Compass July 2011

In this issue:

Compass is the quarterly newsletter of Creekside Partners. All information is obtained from sources deemed to be reliable, but is not guaranteed as to accuracy. Nothing in this newsletter should be construed as financial or investment advice to any reader. All material herein is the copyright of Creekside Partners

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How to Succeed In Debt Reduction (Without Really Trying)

When it comes to our investment strategies, we have to accept the world as it is. We can’t structure our portfolios so that they profit if and only if politicians make the right choices. They rarely do so, and we have to take that into account.

We expect that Congress, the Administration and the Federal Reserve will attempt to recreate the key financial conditions of the early post-WWII era. That era was characterized by (1)significant inflation; and (2) low interest rates. Typically, interest rates on benchmark bonds, such as the 10-year Treasury, will settle themselves into a comfortable spread above inflation. However, during the 1945-1980 period, inflation averaged 4.55%, while the yield on 10-year Treasury bonds averaged 4.85%. Investors barely broke even.

Contrast this with the 1981-2010 era, when inflation averaged 3.16% and bond yields averaged 6.91%.

In fact, during many of the early post-war years, inflation exceeded the yield available on bonds. When inflation exceeds the interest rate paid on debt, a portion of the debt “self-liquidates.”

Inflation averaging 4.5% for the next twenty years means that as much as 60% of today’s existing stock of debt disappears. That’s public and private debt! That rate of inflation for that long means that a dollar today only buys 40 cents worth of goods in 20 years. The flip side is that you can pay off a dollar of today’s debt for only 40 cents.

That prospect is too good to pass up for political animals such as congressmen, senators and Fed appointees.

In a significant paper published in March of this year, Carmen Reinhart and Belen Sbrancia concluded that the national debt, as a percentage of the entire economy, was less than half of what it would have otherwise been in only 10 years after the end of the war. These authors have termed the 1945-1980 era a time of “financial repression.” Policymakers kept a tight lid on interest rates, while allowing inflation to grind away. A number of policy objectives were pursued, chief among them a “free lunch” payback of Great Depression and WWII debt.

We all know that, in economics, there is no such thing as a free lunch. Somebody paid that debt down — conservative savers that kept money in low-yielding bank accounts and Treasury bonds.

As we said in our first paragraph, we’re not arguing that this is a good thing or a bad thing — it just is what it is, and investors need to figure out how they are going to live with it.

While we are convinced that policymakers will attempt to create conditions of financial repression, we are not as confident that they will succeed. Things were different in 1945. The transition from an agricultural to manufacturing economy was reaching its peak. We ran trade surpluses with the rest of the world. We produced nearly all the oil we consumed. There was no China or other emerging market manufacturing powerhouse to compete with us.

The Treasury bond market did not trade freely – the Fed decided what interest rates bonds would earn (and at what prices they would trade), and that was that. Bank deposit interest rates were regulated – and capped.

It is one of the more dangerous things to say in the investment business, but we’ll say it anyway: Things are different this time.

The question is whether the combined efforts of the two elected branches of government and the key non-elected branch (i.e., the Federal Reserve) can successfully and artificially keep a lid on interest rates. Maybe they can; maybe they can’t. Our job is to prepare for both outcomes, not hang our hats on one or the other.

For example, if we believed that they will be successful, we would load up on “long-dated” assets (such as stocks and long-term bonds), regardless of current prices. If rates stay low, we win.

But, if rates go high, we lose. Let’s look at the investment implications of success versus failure.

Policy Success: Low Rates, High Inflation

Bonds. As inflation moves higher, bond interest rates would normally move higher as well. But if government intervention keeps rates low, then bond yields are unlikely to pass our “hurdle rate.” Our hurdle for buying bonds beyond short-term maturities is 4-5%, after tax. That provides us with a net yield that will at least keep up with inflation.

At present, we can just barely earn those yields on highgrade municipal bonds. We are continuing to buy short– and medium-term municipals.

Stocks. If inflation is occurring throughout the economy (meaning that it affects both prices and wages), then corporate earnings will tend to also grow with inflation. Historically, earnings have grown at a rate of about 1.5% above the rate of inflation, on a per-share basis. Government intervention to keep interest rates low also helps corporate profits since borrowing costs are low.

Stocks suffer no direct ill effects from a sustained financial repression economy. The problem we have with stocks is that current prices are too high to make a full commitment (see page to the right). When and if stocks are priced attractively, we will not hesitate to move toward full allocations.

