Albert Einstein once called compound interest the eighth wonder of the world, adding, “He who understands it, earns it... he who doesn’t… pays it.” It’s one of the most basic tenets of finance, and the principle on which modern banking systems operate. Unfortunately, in Europe and Japan, the world’s largest and fourth largest economy respectively, even if you understand compound interest, you’re still paying it. Americans really need to start doing their homework because negative policy rates probably won’t be a novelty over the next five years, and could be commonplace.
Before each of the past seven US recessions, long-term interest rates fell below short-term rates, producing what economists call an inverted yield curve. However, the (potential) upcoming recession would almost certainly buck this trend, because short-term rates are already zero. As perverse as this environment is, it seems unreasonable to expect an inverted curve out to 10 years with the short-end at or below zero. Nevertheless, the New York Fed’s yield-curve based model implies a less than 5% chance of recession in 12 months. The Cleveland Fed puts the chances slightly higher, at 6.19%. A recession is certainly avoidable, but the odds are much higher than that.
Investors are stunned to see 10Y US Treasury’s yielding less than 1.75%, but that’s still a whopping 150bps more than a 10Y German Bund. In 2008-2009, the Fed reacted faster and stronger than the ECB in almost every respect, which drove up longer-term yields – at least relative to Europe. You’ll recall the ECB actually raised benchmark rates in 2008, albeit before the Lehman bankruptcy. Europe, weighed down by Greece and a common currency, has been stuck in the deflationary mud ever since. But it appears those deflationary winds have now entangled the US, and it’s entirely possible the spread between Treasury’s and Bunds will cross somewhere below 0.50%.
It seems as though the US is following the path of Europe, but Europeans are really just following Japan’s lead, where 10Y JGB yields went negative this week. Excess debt is the common denominator in all of these economies, and yet the leverage just keeps building. The US is still a long ways from Japan, but China is the last domino. The Chinese prevented a global depression in 2008, and it’s unclear whether they’ll be able or generous enough to come up with an encore.
Having said all that it’s important for investors to realize that this isn’t a death sentence for your portfolio. There are assets that do well in crises and deflation. Bonds should be fine, especially those with longer maturities. The 30Y US Treasury offers 2.6% yield versus 0.9% in Germany. The knock on gold has always been that it doesn’t offer a yield, but that opportunity cost is now gone. It may seem like you’re chasing the rally in gold here, but that’s a shortsighted view. We’re only a few weeks away from the second highest level of CFTC gold shorts in history. Bearish sentiment like that doesn’t just go away overnight. The most important thing to remember is that bear markets are tricky, and always include dead-cat bounces. Do your homework, have a view and stick with it.
The Cup & Handle Fund is up around +3.0% YTD, and +12.0% Y/Y. We’ve held steady through all of this volatility, and the portfolio’s construction is holding up pretty well. We’ve still got a decent chunk of cash available for deployment. Obviously I would like some of our winning, high conviction positions to be larger but such is the nature of managing a portfolio. Since launching in August 2014 the C&H Fund is +24% versus a -5% decline in the S&P 500. Some of our monthly picks are down, but others have won huge. In the end it’s the aggregate that matters. If you’d like to start receiving these letters click here.
With that I give you this week's letter:
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Until next time, tread lightly out there,
Managing Editor – Cup & Handle Macro