No Inflation In Sight, Say Two Bond Masters
Hoisington’s bond managers doubt the global economy will rebound soon thanks to low industrial output, heavy debt, and the commodities collapse.
By Jonathan R. Laing
Since the 2008-09 Great Recession, it has been an article of faith in many circles that the loose monetary policy of zero-bound short-term interest rates and successive rounds of quantitative easing would lead ineluctably to a ruinous surge in inflation and interest rates.
Yet just the opposite has occurred. The open monetary spigots around the globe have been associated with falling sovereign-debt interest rates, declining inflation, and disappointing gross-domestic-product growth in the U.S. and other key developed nations. As a sign of possible desperation, central banks in the euro zone, Denmark, Sweden, and, most recently, Japan have imposed negative rates on bank deposits in an attempt to entice lenders to put their idle reserves to work.
One beneficiary of this turn of events has been Hoisington Investment Management of Austin, Texas, which runs some $5.5 billion in U.S. government bond portfolios. Over the past decade through 2015, the outfit has repeatedly and successfully bet on widespread economic weakness and nations’ eagerness to fight it.
Hoisington has ridden the secular decline in government bond rates and the handsome concomitant rise in bond prices to annual compounded returns of 7.9%. This exceeds the annual returns of the S&P 500 over the same decade and lays waste to the performance of the bond industry bogey, the Barclays Capital Aggregate Bond Index, up just 4.4% a year in the same period. Moreover, the $375 million mutual fund that the company subadvises, the Wasatch-Hoisington U.S. Treasury (ticker: WHOSX), has finished in the first and 11th percentile of Morningstar’s Long Government fund rankings for the past 10 and five years, respectively.
Hoisington Investment Management has achieved this sterling record by embracing maximal interest-rate risk for most of the period by investing in the outward reaches of the government bond yield curve—durations of 20 years or more. Out in this realm, slight moves in interest rates result in much-magnified gyrations in bond prices.
It’s no game for the faint of heart. In 2013, the Hoisington funds had negative returns of more than 15%, when government bond rates shot temporarily higher on fears of an imminent U.S. debt default—as a result of political wrangling over the federal budget—and hints that the Federal Reserve would taper its bond buying under its third quantitative-easing campaign. But in the following year, Hoisington’s portfolios roared back, with positive returns exceeding 30%.
“We tell potential clients—pension funds and the like—that if they can’t embrace this volatility, not to put money with us,” Hoisington’s executive vice president and economist, Lacy Hunt, told Barron’s in a recent telephone interview. “They must accept our macroeconomic view of long-term trends, namely a continuation of sluggish economic growth and limp inflation in the U.S. and around the globe, weighed down by surging levels of private and public debt. We’ve been playing these themes since 1990, to some outside derision on Wall Street and elsewhere, and our current analysis indicates that these trends will remain in force for some time to come.”
One might wonder how much capital-gain potential is left in long-term U.S government bonds with the 30-year yielding less than 2.7%. Hunt has a ready answer. Other long-dated sovereign bonds, such as those of Germany, Japan, and Switzerland, trade at dramatically lower yields. In Germany and Japan, the shortfall is some 170 basis points (1.7 percentage points); in Switzerland, almost 240 basis points. This disparity is liable to induce much foreign buying of U.S. long bonds.
For a U.S. government portfolio with a 20-year duration—similar to those of Hoisington, a 100-basis-point drop in rates would produce about a 20% capital gain at current yields, Hunt reckons. And if, God forbid, the economy falls into a deflation abyss of a negative 0.5% reading, a long-dated U.S. government portfolio with a yield of just 1.5% would boast a real return of 2%. “That, interestingly enough, matches the average real returns of long-term government bonds during their history from 1890 through last year,” Hunt observes.
To be sure, Hunt and the firm’s other co-founder, Van Hoisington, tend to look through the glass darkly when it comes to projecting economic growth. A strong economy invariably brings higher interest rates that pummel bond returns. Both men had conservative bank-trust-department backgrounds before founding their firm in 1980, after experiencing the 1970s fixed-income horror show of chronic stagflation. However, they didn’t fully ride the secular wave of falling rates until navigating the volatile fixed-income markets of the late 1980s.
