Recession is Coming

 

Recession is coming. No one likes to hear it but a storm is brewing. The Federal Reserve wants inflation below 2% and it's going to get it by forcing the US economy into a recession. (How we got here? That's for another email.) By consistently raising short term interest rates in an attempt to bring down inflation the Fed has inverted the yield curve. (Where short term rates are above longer term rates.) If you notice below, a 2 year rate higher than the 10 year has preceded every recession throughout the entire data series.     Source: Federal Reserve It can take a while for pressure from an inverted yield curve to work its way through the economy but there are already a few signs. Temporary help is already negative on a year over year basis and it leads full time employment.     Source: Federal Reserve Continuing claims for unemployment have also turned up on a year over year basis. Like the employment data it's not screaming Recession just yet, but the direction higher coupled with continued yield inversion will send more people to the unemployment office. The COVID lockdowns broke the graph, so here is the data before, after, and with COVID.         Source: Federal Reserve   So, how can you prepare yourself for the upcoming financial storm? Raise Cash: I've been slowly reducing the risk of client portfolios. I suggest you do the same in both your investment accounts and personal financial profile. Liquidity: This is not the same as cash; do you have excess buying power on your credit cards, lines of credit, etc.? Untapped debt you can access during a recession can help one get through the rough patches or capitalize on the dislocation. Shopping list: I'm already building one for assets to purchase during the upcoming financial storm. This doesn't have to be stocks, bonds or market related items. Are you planning on a vacation? Consider deferring the decision until prices drop. Counterparty Risk: How will a recession affect those you do business with? This could be an employer or a business partner. Do you have any loans or financial commitments coming up in the next two years? Now would be the time to consider how a recession would affect those relationships. Opportunities arise during the chaos of a recession, which can counterbalance the inevitable disruption which occurs during an economic downdraft. Don your metaphorical financial rain coat and get ready.

I'm buying TIPS again

In my last post lamenting the paucity of options available to low risk investors I highlighted the guaranteed negative return one would receive investing in Inflation Protected Bonds from the US Treasury.

Oh my, how the world can change in a few short months.

Source: Federal Reserve

What was once guaranteed punishment has flipped dramatically.  My mental buy price was a real 1% on the 10 year TIP rate.  We recently passed that and thus I will started buying these once again at auction for my clients in certain situations.  For those of you who don't wish to purchase individual bonds or deal with the tax headaches (I do this for some clients as well) you can mimic the return by buying the etf TIPS

Considering the parabolic move in yield (and converse decline in price) be careful. Remember I'm holding these individual bonds to maturity so I would prefer it (at least for this part of the portfolio mix) if the yield continues to rise.  How high the yield may rise is something I cannot answer but at least one is no longer punished for saving right now.

The Lament of a low risk investor

 The Lament of a low risk investor

10 year TIPS rate

source: Federal Reserve

One of the challenges in managing a portfolio during the distribution phase is balancing the conflicting desires of certainty and return.  This is the classic risk versus return debate.   Higher risk should be rewarded by higher return, with the opposite also true.  When you accept a lower risk your return will be lower as well.  

When a portfolio shifts to one providing income for the owner, return of principal becomes more important than return on principal. One of the ways I used to provide certainty was the purchase of inflation protected securities from the US government.   They provide a guaranteed return over the inflation rate.  Well they used to, but please read on.

Some of you are already considering not reading further. I'm a stock jockey Greg!  I only care and invest in stocks, equities, risky stuff. Why should I care about the ramblings of a manager trying to eke out a return for some grandma?   Please endure for a little while, my dilemma affects you as well.

As the chart above shows, nearly two decades ago one was rewarded for giving your funds to the US Treasury for 10 years with a low return of  around two percent above inflation.  That's not much, but remember, we are looking for the money to be there when it matures; security first, return second.

Some of you may reply the official inflation numbers are incorrect, and I would say you may be correct in this assertion.  Inflation for a person in their 20's is very different than one in their 80's.  The mix of products and services required of a retiree are very different from that of a young adult. Furthermore there is debate if the basket of products is properly measured at all.  I don't wish to make this article a discussion about the accuracy of government statistics so for those disagreeing please concede to me that this is the measurement I have, and these securities' returns are based upon that measurement.  It's the best we have right now.

Around the great recession of 2008 I started purchasing these 10 year securities at auction, slowly building up a small laddered position for those in the distribution phase of life. The goal was to have a laddered portfolio of these maturing every six months. I grumbled at the returns but knew their utility, a safe but low return security that would form the foundation of  a clients' portfolio.  (There is an ETF doing effectively the same. The symbol is TIPX)

Notice on the graph above how real yields dropped to below zero around 2012.  While I was willing to accept a low real return, a negative real return was not acceptable.  

