June 2005
Since the start of 2003, the stock market has jumped 40%. Ten year government bonds yield below 4%. U.S. housing prices have increased by 50% in just five years. And money market funds still yield half of what you could get only a few years back. There is little question that investors are now demanding far less return on their money.
It is interesting to see just how pervasive this phenomenon really is. Take a look at government bonds and high quality corporate bonds. After subtracting out inflation, investors' are accepting at least 2% less when compared to the yields that were available in the late 90's. The story is about the same in lower-quality bonds with investors demanding 2.5% less after inflation.
Beyond bonds, utility stocks used to yield around 6% in the late 90's and as recently as 2002. They now yield 3% less. In general, utility stocks have moved up an astonishing 40% over the last two years. Further, real estate investment trusts (REITs) have seen dividend yields cut in half too! Even better than utility stocks, real estate stocks have returned 20% per year over the past 5 years. It seems wherever yield once was - it is now almost gone.
Not only have income producing securities been bid up in price, more importantly, housing values have been pumped up by the cheap money. Fed officials are beginning to publicly voice concern with their rise - recently describing the housing market as a bit "frothy" in select U.S. cities.
To give you a sense of the global nature of this issue, home prices in France have about doubled since 1997. They were up 15% last year alone in Spain and New Zealand. Over the past 5 years, residential real estate is up about 50% in both Italy and Belgium. They are up almost double that in Ireland. The statistics clearly show that money is flowing and it is having an affect on more than just the stock and bond markets.
It's important to remember that what counts in investing is your real return, not your nominal return. Anyone living in the late 70's understands that a 10% nominal return in a 15% inflationary world was not too fun. Inflation matters. The interesting thing to note is that inflation really hasn't budged all that much over the past 10 years. From the 1992-2001 period, consumer prices rose about 2.5% per year on average. Today, inflation expectations sit right at about the same level.
With risk-free 10-year government bonds returning 4%, the real rate of return after inflation now stands at 1.5%. In the recent past, in a similar inflation environment, investors demanded about 3.5% in real return.
The data shows a dramatic real return give-up in today's world. Across traditional income stocks like utilities and REITs, and across bonds of varying credit qualities and maturities - time and time again the return after inflation is about 2% or so less than only five years ago. So what gives? Why are investors suddenly demanding so little?
China, India and many other countries have a massive advantage of far cheaper labor. Added to that advantage are their very cheap currencies and more than willing U.S. retailers and consumers to sell to. It is logical for investors to assume that inflation is not going anywhere but down - over the long term! But is this a safe assumption to make over the short-term and should investors willingly accept so much less based on it?
Investors need to be careful of making investment decisions largely based on a long-term trend. Can investors be both right and wrong at the same time? It turns out that the internet has changed how people shop, compare prices, book flights, and yes, sell the junk in their attics. Companies are really moving their advertising dollars to the web in dramatic fashion. Investors in the late 90s were absolutely right in making these predictions. But they were terribly wrong about the internet's affect on our economy and their own stock portfolios.
Today, investors cite the long-term impact of educated Indian engineers and modern Chinese factories on U.S. and European economies. They confidently predict China overtaking the U.S. economy within the next 30 years. Most agree that outsourcing is a growing and inevitable trend. Naturally, investors have taken this thinking to its conclusion. With capital and labor so mobile and cheap, they say, there's no doubt that inflation is going lower. And, of course, with inflation dropping, it's time to reach for as much yield - while you can get it. In other words, because they feel that inflation has been permanently vanquished guarding against lower future yields is the "risk of the day".
Are investors going to be right and wrong again? We don't know anything for sure. But it's safe to assume that in the future investors will re-define the big risk many times over. Investors are clearly grasping for yield anywhere they can get it. We aren't inclined to play along.
Jason P. Tank, CFA
jason@frontstreet.com