Much of their continuing dour outlook on U.S. and global growth revolves around the explosion of combined private and public debt as a percentage of economic output. According to Hoisington, in the U.S., that has jumped from 200% in 1987 to about 370%. In the euro zone, it has gone from about 300% of GDP in 1999 to more than 460%. Japan’s debt stands at a monstrous 650% of GDP, while China’s total debt has quadrupled since 2008, to 300% of GDP. And that’s probably a conservative measure, considering that China consistently juices its GDP growth numbers.
According to Hunt, the growing debt load, especially in the past decade, acts as a blanket of snow and ice, freezing growth. Money is wasted by financing temporary boosts in consumption, rather than being used for sensible capital spending and infrastructure projects that would yield much future growth. As China has shown, capital investment is unproductive if it just builds highways to nowhere, redundant industrial capacity, and empty housing complexes.
Debt growth is sustainable only if the projects it underwrites produce a stream of income sufficient to repay the interest and principal. This, according to Hunt, is becoming problematic in many areas of the globe, including the U.S., where the energy and mining sectors are in a world of hurt.
According to Hunt, overindebted economies have certain telltale characteristics. Jumps in economic growth, inflation, and high-grade bond yields prove short-lived because debt constrains economic activity.
Difficulties in making debt payments, in turn, push economies into frequent downturns and hurt productivity. Monetary policy loses effectiveness as the debt overhang stunts expansion of the money supply, slows monetary velocity, and quenches the animal spirits of producers and confidence of consumers.
Hunt sees just such trends at work in the U.S., where industrial production dropped 1.8% in December from the year-earlier level, despite a red-hot automotive sector. One can argue that manufacturing employment accounts for under 10% of total U.S. jobs. But, as Hunt points out, the U.S. industrial sector, according to Fed estimates, delivers about a quarter of GDP on a value-added basis. Likewise, industrial activities generate more than 65% of the earnings of S&P 500 stocks, he adds.
THERE ARE OTHER SIGNS of trouble. GDP growth, on a real or nominal basis, is flagging, as indicated by the limp 0.7% clip seen in the fourth quarter. The ongoing crash in commodity prices is stifling output throughout the world. (For a more upbeat outlook for the economy, see our cover story, “This Storm Will Pass”.)
Personal consumption, which accounts for more than two-thirds of U.S. GDP, is sluggish, according to the fourth-quarter estimate. The fourth quarter’s 2.2% growth rate was well below the 4.1% a year earlier. In fact, it was the worst year-end showing, year over year, since just after the 2008-09 recession ended, says Hunt.
Industrial production dropped 1.8% during 2015, largely because of slowdowns in mining and manufacturing triggered by the collapse in global commodity prices and processing. So far, debt problems and heavy layoffs in the energy sector have outweighed the positive impact of lower industrial input prices and savings enjoyed by consumers on vehicle fuel and home heating.
Hunt also expects inflation to remain quiescent over the coming year or two. Certainly, the decline in energy prices eventually will end. But, he contends, dropping nonoil import prices will hold down inflation in the years ahead.
TO DATE, THE DOLLAR’S roughly 30% surge against our major trading partners’ currencies since July 2011 has sparked only a 4.8% decline in the import price index, excluding petroleum. But, with currency wars appearing to heat up in Asia and Europe, further deflationary forces are likely to wash up on U.S. shores in the form of lower import prices and a loss of competitiveness for U.S. manufacturers, both at home and abroad.
Finally, Hunt contends, much of the disappointing U.S. output growth during the current economic recovery can be laid at the feet of the Federal Reserve and unintended negative side effects of its loose money policy.
Citing research by Nobel laureate economist Michael Spense and former Fed governor Kevin Warsh, Hunt claims that the U.S. central bank’s successive waves of quantitative easing diverted funds from productive uses in the real economy and into financial assets, sending the latter’s prices higher.
As a result, gross private investment suffered dramatically substandard growth during the 2007-14 period. The two authors note that, in 2014, S&P 500 companies spent more of their operating cash flow on stock buybacks than on capital projects. This boosts executives’ earnings-per-share-based compensation and might repel activist sharks, but it bodes ill for corporate growth.
Hunt realizes that the decades-long slide in U.S. government bond rates can’t go on forever. He and Hoisington, as confirmed monetarists, are watching closely for any significant pickup in monetary growth and velocity that would indicate a possible surge in inflation. But as long as tepid industrial-output gains and disinflation obtain in the U.S., the Hoisington funds will continue to ride the long end of the bond curve.
Or, as Hunt and Hoisington put it in their January client letter: “In short, we believe that the long-awaited secular low in long-term Treasury bond yields remains ahead.”