Frank Thoughts: The Unimaginable
Dave Canal
October 15, 2019

The word, unimaginable, has a fearful connotation.   It describes something we cannot comprehend because we have not experienced it before.  This is the reality of a subzero interest rate environment.  There is now 17 trillion dollars in sovereign debt paying a negative interest rate.  Why would anyone want to purchase a bond guaranteeing them a loss?  There is no reason, other than a fear of everything else that pays a positive interest rate. 

The reason for this global Madness of Crowds is a subliminal awareness of the secular nature of interest rates changes during the past 75 years (see chart).  You will notice – while there are counter trend moves – rates, from 1945 to 1982, moved higher on a secular basis. Then from the peak of 1982 to the present (37 years) interest rates moved lower creating the longest fixed income bull market in history.  As a consequence, almost every adult thinks of bonds as a safe investment.

And therein is one of my “observations.” Trends in motion stay in motion … until they don’t.  That is the only reason that explains to me why investors would “invest” in a negative yield and a guaranteed principal loss.  However, if rates continue to move lower, they could make a capital gain off the bond’s market value (it would go higher).  In the stock market this frothy experience is called a “blow-off.”  It represents the top of a bull market in bonds, much as it did for stocks in 2000. 

The difficulty for market participants to deal with this is called “institutional memory.”  It is the collective knowledge and learned experience of a group of people.  It sets the mindset of how to deal with a given situation.  Again, it is right, until it is wrong.  The current collective wisdom is that interest rates will stay low for years.  Possibly even go lower. That is based on their adult life experience.  To them, it has always been a bull market. 

Given the 37 years, it would be unimaginable it could be otherwise.  We know the debt crash of 2008-2009 was caused by 32,000,000 subprime mortgages.  It was the largest “asset” class in the world.  The result of every debt crash throughout history is a period of deflation.  Debt, which is nothing but leverage, magnifies investor pain on the downside just as it magnified returns on the upside.  But given the debt market is 2.5 times the size of the equity market, the negative impact is much greater.

Given that reality, it is not at all surprising everyone seemingly fears the years ahead will show slowing economic activity with continued negative subzero interest rates.  But to a contrarian, when virtually everyone shares the same opinion … it is apt to be an inflection point of change.  This is especially so when the accepted wisdom of that occurring is unimaginable.  I submit that is where we are.  But I know change always takes longer than we expect even when it seems obvious.

The reason I chose to write about the possibility of rates going higher (besides being a contrarian) is because of our research effort this month.   As you know, we do long term – six, twelve, eighteen months - relative price strength analysis.  Each month we analyze over 2,000 individual stocks, 11 sectors and 100 industries.  In our institutional research book we then highlight a buy or sell call on an individual industry.  This month it was BUY:  Insurance.  These stocks have languished for years in a period of declining interest rates.  They have historically benefited in a period of rising interest rates.

-Francis Patrick Boland


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