Big Thoughts and Small Ones – The Voice of Reason

The noise is getting louder and louder. We are clearly not forecasters, nor can we tell you what the weather will be like tomorrow with any consistency or certainty. However, there are some facts we need to pay attention to. There are some irrational things happening that may go on for a long time, but will have a difficult time persisting.

Let’s look at a few of these things:

Interest Rates and Fixed Income

Central banks around the world have pressed rates so low that many of them are now printing negative longer term rates. For example, the 10 year Japanese bond is now yielding -0.035% (February 9th 2016). The two year bond is at -0.259. What will the Central Bank of Japan’s next move be? Will they take the 30 year bond to negative interest rates as well? All of this in search of the inflation holy grail of investing. This is madness. It also reminds us of the law of diminishing returns. Once rates are below zero, more negativity does not necessarily beget more spending. Or does it?

The rest of the world may not be far behind. It’s like a bad rerun of Dumb and Dumber. What would happen if Japan lowered rates to below zero? The Swiss are already at negative interest rates on their 10 year note. Germany, the European economic power house, must be better – NOPE they are negative out to 7 years. Well here in Canada and surely in the U.S. we will never see negative interest rates, right?! Potentially. Canada and the U.S. still have a long way to go, but have picked up speed recently. The 10 year Canada bond is yielding 1.17% and the U.S. is at 1.74%. The good news in this is that they still have a lot of room to move rates lower! Remember, the U.S. just bumped rates higher. I am guessing that they are wishing they did not do that given the recent market volatility. We wish they didn't!

So, can rates go lower in the Canada and the U.S.? It appears so... Does this play well into bond returns? Yes. When rates go down, bonds go up. Is there a lot of room here? We need to look at the math. If Canada took its 10 year $110.49 (bond price) to a yield of negative 0.06, it would be about a 1.2% points move from current rates. This would likely equate to a price difference of about $10 tp $12 maybe more in a frenzy, or a total return around 10% going long the 10 year Government of Canada Bond. This seems like a crazy investment idea today, but these are the facts of the math and it is the reality for the rest of the world. So, maybe being ‘Dumber’ does hold some investment street cred?

In a world gone mad, there appears to be some opportunity for a trade in the bond world. However, this is not a permanent condition of return. Once again, we need to go through the numbers to confirm this; nonetheless, yield cannot and will not be pushed to deep negative multiples. Once you sink the entire yield curve under water, there is no need to push them lower. Theoretically, does negative 2% provide more disincentive than negative 1%? Wait, let’s get really crazy and go to negative 5% on the 10 year bond. Evidently this provides greater disincentive to invest money in bonds. At some point, the world says UNCLE.

Fixed Income Alternatives

Let’s review banks for a moment. Royal Bank has a 4.65% dividend. Let’s make a few assumptions:

Dividend Growth Rate is let’s say 1% – the historical 5 year dividend growth rate was 9.3%

Return of the stock looking forward is, let’s say, 1% annually (modest thinking here)

Some very simple math would suggest that you get a 4.65% dividend annually and you get 1% capital appreciation. On an interest equivalent basis, you are approaching a 7% return.

Now, will Royal Bank go up over the next 5 years? Likely, maybe, I don’t know? These are all good answers. If there is one shred of recovery or growth that creeps back into the Canadian economy, the answer becomes a resounding yes. So either buy the government bond and hope the world remains irrational and clip virtually no coupon, or buy the bank and clip a nice coupon and expect some rationality at some point.

It is a tough bet either way.

Oil

We know the story and all the moving parts by this time. Goldman Sachs published a research note with a target price below $20 on oil. If this happens it’s a – well you don’t want to know. Banks will take huge loan losses (and or provisions) and companies will go out of business at which point supply will really be constrained. We will likely also have another global commodity led credit crises – think 2008 with more teeth. The trade would suggest that, if oil tanks, all other commodities (with the exeption of GOLD) would hit the deck as well. Anything can happen. Once again, will the Saudi’s and OPEC let this happen? It would be a very extreme trick for a one trick pony to make this move.

In a game of chess, this is called a gambit – the sacrifice of a pawn (current oil price) for the sake of some compensating advantage (more market share). If this gambit does not pay off, you are left hobbled and will likely lose the game (will have to cut production). If it does pay off, you gain your market share and can move price up as you have squeezed out higher cost production (constrained supply). There is a gambit happening right now. Either way, win or lose, production will have to come down in the future. The timeline is unknown.

Could perhaps this gambit drive the world into global economic slowdown and the move never works – stale mate (oil prices remain low for a long time)?

Application of Capital Today – Our Process and Discipline

This, at all junctures, gets called into question. When the markets are good, you are not good enough. When markets are bad, well, you are still not good enough. Gulp. One thing that is certain has been sticking to the process of departure from what has not worked to something that is working. It sounds simple, but is really difficult on a number of levels. The key, and critical level of engagement, is timeline. Everyone has a different one, and many of those are well challenged.

Back to the Banks

Is Royal Bank working today? Not really. It has been sliding since April of last year, down from over $80 to $67. Look at the price action compared to the yield on the 10 year Canada:

Source: VIP Wealth Solutions & Bloomberg

In the short term, if rates are going lower, the Banks are likely going lower as well. So, are bonds the place to be?

Times are tough right now, and the big money is starting to drool. This is when longer term commitments to real companies shine. This takes time. Not a month and sometimes not a quarter, sometimes longer.

What Should We Do?

All the constructs suggest to be defensive. The possibility of a snapback is always ever present, as 2015 demonstrated, so broader kneejerk moves need a degree of measure.

The love affair with capital markets globally is almost all but over, suggesting the highest degree of complacency. This is typically when opportunities present themselves. The search for these opportunities remain constant and ever present. Growth, in a macro sense, is going to be harder to come by. China will likely not build any more cities that no one wants to live in, and the historical insatiable appetite for commodities will be somewhat more muted than in the past. However, we are still driving combustion powered vehicles and, in China, they are buying and driving more. This is not going to stop overnight.

Like the car, we drive forward. We know that things appear difficult. We have seen this video before and prospered in the face of it (think 2008).

Long term bonds are not a long term growth solution, nor are short term bonds helping with the long term growth of capital. They may provide some short term resistance to market declines, but we know that you cannot gorge on a free lunch (zero percent interest rates) forever.

Rationality will return, the noise will fade and the understanding of this commentary will be clear at that point.

When the crowd is cheering for a Payton Manning Super Bowl touchdown pass, it is difficult to hear what the beer guy is saying.

The opinions expressed in this report are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP Limited or its affiliates. Assumptions, opinions and estimates constitute the author’s judgment as of the date of this material and are subject to change without notice. We do not warrant the completeness or accuracy of this material, and it should not be relied upon as such. Before acting on any recommendation, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Past performance is not indicative of future results. Richardson GMP Limited is a member of Canadian Investor Protection Fund. Richardson is a trade-mark of James Richardson & Sons, Limited. GMP is a registered trade-mark of GMP Securities L.P. Both used under license by Richardson GMP Limited.