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Stockpiling Income – An Update (December 2016)

Source: istockphoto.com

Highlights:

• In the wake of the election resulting in a market rally and sell-off in fixed income, this article revisits the original ‘Stockpiling Income’ blog published on our website in March 2016. 
• Bond markets are positioning for cyclical reflation, or Trumpflation, with break-even TIPs/Nominal Treasury yields surpassing 2% for the first time in a couple of years. 
• Secular disinflationary forces such as high debt loads and aging demographics should keep a lid on nominal and real rates. 
• As the forces of cyclical reflation and secular disinflation butt heads with each other, investors should consider ‘stockpiling’ income using a hold-to-maturity bond portfolio where the expected rate of return is approximated by the yield-to-maturity. 

Note: this piece is an update to the one originally published in March 2016 titled, “Stockpiling Income,” which can be found in the News & Insights section at 3dadvisor.com.  We begin the article with an overview of time-segmented retirement income planning and the need for deferred income options for the short-to-intermediate segments.  Following this overview, we provide a broad outlook in light of the post-election market behavior, namely the rise of cyclical reflation in the face of secular disinflation.  We believe this helps set the context for why investors should consider hold-to-maturity fixed income solutions. 

Reflation for the Short-Term…

Fixed income investors find themselves in a tricky situation following the November election.  The post-election period has produced some clear winners (U.S. small cap value, financials) and losers (bonds, equity bond-proxies, and foreign currencies).  Trying to discern how much of the post-election market rally is fundamentally-driven versus speculative (i.e. wishful thinking) can prove to be a futile exercise, since ‘fundamentals’ and speculation sometimes turn out to be one and the same.  In general, the market attempts to discount all the forward implications upon major regime shifts; in this case, the implications of a Trump presidency on global trade, U.S. business conditions, and inflation.  Yet, it remains to be seen how much of what the market is discounting comes to fruition because the market is discounting the enactment of government policy subject to the whims of political dynamics as opposed to market forces.

However, as we first published back in September (Mission Accomplished (Update September 2016)), we were starting to see the seeds planted for a global reflation cycle prompted by a shift in global central bank policy from pursuing negative rates to engineering steeper yield curves.  At the time, it was unclear whether the bond market would play along as it has seemed that any sell-off in the long end of the curve was immediately bought.  This pattern of ‘buying the yield rally’ reflected ongoing skepticism of central bank efforts to pursue ‘normal’ monetary policies and depart from the emergency quantitative measures that have largely been in place since the 2008 financial crisis.  Since the Brexit referendum vote this past June, U.S. inflation expectations (as priced in the difference between the 10-Year TIPS/Nominal Treasury difference versus the 5-Year TIPS/Nominal Treasury difference or 5-Year/5-Year Forward Inflation Expectations) have sharply risen (Exhibit 1).  Central banks are trying to engineer reflation, and it appears they’ve finally accomplished their mission, at least as reflected by the market. 

Exhibit 1 – The Reflation Cycle Begins: Long-Term Inflation Expectations Break 2%

The global reflation trade has gained additional traction following the election with cyclical risk outperforming defensive risk, small caps outperforming large caps, and value outperforming growth.  Meanwhile, the sell-off in the bond market has accelerated from July/August with the 10-year U.S. Treasury yield reaching 2.38% at the end of November 2016 from 1.83% at the end of October and from the post-July Brexit lows of 1.38% (Exhibit 2).  Since Brexit, yield-oriented investors have given back a chunk of total returns enjoyed in the first half of this year.  From July 1 to November 30, S&P telecoms and utilities – the two bond proxy sectors within U.S. large caps, are down 8.52% and 10.21%, respectively.  Long duration Treasuries have been hit the hardest with the iShares 20-Year Treasury ETF (TLT) down just over 15% over the same period.  Risky U.S. fixed income, such as high yield, has held up better with the Bloomberg/Barclays U.S. High Yield Index returning 5.46%.  But, in general, investors’ thirst for yield that drove much of 1^st half narrative (as well as flows) has come back to hurt these investors as total return losses have swamped any incremental income above riskless cash.  Indeed, the five-year narrative of global secular stagnation is giving way to a narrative of global cyclical reflation, even if much of shift is shorter term in nature. 

