Outside the Box Hoisington Investment Management — Quarterly Review

Last week Greg Weldon made the case for rising  interest rates on US treasuries. This week Lacy Hunt offers us the case for a continued low -interest-rate environment for long-term treasuries. This is one of the most fascinating tugs-of-war in the investment world today. I’ve made the argument that we are in a deflationary deleveraging world for quite some time to come, or at least until the velocity of money turns around. Lacy makes that point, too, and offers some insights into the velocity of money. This is a fascinatingOutside the Box. and I won’t spoil it by stealing any more of Lacy’s thunder.

I write from a sunny, if cold, Dallas. The thermostat has been a topic of conversation in my apartment lately, and not just because we need to keep turning it up. By now, the entire world knows that Google bought the thermostat company Nest for $3.2 billion, a good 50% more than the valuation Nest was trying to raise money on just a month earlier. I was rather surprised at the price, but I was also surprised that Google paid $1.65 billion for YouTube. Now, six years later, the YouTube franchise produced almost $6 billion in revenues last year. Clearly, the founders of Google saw something that much of the world did not see at the time. My suspicion is that Nest will end up ranking in the same category of return on investment for Google.

I have installed the cool new Nest thermostats in my new apartment. Having bought and installed thermostats on my own for various homes in the past, I was thoroughly surprised at the value of the Nest thermostat. Just a few years ago it would’ve cost some three to four times more to buy the same functionality that the Nest thermostat has. And this little toy does so much more. It actually adjusts itself to my personal habits and preferences and allows me to change everything from my iPad when I go to bed in the evening or get up in the morning, with a thoroughly programmable slate of settings. It even senses when I come close to it. It is just one element in what will soon be the Internet of Things that Cisco CEO John Chambers says will rapidly come to be worth $20 trillion.

I’m enjoying all the new technology that we’ve installed in the apartment, and we’ve designed and wired it to be able to adapt to what we think will be the direction of further change. I’m just hoping I don’t have to buy antivirus software for my oven.

Have a great week.

Your thinking about mortgage interest rates analyst,

John Mauldin, Editor

Outside the Box

Hoisington Investment Management – Quarterly Review and Outlook Fourth Quarter 2013

In The Theory of Interest,  Irving Fisher, who Nobel Laureate Milton Friedman called Americas greatest economist, created the Fisher equation, which states the nominal bond yield is equal to the real yield plus expected inflation. It serves as the pillar of macroeconomics and as the foundational relationship of the bond market. It has been reconfirmed many times by scholarly examination and by the sheer force of historical experience. Examining periods of both low and high inflation offers insight into how each variable in the Fisher equation affects the outcome.

Hoisington Investment Management

Inflation

A host of different factors caused inflation to vary in the aforementioned periods, but two points of significance are identifiable. First, the seventy-year plus span between 1871 and 1948 (excluding the World War years) was an extended global market era. It began about the time of uninterrupted transcontinental railroad travel and the completion of the Suez Canal and resulted in a period of rapidly expanding global trade. By 1871, 10% of U.S. railroad traffic carried goods that were traded globally. This era produced increasing returns to scale and minimized price pressures. Second, the 1871-1948 period encompassed two episodes of high indebtedness: the 1870s and then the 1920s until the mid-to-late 1940s. Both severely destabilized economic activity and produced minimal inflation, which in turn led to bond yields that eventually reached slightly less than 2%.

From 1871 to 1948, there were two, twenty-year periods when the total return on long- term Treasury bonds exceeded the total return on the S&P 500: one from the 1870s to the 1890s and another from 1928 to 1948. Additionally, the traditional vibrancy in demographic trends in the United States ended during the 1930s as both the birth rate and total increase in population slowed dramatically.

The period from 1948 to 1989 differs markedly. By 1948, a global market did not exist, and the excessive indebtedness of the 1920-1930s had been eliminated. In the late 1940s, the Iron and Bamboo Curtains imposed by Russia and China removed roughly 50% of the worlds population from global trade, reducing economies of scale. During the war years, from 1933 to 1948, the U.S. ratio of public and private debt to GDP dropped from 295% to 139%, as the personal saving rate jumped from below zero to 28% (Chart 2). With normal and sustainable debt levels the U.S. entered the post-war boom, a period of rapidly rising prosperity that produced greater returns in the S&P 500 than on long-term Treasury bonds. Additionally, the abysmal demographics of the 1930s gave way to the post-war baby boom as households became more positive about their economic prospects.

Today, conditions resemble the 1871-1948 period. Global trade is once again less inhibited and public and private debt is high and rising. The saving rate is also greatly depressed. In this modern era of high indebtedness, there have been long periods of negative risk premium which have lasted over a decade. Demographics have also soured. The birth rate in 2013 fell to the lowest level on record, and the population increase was the slowest since the depression era year of 1937. Thus, fundamental conditions are now conducive for an inflation rate averaging 1% or less. Based on the Fisher equation, long-term bond yields should be comfortable trading at 3% or lower.

The global inflation rate is influenced by many factors, but the current bout of low inflation and the insufficiency of demand are both symptoms of extreme over-indebtedness. Weakness in prices is evident in various price indices. Over the twelve months ending in November, the price of goods in the CPI actually decreased 0.5%, while the more accurately measured durable and nondurable components of the U.S. personal consumption deflator fell by 2.0% and 0.6%, respectively. Prices of imported goods fell 1.5% over the same period; excluding oil the decline was nearly as large. Facing weak domestic demand, foreign producers cut prices on goods headed toward the U.S. market, and this forced domestic producers to match those lower prices.

A lack of pricing power is likely to continue in 2014. First, the global economy continues to incur more indebtedness. Both public and private debt in the major economies of the world continue to move further above the levels that create a sustained negative impact on economic activity. Second, monetary conditions moved in the wrong direction last year, partially as a result of misguided policy efforts at quantitative manipulation of reserves. Third, although the sequester of government expenditures will be less in 2014 than in 2013, fiscal policy in the broadest sense is not supportive of economic growth.

Indebtedness

Academic research has shown that a public and private debt to GDP ratio above the range of 260-275% has a depressing impact on economic growth. In 2000 the U.S. debt level exceeded this range. Since then, the bond yield has averaged 4.6%, with inflation 2.1% and the real yield 2.5%. By comparing growth and debt figures prior to 2000 with those afterward, the magnitude of the problem and likelihood of its persistence can be assessed. From 1871 to 1999, private and public debt averaged less than 165% of GDP (well below the 260-275% critical level), and the trend growth in real GDP was 3.8%. From 2000 through 2013, growth has faltered to just 1.9%. Based on