Reasonably strong economic growth has enhanced the case for a rate hike, likely in December barring significant negative developments between now and then. While I’ll be the first to say that U.S. and global economic growth is sub-optimal, current Fed Policies are extraordinary and should only be implemented in extremely dire economic scenarios. This is just not the case today, and the damage of low rates felt by retirees, savers, and those blindly piling into overvalued assets, outweighs the benefits of holding interest rates steady.
At T&T Capital Management (TTCM), we have written extensively about the negatives of investing in bonds or bond-like investments due to the obvious overvaluation that exists in these assets. Market participants across the globe are increasingly investing in longer duration assets at higher valuations, as traditional alternatives such as CDs and savings accounts offer virtually nothing in terms of interest. The 10-year Treasury bond yielding 1.7% might sound appealing if you are comparing it to a savings account yielding .0017%, but a 1% increase in interest rates would wipe out several years of interest payments. The immediate result would be about a 7% loss on the bonds, which definitely can do some damage to a retirement portfolio. Keep in mind that even the best case scenario, where you would make 1.7% a year, isn’t adjusted for inflation. If inflation averages 1.7% per annum, or higher, your real returns would be negative even without any interest rates hikes.
As opposed to blindly following the crowd, we have taken an extraordinarily contrarian approach. We have been invested in the most hated, and undervalued sectors such as financials and lately healthcare. Our financial positions would benefit tremendously from higher rates, unlike the vast majority of assets and securities available today. Even better, we are buying these companies at discounts to a conservative estimate of liquidation value and at extremely low price to earnings ratios. While this seems like a sensible approach in what most would consider to be an overvalued market, most market participants would never tread this path. Instead they will jump into an index or a fund because it is what others are doing, or they will buy bonds or bond-like investments with the belief that they will get out before the bubble bursts. Our contrarian approach can be mentally tough as our performance is virtually guaranteed to deviate considerably from the S&P 500 over short-term periods, as we saw early in the year when financials were struggling as the prospect of lower rates for longer evolved. Now it is helping us, as financials have been outperforming by a wide margin and those bond-like investments have been getting pummeled. This change in market leadership has occurred despite the fact that no rate hike has occurred yet this year. Once one occurs, it becomes more likely that there will be more to come. This preview of asset performance is really just the beginning, which could be a multi-year run of epic proportions.
Our base case scenario is that the S&P 500 will return 3-5% per annum over the next 5 years. If returns were lower than that, I would not be nearly as surprised as I’d be if returns were higher. My outlook for financials and for many of the healthcare stocks that we own is to see 50%-100% returns over 5 years. We also believe that bonds are likely to return even less than stocks, and for longer-duration assets returns will be negative. This is not the popular belief on Wall Street, but this is why we do our own analysis. Below you’ll find a fabulous article on how bonds and interest rates interact. I’d highly advise reading it as it will be a very important concept to understand as the 30-year bull market in bonds is likely over.