It’s tough to be a contrarian these days, as I noted in a recent column. But Dr. Lacy Hunt — the Executive Vice President of Hoisington Investment Management, the holder of a Ph.D. in Economics, and a long-time fixed-income observer and investor — stakes out a clear contrarian position on interest rates: they’re probably going to go lower, which will affect bond and stock investors alike.
In the latest Quarterly Review and Outlook from the Austin, Texas-based institutional fixed-income money manager, Dr. Hunt analyzes four widely accepted assumptions about the economy and the bond market and concludes they are all off the mark.
The most widely held “misperception,” he says, is that the current poor performance of the U.S. economy is only temporary and that once some spotty problems clear up, the economy will grow, ignite inflation, and push interest rates higher.
Not so fast, says Dr. Hunt. Industrial output is expected to decline more in the second quarter than it did in the first, and the velocity of money, or how frequently a dollar in circulation is spent on goods and services, is probably declining faster than the estimated rate of 3.5%.
Dr. Hunt next points to the “Wicksell effect,” referring to the work of the late 19th and early 20th century economist Knut Wicksell, who found that when the market rate of interest is higher than the “natural” rate of interest, funds are drained from income to pay financial obligations. Using the interest paid on the bottom tier of investment-grade bonds as a proxy for the market rate, and the growth rate in nominal GDP as a proxy for the natural rate of interest, Dr. Hunt says the market rate yield of 4.9% is 230 basis points greater than the gain in nominal GDP expected by the Fed for 2015.
“Since 2007,” Dr. Hunt writes, “the market rate of interest has been persistently above the natural rate, and we have experienced an extended period of subpar economic performance. The ratio of public and private debt moved even higher over the past six months suggesting that the Wicksell effect is likely to continue enfeebling monetary policy and restraining economic growth and inflation.”
Today’s Unemployment Announcement
Then there’s the notion that the improving economy will drive up wages and therefore inflation. Despite today’s news that new jobless claims slid to their lowest level since 1973, Dr. Hunt believes there is still considerable slack in the labor market considering the huge and growing number of part-time and contingent workers who are not unemployed but not fully employed either.
Other factors that Dr. Hunt believes mitigate against a rise in rates, but which I won’t go into here, include the economic harm from a stronger dollar that would accompany a federal funds rate hike, and the fact that the real yield on Treasuries is currently the same as it was in 1990 when the nominal yield was 9%, indicating there is no bond market bubble.
“In summary, economic theory and history do not suggest the secular low in inflation, or that its alter ego, Treasury bond yields, is at hand,” Dr. Hunt concludes. “The excessive debt burden, slow money growth, declining money velocity, the Wicksell effect and the high real rate of interest indicate that the fundamental elements are exerting downward, rather than upward, pressure on inflation.”
Your Action Steps
For dividend-oriented investors Dr. Hunt’s outlook means that interest-sensitive utilities, which have been battered of late on higher rate worries, could prove to be a good buy. Also, solid Blue Chip and near Blue Chip stocks that have weathered many economic cycles and continued to pay dividends are likely to fare better than expected and provide a welcome income kicker.
And as a minor pundit, I look at Dr. Hunt’s contrarian views as semi-vindication. While he disproved my view that it’s tough to be a contrarian these days, he strongly believes that Treasuries (a virtual sibling of my contrarian pick of cash, because both are so liquid) are still a worthwhile asset class. So if safety, returns, and contrarianism appeal, and if you think Dr. Hunt knows more about the fixed-income world than I do (a very safe bet), I wouldn’t be hurt in the least if you made a mix of Treasuries and cash your contrarian bet.