10 Mar 2006 Long-Term Rates are Finally Rising
Interest rates are rising across the board. Just last week we discussed the inverted yield curve and the problem it posed for banks and for those who borrow from banks. Since our last Brief, the yield on the 10-year note has gone up 10 basis points, or a tenth of a percent, while shorter maturities such as the 2-year note is up only modestly. The result has been a yield curve that is a bit more accommodative for banks. Our experts believe the yield curve will not change much from here, remaining relatively flat (short term rates close to long-term rates), therefore challenging for banks, but not disastrous for them or the economy. If the Fed raises the funds rate to 5% by May as many predict, then the 10-year Treasury bond yield will also likely to rise to 5%.
While the increase will be uncomfortable for bondholders and stockholders alike, it will not be crippling to the economy. A yield of 5% on the 10-year is still well below its average of 7% during the go-go 90’s. The graph to the left reveals just how far yields of the 10-year note have fallen in the past thirty five years. Rates peaked in September of 1981 at 15.8%. It was a time of extreme inflation when the Baby-Boomers were acquiring things like homes and cars. As a broker back then, I remember how difficult it was to sell AAA tax-free municipal bonds yielding 14%. People thought yields would go even higher. A yield of 14% tax-free is equivalent to 20% taxable 28%, the long-term capital gains rate at that time. At 14% tax-free, money doubles every 5.3 years! But many remained on the sidelines waiting for more. They missed it.
Today is a remarkably different story. Inflation, less the volatile food and energy components stands at just 2.1%. In June of 1980 prices were rising at 13.6% a year. Would-be buyers of those 14% munis reasoned that with inflation so high their real return on the bond would be a paltry .4%. They were right in the short-term, but they underestimated the tenacity of Fed Chairman Paul Volker and the strength of theUSeconomy. By December of 1982, inflation, as measured by the CPI had fallen to 4.7%. It stayed in that range until the early 90’s when the technological and information revolution created a prolonged period of high productivity which in turn drove inflation into near-permanent hibernation.
While inflation is yet to come from its cave, the Fed is worried that high energy prices, a constrained job market, and factories at near capacity will revive it. For this reason it is a near certainty that they will increase the funds rate another quarter point this month to 4.7% and probably to 5% in May (they don’t meet in April as they are busy doing their taxes like the rest of us).
But beyond May, the majority of global investors seem to think the Fed will stand pat on rates. The Fed is hyper focused on the upcoming economic data as they consider their future rate decisions. Michael Moskow, president of the Chicago Fed said today that inflation will require “careful monitoring” as the economy approaches the limits of “resource utilization,” the new buzz words for low unemployment and high capacity utilization. But he also credited the anti-inflationary role of productivity. He said that “manufacturers often tell me they have a great deal of flexibility to produce without generating cost pressures.” Indeed we see it quarter after quarter as earnings surpass analysts’ expectations. Moskow also said that the Fed’s main interest rate had reached neutral, a level that neither spurs nor restrains the economy. Yet they remain ready to raise rates and, thereby risk stalling growth, if they believe long-term inflation is in the cards.
As rates rise, investors begin to consider bonds once again as an attractive choice. Clearly if rates continue to rise, bonds should be avoided, but once they peak, they become attractive to some. The risk is that investors who compare only stock dividends to bond yields miss much of the story. They correctly observe that the average dividend of the S&P 500 is only 1.8% which falls well short of the 4.6% yield of the 6-month T-Bill. But, over time, dividends rise relative to the initial sum invested in the stock. A dollar invested in the S&P 500 in 1970 yields 25% today; while a 1980 investment in the S&P yields 17%, and a 1990 investment yields 7%. But dividends and their growth are only half the story. Capital gains since 1970 with dividends reinvested amount to 4,288% or 11% annually. Since 1990 the gain remains the same 11% annually. The annualized return for the 2-year Treasury since 1990 is 5%.
Today, corporations are busy raising their dividends and buying back their stock in efforts to regain the trust that investors lost over the many corporate scandals of recent years as well as the market bubble of 2000. Since mid-2003 the rate of dividend growth has increased more than twice the average rate sustained since 1970. Today an investor can buy a share of General Electric (and many other S&P 500 stocks) with a dividend yield 3% that has grown at a 9.6% rate over the past five years. Or he can buy a five-year treasury that yields 4.8%, and maybe more in the next few weeks. But in five years that bond will still yield 4.8%, guaranteed. However, the investment in GE may also yield 4.8%, if past trends continue (but there’s no guarantee they will which causes the more stalwart bond buyers to avoid stock). But here’s the gravy; if GE continues to grow its earnings at say 10% (actually they have grown at 11.5% over the past five years) for the next five years, the shares would be worth $54.00 using the same price earnings multiple as exists today. That’s a 60% increase in value of a shre of GE, compared to a bond which would be worth what you paid for it.
Bonds have their place in an investment portfolio, but that discussion is beyond the focus of this Brief. If one believes that the global economy has its best years ahead of it, as we do, then equities of high quality, well managed corporations will provide the best returns in the years to come.