Emerging Portfolio Themes
In the past couple of months, a number of headlines have caught our attention. We are reminded that corporate debt is surging, interest rates are at very low levels, and a trade war is ongoing. This week we look at specific portfolio actions that can be taken to weather the storm.
“Volume of New Corporate Bond Issuance Breaks Weekly Record” — Bloomberg (September 9, 2019)
“In Bond Anomaly, Negative Yields Bring Positive Returns” — Wall Street Journal (September 8, 2019)
“As Trump Escalates Trade War, U.S. and China Move Further Apart With No End in Sight” — New York Times (September 1, 2019)
Dealing With Debt
The world’s debt load is far higher today than it was forty or fifty years ago. Years of unbalanced trade and capital flows helped drive global debt higher, especially after the year 2000 (charts, below). We discuss this tie-in between trade, capital flows, and debt in a recent comment titled “How Trade Policies Lead to U.S. Debt.” Whatever the cause, the fact remains that rapid growth in debt brings with it added risk. Because the debt remains high and the cycle is aging, it makes sense to now focus on companies that go relatively light on debt.
The clear and well-established link between trade imbalances and debt is evident in the charts below. Rising domestic debt is a byproduct of trade and capital account imbalances (chart, left). Global debt has grown far faster than productive capacity, making for rapid rise in debt which can lead to risk (chart, right). In the presence of excess liabilities, equity holders can suffer sudden losses. Losses can occur, in part, because leverage creates a fixed cost, interest. As leverage increases, changes in value becomes amplified through the balance sheet down to equity holders. Defaults can rise quickly with an unexpected drop in business activity, a surge in interest rates, or both. One way to reduce such risk is by focusing on consistent profitability and lower leverage in stock selection.
Along with rising imbalances and debt came increased demand for safe assets. Surplus countries like China had to export large amounts of capital to the United States and other developed nations. As safe bonds from Europe and the United States became scarce in the face of recent years’ austerity and central bank bond-buying campaigns. The surge in bond prices and the rise of negative-yielding sovereign debt is unprecedented. Negative interest rates can now be seen on $14.5 trillion of bonds, according to Bloomberg. We are unaware of any other time in human history when borrowers borrowed, and creditors lent at negative rates. In Sidney Homer and Richard Sylla’s “A History of Interest Rates” we were unable to find a single example of negative-yielding loans throughout recorded history, for example. Homer and Sylla’s 660-page third edition tome begins with loans made in 3,000BC in Mesopotamia and continues to modern days.
In the past, the yield on 10-year U.S. Treasury Bonds tended to track domestic growth (chart, below) broadly. While not very a precise relationship, we are approaching the low end of a reasonable range given the historical relationship. We still believe that bond yields will eventually revert toward a long-run average near nominal GDP growth. Disruption in trade and capital flows could be one catalyst for a change in global capital flow and could also signal a shift in direction for yields. Whether bond yields drift higher or spike, returns from yield sensitive investments could suffer. This is one more reason why we find yield for yield’s sake investments uninteresting now.
Here or There?
Whenever imbalances are finally unwound — as we believe they must — it will be trade deficit countries like the U.S. that are best positioned. The reason for this is simple. Trade deficit countries tend to be countries with robust internal demand. Such demand is of great value to the rest of the world, which is often starved for such demand at home. This phenomenon is why the United States, a trade surplus nation at the time, suffered so severely in the 1930s. It is also why Japan, another surplus nation, has endured decades of sub-par growth since the 1980s. Deficit countries tend to fare better than surplus countries as trade and capital imbalances unwind. We have reason to believe that domestic equities can continue to perform relatively well.
It is appropriate to reassess portfolios given today’s headlines. What worked in the past, as past economic relationships evolved, may not work in the future. A focus on less levered, less yield sensitive, domestic stocks makes sense as historic changes unfold.
Kevin Caron, CFA, Senior Portfolio Manager
Chad Morganlander, Senior Portfolio Manager
Matthew Battipaglia, Portfolio Manager
Steve Lerit, CFA, Client Portfolio Manager
Suzanne Ashley, Analyst
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