Real Estate. A sustained environment of inflation, combined with low rates, can be quite bullish for income real estate. Inflation pushes rents higher, while interest costs stay low and fixed. In fact, we think that real estate fund (REITs) prices already reflect this outlook, and have somewhat overrun fair value. If prices correct back to normal, we will look at adding REITs to our portfolios.

Natural Resources. In an environment of sustained inflation, natural resource company stocks should provide quality sustained returns. As with other stocks, we will look for a reasonably priced entry point. We reduced holdings in natural resources in May of this year as oil prices peaked, but we look to add to holdings going forward.

In sum, a successful policy of financial repression can be positive for many asset classes, with the usual caveat that one must pay attention to valuation and not overpay. The principal asset classes that will suffer under this regime are (1) long-term bonds of all types; (2) cash equivalents (savings; money-markets); and (3) short-term high-grade bonds, such as Treasuries. These assets all perform poorly since their after-tax yields will not keep up with inflation.

Policy Failure: High Rates, High Inflation

Bonds. If the government fails to keep interest rates down, those investors that own long-term bonds going into such a period will suffer serious capital losses and loss of purchasing power. Owners of short-term bonds will be able to roll over maturing principal into high-yielding paper. This occurred in 1980-82, and smart investors bought longterm bonds with very high yields and were able to sit back and clip double-digit coupons for the next 20 years.

Stocks. A spike in interest rates will likely trigger a significant stock market correction. This could present a buying opportunity. Again, valuation is the main driver of our stock outlook. We are underweight now, but will buy stocks under either economic scenario – if the price is right.

Real Estate. Rising interest rates are never good for real estate, and we would not expect that to change.

Natural Resources. Any time inflation is high and sustained, natural resource companies can post solid earnings. However, rising interest rates will eat into those earnings and depress demand. We will have to watch how valuations unfold.

What is common to each of these scenarios:

  • We need to avoid long-term bonds, and we need to avoid low-yield Treasury bonds of all maturities.
  • We need to be disciplined and watch for attractive entry points for stocks. Stocks, and natural resources, can perform just fine under either outcome. The key is not overpaying.

As the future becomes the present, we will react accordingly and move money into the assets that we believe offer the highest expected after-inflation return. We face highly uncertain times, and the successful investor will remain attentive and flexible.

Rick Ashburn & Andy Hempeck

*The third scenario. There is one additional possible outcome of policy – the government could fail to trigger inflation. This could be the outcome if the economy truly does not recover, and consumers take to hunkering down and saving their earnings. This is the “Japan Scenario” and, while it is possible, we consider it rather unlikely. The US economy is far more diverse than Japan’s and we have a domestic demand for goods and services that is the envy of the developed world. We’re not really making any long-term bets that this scenario comes about. Our generally conservative nature provides our clients with what we believe to be sufficient protection against this outcome.

Major Asset Classes Valuation

Record Earnings and Near-Record Unemployment…at the same time?

Corporate America is living in a far, far different world than the average American worker. Profits are at all-time highs. The share of GDP that corporations are taking as profit is at an all-time high. Profit margins are at an all-time high. Cash balances are at an all-time high. Lobbying expenditures for tax breaks in the face of this tsunami of earnings is also at an all-time high.

Yet, these companies, as a whole, are not growing their work forces.

Unemployment remains stubbornly high, no matter how it is measured. Millions of workers aren’t finding jobs, yet the nation’s largest employers are generating sky-high margins and earnings. These companies are spending far more money buying back stock than investing in business expansion.

This conundrum poses the question: Is this a new, and possibly permanent, state of affairs? Can an economy transition to a state where its corporations make huge sums of money, while employing only a fraction of the workforce? In the short run, yes it can. The new hires are overseas, where they make stuff and ship it to us. That works for a while. But one must wonder how we will continue to buy the stuff when 1 out of every 6 of us are not working.

We don’t profess to know how this current situation plays out over time. We are strongly inclined to invoke the adage, “If something can’t go on forever, it won’t.”

And we don’t think this can go on forever.

Economic Factors
Headwind or Tailwind?

Inflation. The money supply grew 5.0% over the past year — a significant acceleration from a year ago. The money supply growth rate continues to tick upwards as the Fed tries to stimulate wage and price inflation. Inflation year-over-year totaled 3.6%, and the additional money supply will eventually find its way into prices and wages.

We’ve always been worried about longer-term inflation, but now we’re paying attention to the shortterm. In a sense, the long-term outlook is in the here-and-now. We shudder to think what happens to the stumbling recovery if the Fed starts to raise rates to battle inflation.