Now consider this please, dear reader.  Why would you voluntarily hand the US government your funds for 10 years with the guarantee of a loss after inflation? (and taxes if you don't place them in a Roth IRA)   Yes, traders may want to buy them in order to profit from the price changing day to day, but I am holding these to maturity.  

I paused the purchases during this negative period and restarted when rates were again positive.

Which brings us up to today.  10 year TIPS rates are quite negative and have been so since the COVID scare of early 2020.  As you may guess, I have stopped buying TIPS of any sort.  

I doubt the US government has noticed the lack of my purchases, but I'm not the only one who has noticed you are handing your money away for 10 years of punishment.

Why do I bring this up? Because other purchasers with a low risk mandate will have come to the same conclusion.  Why should I buy something that guarantees me a loss? Those buyers, like myself, will start to look elsewhere for returns.  

Are there alternatives for the low risk investor? Well not really.

There are I Bond savings bonds from the US Treasury.  The purchase of which is somewhat involved and are currently offered at a rate of 0, which means you will receive the inflation rate.  It's not a positive return, but at least it's not negative like the current 10 year tip rate.  There are exit fees if you redeem them early however.   Please read up and consider the negatives before you purchase them.

How about longer term US Treasury bonds? Well, same problem.  Negative real return, on top of adding quite a bit of duration risk

Source: Federal Reserve

Hmm. Perhaps high yield bonds? Switch from duration risk to credit risk? Same issue, return is negative on a real yield basis.

Source: Federal Reserve

So you can hopefully see the quandary.  There is no place to squirrel money away and not get punished for it.  This should violate the risk / return idea I highlighted at the beginning. I am willing to part with some funds for 10 years but right now I'm punished if I do so.  So what to do....

That comes later, but for now realize the situation we are in and realize individuals and institutions are responding.

As for the stock jockeys who managed to continue reading, realize the negative real rates affects your stock returns.  As the discount rate falls to a negative number this naturally inflates the value of stocks. Why is the CAPE ratio in the stratosphere?  Earnings are being discounted by a much lower number, raising their present value.   The movement of US Treasury interest rates affect the value of your assets as well so it behooves you to watch them.

Get ready to refinance. Again.

Get ready to refinance. Again.

At least there is one positive aspect to the COVID-19 crisis, the drop in interest rates.  And notice I said get ready.  It appears it would be better to wait to refinance. If you can.

Source: Federal Reserve

The Green line in the image above is the difference between the 10 year Treasury bond rate and 30 year mortgage rates.  If you notice, during the 2008 and current recessions the difference between those two rates expanded dramatically before eventually closing.

I downloaded the data from the graph above.  The average difference is 1.76% with a standard deviation of 0.29%.  Right now we are at a ~1.65 standard deviation event, which is very unusual.  To put it another way, if mortgage rates were 'average', right now they would be 2.44%

Yes, a sub 2.5% 30 year mortgage.

Now, we may not get there.  10 year Treasury rates could rise before the mortgage market normalizes, or they could go down.  I'm not going to make a prediction on interest rate movements in this post.  But if nothing happens with longer term Treasury rates we could see a sub 2.5% 30 year mortgage rate in the future.

Refinancing your house is only an option if you can, and for quite a bit of America this unfortunately is impossible due to business or job dislocation. But if you are able, go to the link above and watch it weekly. I sure am.  

Predictions are hard, especially about the Future

One of my favorite books ever is the book Dune by Frank Herbert.  He built a universe with a complex religious, economic and political framework that transports you to a completely different world.  It is not a dry technical read about an alternate reality but a compelling and rich story with an amazing tapestry behind it. 

I will stop gushing over the man, but I want you to watch this video and remember the respect I have for this man and his capabilities.  It's short at around 4 minutes.  He explains his natural curiosity and his broad skill set that created the situation for him to write the book series.  However even Mr. Herbert gets the end of fossil fuel prediction VERY wrong. 

When you extrapolate out the current state too far into the future one will come up with very wrong results.  The world is extremely dynamic.  Humans are very clever.  New technologies and innovations which were too expensive drop in price enough to totally transform the dynamics of a system, rendering your prediction invalid.

In this 1977 interview he states we will run out of fossil fuels in 40 years.  We are 3 years past that deadline.  Even brilliant people can be wrong on occasion.