Exhibit 2 – Spike in Primary Developed Market Bond Yields

…Secular Disinflation for the Long-Term

It should be no surprise that two primary secular themes, high debt levels and aging demographics, will likely keep a long-term lid on global yields.  Both themes are disinflationary because they ultimately serve as a dampener on current and future demand.  Conceptually, debt plants the seeds for future capacity expansion (and the classic boom-bust cycles whether agriculture in the 1700 and 1800s, land speculation, railroad bonds, and more recently housing and commodity expansions); hence debt allows consumers to consume more than their income and for industrial suppliers to add on capacity to meet this incremental demand.  This added capacity ultimately proves to be disinflationary should a global capacity glut result from the expansion, something we’ve experienced over the last two decades (i.e. emerging market add-on capacity in industrial production).  In the subsequent ‘correction’, both the debt and the excess capacity get extinguished but a lot of pain in the form of unemployment and lost income results from the correction (i.e. recession or in extreme cases, depression). 

However, the last two debt cycles never saw the stock of debt get extinguished despite several recessions, including the painful 2008 recession.  Total U.S. non-financial debt as a percent of GDP has now reached unprecedented levels of 240-250%.  As a result of the high debt load relative to an economy that can service that debt load, the velocity of money, or how much incremental nominal GDP is gained with each $1 of debt, has seen a secular decline – this is otherwise known as the diminishing marginal return of adding debt capacity to generate economic growth.  Exhibit 3 charts the long-term velocity of money against the cumulative debt as a percent of GDP ratio.  

Exhibit 3 – High Debt Load Presents Long-Term Secular Headwind on GDP Expansion Relying on More Debt to Fund that Expansion

Aging demographics also present a long-term headwind on growth (demand) and inflation.  Readers may be interested in perusing the United Nations World Population Report 2015 for the latest aging demographic trends.  Exhibit 4 reprints a chart that displays the accelerated growth in the 60 and over cohort versus the other age bands projected to 2050.  According to the report, “In 2015, there were 48% more people aged 60 years or over worldwide than there were in 2000, and by 2050, the number of older people is projected to have more than tripled since 2000” (emphasis ours).  And much of the growth in younger populations will come from emerging markets rather than developed markets (this will test developed market immigration policies).

Exhibit 4 – An Aging Demographic Explosion

Hence, an older population and a higher ratio to workforce age bands will weigh on future consumption.  There will also be less of a need to add on future capacity for the production of finished goods (services, such as healthcare provision, are another matter).     

Granted, high debt levels and aging demographics are long-term issues with long fuses and can certainly be overwhelmed in the short-term by cyclical reflation such as what we will likely experience over the next year or two.  Yet, apart from credit concerns priced into sovereign debt, these secular forces, along with world liberalization of trade and capital flows, should keep a lid on both nominal and real rates (Exhibit 5).  World governments may be tempted to increase the money supply to boost price levels (and prevent deflation), but that is like pushing on a string as the precipitous drop in money velocity indicates. 

Hence, it is difficult to see how real rates can sustainably remain above 2%, let alone 1%, barring an unexpected burst in currency volatility or sovereign credit risk.  And it is difficult to see how inflation can sustainably remain above 2% over the long-term, barring an unexpected collapse of confidence in the U.S. dollar. 

Exhibit 5 – What Will Push Real Rates Above 1-2%?

Those who believe in the long-term secular lid on real rates may be tempted to buy this bond market sell-off, particularly if you believe the market is overly optimistic on Trumpflation, and that may be a winning strategy for investors seeking high total returns (capital gains plus income).  Of course, there is always the risk that Trumpflation prevails leading to a heightened inflationary cycle.  The market seems to price in 2% inflation for the foreseeable future based mostly on Trump administration policies and the consensus view on Trumpflation seems to indicate that inflation could run higher.  Yet, it remains to be seen how robust this reflationary cycle will manifest itself in the face of secular disinflation. 

Retirement Income Planning: A Time-Segmented Approach

We at 3D have been working with an increasing number of advisors who take a more holistic approach in building custom income distribution plans for their clients.  3D’s investment strategies are tailored for outcome-oriented solutions such as retirement income planning.  As we originally stated in ‘Stockpiling Income’:

“3D believes in a time-segmented approach to retirement income planning as opposed to systematic withdrawal programs which seem to be the default for most individual plans.   The main issue with the latter approach is the ‘sequence-of-returns’ risk (see ‘The Lifetime Sequence of Returns: A Retirement Planning Conundrum” authored by Wade D. Pfau).  In essence, dollar cost averaging works when investing in the market, but works against you when withdrawing from the market.  This is primarily due to the impact of market volatility, where contributions help smooth out the impact but distributions lock in losses and decrease account values; these losses are more difficult to recover.”