Bond Interest Rates. We have a hurdle rate in mind for bonds. In order to buy any bond longer than five years, we need to see an after-tax return above our inflation expectations. That expectation is 4.0% to 4.5%. We are finding fewer and fewer attractive bonds these days. However, low bond yields are good for the economy.

Housing. Housing prices seem to have stabilized in the more affluent markets, but continue to suffer most everywhere else. The data is, on first blush, contradictory. The “affordability index,” which takes into account incomes, house prices and interest rates, is near an all-time high. But, that’s a paper index. In real life, people don’t have downpayments and don’t have the credit scores. Robert Shiller estimates the nation has as many as 2.4 million more houses than it needs right now.

The ultimate “train wreck scenario” for housing is if interest rates start to rise despite the government’s attempt to keep them low. Housing is, and will remain for some time, a headwind against the economy.

The Debt-Limit Stare-Down

As we go to press with this letter, the bobbleheads in Washington are posing and posturing for the upcoming 2012 election cycle. Both parties are using the looming federal debt ceiling in a game of brinksmanship to get what they want. There seems to be general agreement that the federal deficit needs to be reduced, and sooner rather than later. The arguments are over just how to best accomplish that. Both sides are locked in a game of chicken over extending the debt limit, using it as leverage to argue over spending and taxes.

The debt limit is important because new debt has to be issued to cover the deficit. As old debt matures, it is repaid with cash from tax collections, leaving less to pay expenses. New debt is issued to fund the shortfall of revenues to these expenses.

If new debt cannot be issued, something doesn’t get paid. Either maturing debt, or government expenses. From a constitutional perspective, the government will ultimately have to pay the debt first. The 14th Amendment says so. It is doubtful that the 14th Amendment would allow the government to issue new debt to pay off the old debt without congressional approval, but it seems pretty clear that the old maturing debt has to get paid before anything else.

An outright default by the United States of its debt payments is almost unthinkable; the Supreme Court would surely step in and order payments to be made. Even if short-lived, the repercussions of default could last for decades. That’s why we don’t think it will happen.

What is perhaps likely to happen is a government shutdown of one form or another. This is not necessarily all that disruptive, in the big picture of things. We live in a political democracy and we, as a nation, need to make some hard choices about taxing and spending.

Until there is majority agreement in Congress, there can’t be any taxing and spending. Debt default? No. Partial government shutdown? Entirely possible.

Investment implications of shutdown? Temporary.

Rick Ashburn

Lessons from 1970’s Reruns

I recently watched a 1974 episode of Hawaii Five-0. Not only did the episode bring me back to when I actually watched the show with my father in the 1970’s but it also gave me perspective on where we are today.

In this particular episode I was struck by how things change, but stay the same. At that time the US was still in Vietnam (today, Iraq and Afghanistan). One of the characters pulled into the gas station and asked the attendant for $1 of gas. Gas was approximately 60 cents a gallon because of the 1973 oil crisis or about $5.11 in today’s dollars. The same character then jumped into a phone booth — which my 11 year-old daughter laughed about because she had never really seen one and couldn’t believe nobody had mobile phones.

Jack Lord was also working the walkie-talkies and coordinating his men to catch the bad guys. They used some fairly sophisticated triangulation technology to track down the bad guys that were using CB radios. Other than these technology items being a bit out of date not a lot has changed in the last 40 years.

Houses looked the same, cities looked the same, people looked the same, politics were the same, police work was still performed by police. So, as investment advisors, what can we take away from an episode of a 1970’s show?

My takeaways are the following:

  • Don’t get caught up in the day to day noise of the headlines;
  • The economy will grind forward and not collapse;
  • Technology is great, but it has not really changed our lives as much as we think; and
  • Don’t make trendy investments in the latest phone booth maker, stick with intelligent value-oriented investments and you will do well.

By the way, Hawaii Five-0 with Jack Lord is still a great show 40 years later.

Andy Hempeck

2011 Year-to-Date Index Returns

Large-Cap U.S. Stocks

Small-Cap U.S. Stocks

Foreign Stocks (Developed)

Emerging Market Stocks

Muni Bonds

Taxable Bonds

Inflation

(year-over-year May 30)

5.95%

7.55%

5.27%

0.79%

4.38%

2.49%

3.60%

Wherever possible, we use the returns on Vanguard Index Funds as the benchmark figures for various asset classes.

Readers wishing to review the actual performance record of a composite of our client portfolios should call or email us at info@creeksidepartners.com.