Another attempt at a Dune movie is near release. I hope it's better than the last one.

Keeping your packages and mail safe

The holiday season bring much cheer, and shopping.  In today's modern economy much of that shopping ends up being online with packages delivered to your door. Very convenient, unless they are stolen...

While my primary mission is managing assets for clients I have realized keeping those assets safe, while ancillary, is also something I should assist with as well. With the Great American Shopping Frenzy underway I thought this would be a good time to remind you to keep those packages and letters safe!  Here's a few ways to do so:

Amazon lockers
I use Amazon, too much most likely, for business as well as personal purchases. It's incredibly easy and very competitive on pricing.  Bulk dog food is cheaper from Amazon than my local pet store!  

Shopping via Amazon unfortunately creates an target for porch thieves unless you are careful.  Fortunately there are alternatives; Amazon allows one to have your orders delivered to a 'locker' in a nearby store of your choosing. 

Here's a link to find a locker near you:

https://www.amazon.com/b?ie=UTF8&node=6442600011

 

Physical security of mail

If you don't have a secure mailbox, you'll get your mail stolen.  It's not a question of when but if.  Even something which looks secure may not necessarily be so. Preventing your packages from being stolen may be topical, but getting your mail stolen a year round concern.

Mail theft happened to me several years ago and my solution has prevented any mail theft since. It's a severe response, but look at what a crowbar does to some other options out there

 

The solution, cold hard steel and lots of it, a quarter inch to be exact.  It's probably bullet proof as well, but I'm not going to test it for you.

https://www.fortknoxmailbox.com/product-category/mailboxes/

 

Shred

Once you've received your documents, make sure they don't leave the house intact.  My shredder gets a workout almost every day.  All financial and health documents no longer needed get shredded.  

It is frustrating to have to alter one's behaviour to prevent crime but it's an unfortunate fact of life.  I ask you to learn from my own and other's negative events to keep yourself safe.

Happy Thanksgiving.

Now go eat some Turkey.

Additional links:

Porch pirates stealing your online orders:

https://mynorthwest.com/1187242/porch-pirates-poll-washington-residents/

Health care fraud: Unfortunately people will imitate you for medical care or for identity theft.
https://www.fbi.gov/investigate/white-collar-crime/health-care-fraud

Physical security of the home

https://www.seattletimes.com/pacific-nw-magazine/want-to-keep-your-home-burglar-proof-here-are-some-tips-from-a-burglar/

https://www.king5.com/article/mobile/news/investigations/we-asked-86-burglars-how-they-broke-into-homes/344367382

Chasing the next credit bubble. It feels best right before it pops.

A recent tweet by Kevin Smith of Crescat Capital  (someone I've had the pleasure of meeting in person) reminded me of just how far we've come since 2008 and the Great Recession.

By how far we've come I'm not meaning in a positive sense.  If you look at the selected ratios of debt to GDP for Canada, China, and Australia they've each grown tremendously since 2008/09.   While this has helped goose growth in each of their respective economies (and spilled out into the greater world as well)  it does not bode well for the future.  The thing about debt is it need to be paid off.  Somehow, someway (by default, payment or inflation) the ratios will drop when they reach such lofty heights.  

Crescat capital annotated the above chart rather nicely showing you the negative events which coincided with either a rapid rise in debt to GDP (like Thailand) OR a high ratio overall (Japan, USA, Spain)  Their implication is Canada, China, and Australia are heading toward a likely credit crises and I'm inclined to agree with them.  

These are not the only shimmering spheres on the horizon however.  Look below and you can see all three of the Scandinavian countries are above US levels before our little economic problem in 2008.

Source: Federal Reserve (link)

The challenge with calling the tops in a bubble is you are battling central bankers and their willingness to keep the debt flowing.  Who wants to say no when the money is flowing?  Even central bankers can exhibit human tendencies on occasion, they don't want to be derided for being the Grinch that stole Christmas...  As such it's very hard to know when they will finally start to restrict the lending and tighten liquidity.    While the US is not at the top of this rarified list it is entirely possible our current series of recent (and future?) rate hikes will be enough to tip one of these countries over the edge which could then get the dominos falling.  When is unknown, but that it will happen appears quite likely.

Update:  https://blog.pimco.com/en/2017/05/A%20Less%20Impulsive%20China%20Bracing%20for%20Lower%20Growth

Looks like the Chinese credit impulse may have turned negative recently.  As the data presented above is nearly 6 months old this is very interesting.  While it ripple through to the US markets? We shall see shortly.