Wasatch-Hoisington U.S. Treasury Fund® (WHOSX) 

3Q18
The Enormous Debt Burden of the United States Will Increasingly Restrain Future Economic Growth
by Van R. Hoisington, V.R. Hoisington Jr. and David Hoisington

“The U.S. economy appears to be on a steadily descending path toward recession and disinflation or perhaps even deflation.”

Van Hoisington
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Investing in bonds, you are subject, but not limited to, the same interest rate, inflation and credit risk associated with the underlying bonds owned by the Fund. Return of principal is not guaranteed. Interest rate risk is the risk that a debt security’s value will decline due to changes in market interest rates. The interest rate is the amount charged, expressed as a percentage of principal, by a lender to a borrower for the use of assets. Even though some interest-bearing securities offer a stable stream of income,their prices will fluctuate with changes in interest rates. Inflation risk is the possibility that inflation will reduce the purchasing power of a currency, and subsequently reduce the value of a security or asset, and may result in rising interest rates. Inflation is the overall upward price movement of goods and services in an economy that causes the value of a dollar to decline. Credit risk is the risk that the issuer of a debt security will fail to repay principal and interest on the security when due. Credit risk is affected by the issuer’s credit status, and is generally higher for non-investment grade securities.

For the period ended September 30, 2018, the average annual total returns of the Wasatch-Hoisington U.S. Treasury Fund for the one-, five- and ten-year periods were -4.47%, 4.86%, and 5.99%, and the returns for the Bloomberg Barclays US Aggregate Bond Index were -1.22%, 2.16%, and 3.77%.  Expense ratio: Gross 0.72%

 

Data shows past performance, which is not indicative of future performance. Current performance may be lower or higher than the data quoted. To obtain the most recent month-end performance data available, please click on the “Performance” tab of the individual fund under the “Our Funds” section. The Advisor may absorb certain Fund expenses, without which total return would have been lower. Investment returns and principal value will fluctuate and shares, when redeemed, may be worth more or less than their original cost.

Wasatch Funds will deduct a 2.00% redemption proceeds fee on Fund shares held 60 days or less. Performance data does not reflect the deduction of fees, including sales charges, or the taxes you would pay on fund distributions or the redemption of fund shares. Fees and taxes, if reflected, would reduce the performance quoted. Wasatch does not charge any sales fees. For more complete information including charges, risks and expenses, read the prospectus carefully.

Wasatch Funds are subject to risks, including loss of principal.

OVERVIEW

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 U.S. Treasury Fund registered a decline of -4.26% for the third quarter and was down -4.47% for the 12 months ended September 30, 2018. The Fund’s benchmark, the Bloomberg Barclays US Aggregate Bond Index, was essentially flat for the quarter with a return of just 0.02%. For the 12-month period, the Index lost
-1.22%. As shown in the chart above, the Fund outperformed the benchmark for the five- and 10-year periods ended September 30, 2018.

The 30-year U.S. Treasury bond yield closed the third quarter at 3.21%, up from 2.99% at the end of the prior quarter. The higher yield occurred even though the rate of increase in both inflation and real growth is estimated to have slowed in the summer quarter (June through September), based on preliminary July and August statistical reports and incomplete September figures. Thus, the Treasury bond market followed the lead of the U.S. Federal Reserve (Fed), which hiked the federal-funds rate twice during the third quarter.

The U.S. economy appears to be on a steadily descending path toward recession and disinflation or perhaps even deflation. This may seem improbable in the face of record year-over-year growth in nominal gross domestic product (GDP) over the past decade. Additionally, the U.S. has experienced record stock prices, record confidence levels, a steady upward march of coincident economic indicators and the lowest unemployment rate (3.7%) reported in the past 49 years. These statistical measures, along with many others, however, carry no weight regarding future economic activity. Monetary policy has played a major role in determining recessions. But, unlike the past, the government's debt level has reached such extreme heights that, like monetary policy, it is also serving to restrain economic growth. An analysis of these factors leads to the inescapable conclusion that a bumpy landing is in store for the U.S. economy.

Monetary Policy

Eight Fed increases in short-term interest rates and a 30%, or nearly $1 trillion, reduction in excess reserves of the banking system appear to have had little impact on U.S. economic growth, as yet. True, interest-sensitive industries—autos and housing—have ceased expanding and are currently a slight drag on overall output, but overall consumption, which represents about 70% of GDP, has remained relatively steady.

