditures (PCE) Deflator is part of the National Income and Products Accounts developed by the Bureau of Economic Analysis of the U.S. Commerce Department. The PCE Deflator is a variable weighted index and is widely considered to be the most reliable of all the price indices.
‡Sequestration is the practice of using mandatory spending cuts in the federal budget if the cost of running the government exceeds either an arbitrary amount or the gross revenue it brings during the fiscal year.
‡‡Quantitative easing, also known as Large Scale Asset Purchases (LSAP), 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 money multiplier is the expansion of a country’s money supply that results from banks being able to lend. The size of the multiplier effect depends on the percentage of deposits that banks are required to hold as reserves. In other words, it is money used to create more money and is calculated by dividing total bank deposits by the reserve requirement.
§M2 money supply consists of currency and checking accounts, consumer-type time and savings accounts and equivalent near monies, while M3 money supply consists of M2 plus business-type time deposits and less liquid near monies. Both M2 and M3 exclude monies and near monies owned by the Treasury, depository institutions and foreign banks and official institutions and IRA and Keogh balances owned by consumers.
§§The Patient Protection and Affordable Care Act (PPACA), commonly called the Affordable Care Act (ACA) or “ObamaCare,” is a United States federal statute signed into law by President Barack Obama on March 23, 2010.