Exhibit 6 displays the time-segmented (also knowns as buckets) income distribution methodology:

Exhibit 6 – Time-Segmented Retirement Income Methodology

Source: 3D Asset Management

In addition, we wrote:

“A time segmented approach would call for immediate income needs (Segment 1) to be met by safe assets with little to no risk to capital.  Later segments (Segments 3 and beyond) target higher growth goals such as addressing higher spending risk (i.e. medical, vacations), inflation risk, and/or intergenerational wealth transfer.  These latter segments can be invested in riskier asset mixes that target higher rates of return.  Time segmentation means that current income needs are addressed with near-term buckets (invested in ‘safe’ assets) where later segments are left untouched so as to minimize the sequence of return risk by maintaining the longer time horizons that allow investors to ride out market volatility and grow assets over the long run.  Using this strategy, achieving miniscule yields on ‘safe’ assets does not mean that income drawers must ratchet down expectations on spending; nonetheless, they should not reach for risky yield due to the drawdown risk.”

Essentially, time-segmented retirement planning balances the need for safe, current income with the need to grow assets so that future income needs can be sufficiently met. 

However, we also noted in the original article that many advisors face challenges funding Segment 2 (highlighted by the green dashed circle), or the Deferred Income Segment.  Segment 2 typically is structured with a five to ten year time horizon, which can be too short to take on significant market risk to achieve higher rates of return but too long to accumulate higher income than is offered with principal protection products such as CDs and short-term annuities. 

Stockpiling Income – A Solution for Those Seeking Deferred Income Without Too Much Principal Risk

This brings us full circle to the current investment environment and the conundrums faced by advisors seeking to build an income plan in the face of 1) cyclical reflation against 2) the backdrop of secular disinflation.  For those advisors that do not (or will not) invest in fixed rate annuities and who do not (or will not) build their own bond ladder portfolios, the other retail vehicle options are a basket of exchange-traded bond funds or open-ended mutual funds (we’re leaving aside collective trusts due to high costs and limited access).  The issue with these options is the perpetual nature of the vehicles – they never mature unlike a CD, annuity, or bond ladder.  Therefore, capital losses, like those experienced these past few months with the back-up in yields, can only be made up over time as maturing bonds get reinvested in higher rate bonds.  Many advisors have opted for actively-managed bond funds, where such funds are managed around duration (interest rate) risk and credit risk.  But unless the fund manager is taking inordinate amount of active risk, the results will likely track the underlying fund benchmarks (less fees). 

Unlike perpetual bond funds, the rate of return for a hold-to-maturity bond portfolio is approximately the yield-to-maturity (or yield-to-worst to account for prepayment risk) upon investment (assuming no credit events) less the underlying fund fees.  Hence, a hold-to-maturity bond vehicle can weather out interest rate swings (whether due to Trumpflation or secular disinflation) while earning higher income than what can be gained with a current principal protection product assuming the investor is willing to hold the portfolio until maturity. 

In addition to our risk-based portfolios that were specifically designed for rate-of-return based solutions such as retirement income, 3D has developed hold-to-maturity ETF portfolios where most of the portfolio is invested in a hold-to-maturity ETF and supplemented with other ETFs to enhance the overall income while not introducing significant interest rate risk.  3D Targeted Fixed Income represents our ETF-managed portfolio solution that seeks to replicate the risk and return profile of a hold-to-maturity bond portfolio.  These portfolios will mature similar to a bond portfolio with the net proceeds returned to investors at the end of the vintage year.  We launched two vintages, 2021 and 2025, back in February 2016, which have garnered interest with advisors looking for deferred income solutions.  We recently launched a 2022 vintage and plan to launch a 2023 version early next year.  For comparison purposes, we maintain a yield worksheet on the advisor section of our website.  The November 2016 worksheet can be found here. 

Now may be a good time to consider stockpiling some income as cyclical reflationary forces and secular disinflationary forces butt heads with each other. 

Disclosure:

The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future.  It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy.  It is for informational purposes only.  The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate however 3D Asset Management does not warrant the accuracy of any of these.  There is also no assurance that any of the above are all inclusive or complete.

Past performance is no guarantee of future results.  None of the services offered by 3D Asset Management are insured by the FDIC and the reader is reminded that all investments contain risk.  The opinions offered above are as December 8, 2016 and are subject to change as influencing factors change.

More detail regarding 3D Asset Management, its products, services, personnel, fees and investment methodologies are available in the firm’s Form ADV Part 2 which is available upon request by calling (860) 291-1998, option 2 or emailing sales@3dadvisor.com or visiting 3D’s website at www.3dadvisor.com.