With lags, the impact of Fed policy, however, has a broad reach. As noted in past quarterly commentaries, Fed policy determines world dollar liquidity. That liquidity is palpably shrinking. The symptoms can be seen in emerging markets with declining equity prices and in locations where the cheap money policy of the past has encouraged borrowing in U.S. dollars. These markets are now facing rising interest costs and a more expensive dollar, making repaying their debts increasingly difficult. Significantly, U.S. monetary restraint has caused a similar slowdown in local currency money growth around the world. Additionally, velocity in Japan, the euro area and China has been declining secularly since the late 1990s, as debt has become increasingly less productive. Since the velocity of money (i.e., the rate at which money turns over in an economy) determines GDP in all countries, this cumulative global economic slowdown should impact U.S. economic activity.

In the U.S., monetary actions have already begun to impact the critical indicators, such as the money and credit aggregates, while simultaneously lowering the spread between short- and long-term interest rates (term spread) and reducing the profitability of banks and others who borrow at short-term rates and lend money at long-term rates. The annual growth rate in money supply (M2) has slowed to 4%, well below the 6.6% average annual rate of expansion since 1900. Loans and leases funded by banks and commercial paper have dropped to a 2.5% three-month annualized growth rate, and the asset growth of banks has ceased to expand this year. Another symptom of monetary change, the term spread, which is derived from the yield curve, is now clearly reinforcing the restrictiveness of Fed policy.

Yield Curve

A great deal of analysis has been done on this subject. Recently, economists at the Federal Reserve Bank of San Francisco conducted a study on various spreads in the Treasury market. Using monthly data from January 1972 through July 2018, they looked at each spread and predicted whether the economy would be in recession 12 months in the future. The study found that the 10 year-three month (10y-3m) spread was the “most reliable predictor” in signaling a recession. One of their conclusions, however, was that while the risk of recession might be rising, the flattening of the graph curve showing the 10y-3m yield spread does not currently signal an impending recession. They also correctly pointed out that there is no causality. At the time of the article, there was a one percentage point difference (spread) between the yield on the 10-year U.S. Treasury bond and that of the three-month Treasury bill. As recently as late August, the spread was down to around 0.70 of a percentage point, but, quite volatile, it has recently reversed higher.

An examination of the 10y-3m spread since 1953 is quite revealing. There is the presumption that it is necessary for the yield curve to invert prior to recessions, primarily because all inversions have been followed by recessions. However, if the yield spread is still positive but falls below 0.40 of a percentage point, there is a more than reasonable possibility of a decline in economic activity. The spread is quite variable, but at 0.73 of a percentage point, which it was in August, it was close to the 0.40 percentage point level that would signal an outright recession. Two more 0.25 percentage point hikes in the federal-funds target rate may be sufficient to move the economy into a full recession.

This flattening of the yield curve is consistent with monetary theory. There is a supportive connection between the flattening of the yield curve and the Fed’s action of reducing total reserves in the banking system. Thus, it has been the Fed’s reduction in reserves that has caused major flattenings to occur. The movement of the curve is a symptom of a restrictive monetary policy. This reduction of total banking reserves is, as mentioned, also consistent with slow money and credit growth. The Fed, not surprisingly, acknowledges the flattening of the yield curve, but says it is “one of many indicators” (true but hardly a comfort). In 1989 and 1999, the Fed under then-Chairman Alan Greenspan said the curve inversion was not relevant and the economic outlook remained strong. This may have been one of the main reasons the Fed did not see the 1990-91 and 2000-01 recessions until they were long underway. The Fed under then-Chairman Ben Bernanke also explained away the yield-curve inversion prior to the collapse of Lehman Brothers at the start of the 2008 recession.

In addition to signaling the effectiveness of restrictive monetary policy, the flatter yield curve significantly impacts all depository and other financial institutions that are borrowing short and lending long, as their profitability is eroded through net interest margin contraction. When the major costs (net interest margins, overhead costs and the risk premium, or costs associated with the possibility of a borrower default) are considered, the easiest option is to reset the risk premium for loans. This plus increased competition typically leads to credit mistakes, even though late-cycle ebullient business conditions seem to justify the lower risk premium. Such holding of risky assets has not ended well for lenders or investors in both pre- and post-World War II business cycles.

Fiscal Policy

Just as monetary policy is directed toward slowing growth, fiscal policy is similarly aligned. Large budget deficits can be associated with strong growth and higher inflation. Present circumstances, however, preclude that eventuality as the prodigious level of government debt had accumulated to 106.4% of GDP, or $21.516 trillion, at the end of the U.S. government’s 2018 fiscal year on September 30th. Academic studies have centered on the proposition that government debt roughly in excess of 90% of GDP for a period of five years slows economic growth. Already at 106% of GDP and having been above 90% GDP since 2010, it is understandable and easy to conclude that past and current fiscal policy will be contractionary from this point over the long run. Over the past 12 months, the enormous increase in debt added to economic growth, however, it also added to the already onerous debt burden, meaning it will act as a drag on future economic growth.

