In the Trains, Cranes and Demographics Investment Commentary, I noted the impressive number of construction cranes I saw throughout Switzerland in April. Cranes are a sign of economic activity and optimism about the future. Although Switzerland was the only place I noticed a plethora of cranes, recent numbers reveal that economic growth has been slowly occurring throughout Germany (which I also visited) and the rest of Europe as well.
Therefore interest rates caused a stir last month. Since the Great Recession of 2008 – 2009, lack of growth globally has been associated with low interest rates. It has always been our expectation that signs of economic growth would be accompanied by rising interest rates. But WHEN would that happen?
Every day for the past six years, doomsday prognosticators have been predicting hyperinflation along with an interest rate spike. With an irrational passion beyond understanding, these “Chicken Littles” became gold bugs, buying precious metals, ammunition and canned goods.
Maybe they will be right someday, but for six years now, they could not be more wrong. Interest rates stayed low and declined even further.
During that period, the German 10-year bond traded with a yield of almost 0%. Adjusted for inflation, it has actually had a negative return. Because the German 10-year bond is the European equivalent of the U.S. Treasury bond, we have been monitoring it carefully, viewing it as kind of a canary in the coal mine.
On April 28th, it had an interest rate of .16%. Two days later it was trading at .36%. That might not seem like much to you, but an interest rate more than doubling in two days tells us something might be different.
At the end of May, the German 10-year bond was trading at .48%, another significant increase. And during June, it traded at almost 1%, more than double in a month.
U.S. Treasury bond investors were not oblivious to what was going on with German bonds and promptly began selling the U.S. 10-year Treasury bond, driving the interest rate to 2.48%, up from 2.03% in April. This didn’t cause us to panic, but we began to wonder… Could this be the interest rate spike so many pessimists have been expecting for so long?
As soon as one begins to get excited about the possibility of global economic growth, along comes Greece to remind us that not every country is having a good time.
Sunday, Greek citizens voted a resounding NO against a deal offered by Greece’s creditors. The deal, of course, is a deal by which Greek citizens live quite a bit more frugally than they have been or want to. Like the college kid who has maxed out the credit card, they would like just a little more credit for just a little more time. Germany is saying, “Well, yeah, maybe if your grades had been better, but it’s pretty obvious that you have been partying way too much. No, we are not going to put more credit on that card.”
Stock and bond markets are not quite sure what to make of this. Will Greece go bankrupt? Will Greece leave the Euro? Will Greece leave the Eurozone?
(Wouldn’t it be interesting if countries could be like NCAA football teams? Regardless of their geographic location, they can just switch continents? I mean if Colorado can leave the Big Twelve Conference to join the Pacific 10 Conference even though it is nowhere near the Pacific Ocean, couldn’t Greece say, “Uh, we don’t think it is in our best economic interest to stay in the Eurozone. We have decided to join South America.”? If that ever happens, I want you to remember you read it here first.)
More recently, the bond market has calmed down. Both German and U.S. bonds have seen rates decline somewhat, but it was definitely a wakeup call that global growth might not be wishful thinking anymore.
That’s a good thing, right? Growth leads to prosperity, more economic activity, increased employment and wealth. Yes, these are all good things… unless you own a lot of bonds with long maturities.
We view this initial leap in interest rates as just that – an initial leap of interest rates, not a prelude to a massive interest rate spike. Remember, last year the 10-year Treasury bond rose to around 3% only to decline back down below 2%. Who’s to say that won’t happen again (all the cranes in Switzerland notwithstanding)?
Economic data can give you lots of head fakes. It can cause investors to panic and drastically reallocate their portfolio way too early. As I am writing this, the 10-year Treasury is trading at a yield of 2.21%. The storm is over. Interest rates are not spiking higher this week. We can relax.
Having said that, I think it is important to note traditional wisdom in our industry: if you want to be more conservative, you should own fewer stocks and more bonds. But traditional wisdom can be deceiving. That kind of strategy works really well during 34-year periods like the past 34 years. In 1981, interest rates in the U.S. were in the mid-teens, and for the next 34 years interest rates declined (with a couple of major hiccups along the way). That is a tremendous environment in which to own bonds.
We are pretty sure that is NOT going to be environment for the next 34 years. That being the case, we think that having a higher allocation to bonds does not necessarily make for a more conservative portfolio.
Lately, we have begun to notice that a lot of publicly traded companies have a voracious appetite for other publicly traded companies. M&A (mergers & acquisitions) activity has become quite popular, and if our memory serves us correctly, it tends to become popular near market peaks.
To name a few:
- Intel is buying Altera for $16 billion
- Avago is buying Broadcom for $37 billion
- Anthem (used to be Wellpoint) is bidding $54 billion for Cigna
- Monsanto would like to buy Syngenta (roughly $45 billion so far)
- Teva Pharmaceuticals bid $40 billion for Mylan Labs, which Mylan rejected
This doesn’t necessarily guarantee we are at a market top. But it does make us sit up and take notice.
Stock markets gave a little in June. The S&P 500 was down about 2%. The MSCI All World (ex U.S.) Index was off about 3%. Year to date, they are both up a couple percent. Nothing to get excited about.
Bond markets have settled down, and we have no immediate sense of urgency to change our bond holdings. However, we continue to shorten the duration of our bond holdings as we expect interest rates to rise eventually.
This information is provided for general information purposes only and should not be construed as investment, tax, or legal advice. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.