October 30, 2017
We recently had an opportunity to spend some time with Ben Bernanke as he was visiting Atlanta. He spoke to a small gathering of financial professionals over lunch. The last time we were with him he was still serving as Chairman of the Federal Reserve and was much more guarded in his comments. This time he was free to speak his mind about the economy, politics, Fed policy, and even baseball.
On the economic front, things look pretty good. Growth continues to plug along in what he called “the Rodney Dangerfield recovery” (it gets no respect). Europe is growing faster than the U.S., and they are about three or four years behind us in the cycle, implying they have more room to expand going forward. Japan is doing well. China and emerging markets look pretty good. It’s a goldilocks scenario of synchronized global growth. It won’t last forever, but there is nothing on the immediate horizon that looks ready to derail it. He acknowledged that stock prices are a little high, but nothing crazy.
Of course we asked for his views on the direction of interest rates. “I’m not a good forecaster,” he said. “I felt there was upward risk in yields and it hasn’t turned out that way.” Still, he believes the Federal Reserve will hike rates again at its December meeting but he is skeptical whether we’ll see three hikes in 2018 as current guidance suggests.
On the political front, he reminded us of the independence of the Fed and the importance of it remaining that way. He believes Yellen should be reappointed. That’s the tradition but even if she is replaced with an inflation hawk, he feels there will be very little difference in the near term. There are 19 members on the Federal Open Market Committee which sets short term rates. It is a consensus organization. Changing one or two people will have little immediate impact. It gets more relevant whenever the next recession arrives. The Fed has very little room to cut interest rates and it remains to be seen if a hawkish Fed chair would be willing to reinstitute extraordinary measures to stimulate the economy. Recession risk appears to be quite low for at least the next 18 months and he believes we are likely to see unemployment fall to around 3.5%.
As for risks, he pointed out that we spend 16% of GDP on healthcare in this country and the government pays half of it. That’s much higher than our developed country counterparts, and our outcomes are not as good as others. We’ve got to figure out how to get this under control. It’s not urgent but it’s critical for long term sustainability.
And one final thought on our lunch with Ben: the longest economic recovery in our history started in 1854 and lasted a year and a half longer than our current recovery. Dr. Bernanke says we have a good chance to break that record. Let’s hope he’s right about that.
October 23, 2017
The statement seemed innocuous: “BBBs rule investment grade bonds”. But that simple statement summarizes an important story about the current state of the credit market. Before explaining why let’s first do a quick refresher on the fascinating world of bonds.
As you know, bonds are a form of IOU which governments, municipalities, and large companies use as a means of finance. Bonds are “rated” based on the ability of the issuer to pay back the debt, with a range of ratings from AAA (the best) to D (in default). The highest ratings, from AAA to BBB-, are known as investment grade. Bonds rated below BBB- are commonly referred to as speculative or junk. Only two companies in the US are currently rated as AAA, Johnson and Johnson and Microsoft. Even US government debt has fallen to the second tier AA+ .
There are three main credit rating agencies for bonds: Moody’s, Standard and Poor’s, and Fitch. Each of these rating agencies views BBB bonds as having a low likelihood of default, but with some credit risk if there is an adverse change in circumstances affecting the issuer. Such changes could include more difficult economic circumstances. In other words if you buy BBB bonds you also take on some risk and certainly more risk than in the higher tiers of the investment grade category.
So why does this matter? The answer was in a recent WSJ article which reported that BBB rated bonds now represents 50% of all investment grade debt, an increase from 20% just 11 years ago. The fall in the average quality of investment grade bonds has been unusual. There are likely several explanations but one answer lies in investors’ desire for more yield.
Years of low rates have forced investors to “reach for more yield”. For example, if a AAA bond is yielding 2.5% but an investor opts instead for a 3% on a BBB bond, then they are reaching for more yield. In effect the investor’s wish to increase their return means they are less discerning about the higher risk associated with that return than they would be in more normal market conditions.
This reaching for higher yields has provided a cheap form of finance for companies with some credit risk, for example the BBB bond index has recently yielded 2.89% as compared to the 20 year average of 5.1%. Moreover the differences in yield between higher quality and lower quality bonds has been heavily compressed to levels never seen before. In 2008 the difference in yield between AAA and BBB bonds was 4.0 %. Today that difference is 0.25%.
We debate regularly the risks investors are taking in the stock market but the data above suggests that investors have taken on more and more risk in bonds as their search for return continues. Remember one of our core investment rules is that you should be rewarded for taking on higher risks by commensurately higher returns. That does not seem to be the case in the bond market today.