In just the past 12 months, the amount of federal debt expanded by $1.271 trillion. This is not to be confused with the increase in the deficit, which totaled only $804 billion. Over the past five years, the deficit is up by $2.977 trillion, whereas the total government debt has risen by $4.777 trillion, a difference of $1.80 trillion. How does this happen? Simple. Elected representatives have decided that certain sums of money that are spent (therefore paid by borrowed funds) are in fact “investments” rather than “expenses.” These items include certain transportation expenditures, federal loan programs, Social Security/military/civil service payments where benefits are in excess of tax collections, and a host of other items. It is material. Over the next five years, the Congressional Budget Office (CBO) projects that the deficit will expand by $5.661 trillion. If federal debt continues to rise in excess of the deficit by the same amount as the past five years, then total debt outstanding will reach $28.9 trillion in 2023, compared with the CBO’s projected GDP estimate for that year of $24.6 trillion. Debt therefore will reach 117% of a total year’s income/output of the U.S. economy in just five short years.

An analysis of the interconnectedness of the economy, or what is referred to as the circular flow of the macro economy, reveals another factor, over and above the government debt problem, that will enhance the impetus for economic activity to slow. For all economies, what is produced is equal to what is spent, which in turn is equal to what is earned (i.e., GDP equals income). Based on this circular flow proposition, algebraically, national saving must equal physical investment. Investment is critical to the growth of productivity. Productivity plus labor-force growth determines potential economic growth rates. Therefore, to get an investment boom, greater national saving is required. Herein lies the problem. Government deficits are not saving, but dissaving, reducing the total saving available for investment. Since 1929, net national saving has averaged 6.4%, but with increasing government deficits (dissaving) over the past 17 years, the national saving rate has dropped by more than half to about 3%. It is important to note that the projected increase in federal debt from $21.4 to $28.9 trillion will, all other things being equal, further reduce net national saving from approximately 3% to 2% or possibly even to zero. Thus, investment would be forced downward, continuing to erode productivity, unless, of course, consumer saving were to rise. But, if consumer saving were to rise, this would reduce consumer spending and economic growth, undermining the incentive for more investment. This is a recipe for semi-recessionary economic conditions, regardless of monetary mistakes. Indeed, both fiscal and monetary policy are currently guiding the U.S. toward slower economic growth.

The response by policy makers to this eventuality is a guess, but a higher interest-rate policy appears not to be an option. From the standpoint of an investment firm that started in 1980, when 30-year bond yields were close to 15%, the current 30-year U.S. Treasury bond yield of 3% seems ridiculously low. In the near future, at 1.5%, the 3% yield will seem generous.

Given these conditions and because bond prices have historically moved in the opposite direction of bond yields, we believe the Fund is well-positioned with investments in long-term U.S. Treasury bonds.

Thank you for the opportunity to manage your assets.

Sincerely,

Van Hoisington, V.R. Hoisington, Jr. and David Hoisington

 

 

**The Bloomberg Barclays US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, mortgage-backed securities (MBS) (agency fixed-rate and hybrid adjustable-rate mortgage [ARM] pass-throughs), asset-backed securities (ABS) and commercial mortgage-backed securities (CMBS) (agency and non-agency). You cannot invest directly in this or any index.

The Congressional Budget Office (CBO) is a federal agency within the legislative branch of the United States’ government that provides budget and economic information to Congress.

A credit aggregate measures the stock of bank loans outstanding at a point in time.

The federal-funds rate is the interest rate at which private depository institutions (mostly banks) lend balances (federal funds) at the Federal Reserve to other depository institutions, usually overnight. It is the interest rate banks charge each other for loans.

The federal funds target rate (also known as the fed funds target rate) is set by a committee within the Federal Reserve System called the Federal Open Market Committee (FOMC). The FOMC usually meets every six weeks, and it is at these meetings that the FOMC votes on whether or not to make changes to the federal-funds target rate.

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.

A monetary aggregate measures the stock of money outstanding within an economy at a point in time.

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 velocity of money (V) is defined as the rate at which money circulates, changes hands or turns over in an economy.

The yield curve is a line on a graph that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The most frequently reported yield curve compares three-month, two-year, five-year and 30-year U.S. Treasury securities. This yield curve is used as a benchmark for other interest rates, such as mortgage rates or bank lending rates. The curve is also used to predict changes in economic output and growth.

Bloomberg Barclays US 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 nonconvertible. All corporate and asset-backed securities must be registered with the SEC and must be publicly issued. 

You cannot invest directly in indexes.

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