Mission Accomplished Year-to-date
I promised to write Client Update Letters only when I have something important to say. Now is one of those times.
When I last wrote to you in January, I stated:
“So while just about everything else in the U.S. seems like a complete disaster, stocks are set to continue to rise because credit is flowing.”
In that update letter, I also referred you to a separate 2021 Outlook True Vine Letter where I was calling for a 20% to 25% rise in 2021 for the broad U.S. stock market. As of the Friday (8/27) close the S&P 500 Index is up 23% on the year so we are pretty much there now.
I am happy to report that, depending upon the nuances of each specific client portfolio, my Aggressive strategy is up roughly 32%, my Moderate strategy is up roughly 22%, and my Conservative strategy is up roughly 17%. Aggressive strategy clients have significantly outperformed. Moderate strategy clients have achieved a similar return to the broad stock market while—and this is critical—doing so by taking on less risk (i.e., not even being close to fully invested in stocks). Conservative strategy clients have enjoyed great returns while taking on significantly less risk.
Hazards Ahead
An interesting development has taken place this year in the bond and interest rate markets that very few professional investors are aware of, yet this is critical to be aware of at this juncture.
The U.S. still has to borrow roughly $1.6 trillion to satisfy existing spending commitments from past Covid-era spending bills passed by Congress. In the 1st quarter, the U.S. was selling net new amounts of Treasury bonds and this was causing interest rates to rise (higher rates were needed to incentivize buyers). At the end of the 1st quarter, the U.S. Treasury still had a lot of surplus cash in its checking account at the Federal Reserve (Treasury General Account - “TGA”). Because of the debt ceiling limit the Treasury has been drawing down this account instead of selling net new amounts of bonds to raise money. This has caused interest rates to decline which market participants have widely misconstrued to be exclusively due to a weakening economy. Actually, it was due more to the U.S. not selling net new amounts of bonds.
It is almost September and the Treasury’s checking account is set to run out right about the time the debt ceiling limit will have to be dealt with. Let’s not kid ourselves, the debt ceiling limit will be raised. The important thing to know is that afterwards, the Treasury will have to sell at least $1.3 of net new amounts of bonds in 2021 to pay for prior spending commitments and possibly as much as $1.8 trillion if the Treasury fulfills its guidance of returning the TGA to roughly $750 billion. Somebody will have to buy these bonds at a market clearing interest rate. In other words, interest rates will have to keep rising to incentivize investors to buy them.
The Federal Reserve is buying Treasury bonds but only at a rate of $80 billion per month so unless they change course—they are talking about doing the opposite later this year—they are not going to be able to absorb much of this tidal wave of net new amounts of bonds being issued.
I expect two things to happen.
First, longer term interest rates are going to rise. They will keep rising until enough buyers show up for these bonds. This could be a smooth rise or things could get nasty. At first, the market will likely interpret this as a signal that the economy is strengthening which, in reality, it will really have little to do with. At some point, enough market participants could figure this out and we could enter a danger zone where longer term rates spike unexpectedly higher.
Rising rates are a positive for some stocks that benefit from rising interest rates (e.g., banks) and a negative for other types of stocks (e.g., utilities and high growth technology stocks). This is a disaster scenario for long-term bonds.
Second, $1.3 to $1.8 trillion of U.S. dollars will have to come out of other markets (checking accounts, stocks, etc.) to buy these bonds. This is going to turn market liquidity negative with the potential for short-term pockets of severe market illiquidity. This is a negative for stocks, in general.
Investment Strategy
I am reducing the amount of stocks held by portfolios, especially those which I think will perform poorly with rising rates, while retaining shares of companies that I think stand to benefit from rising rates. I am amassing cash hoards to pick up bargains for you that this scenario is likely to create. Pockets of severe market illiquidity can produce great buying opportunities as stocks temporarily (e.g., just for a few days) fall sharply before staging quick and powerful rebounds, especially when many companies are buying back their own shares (like now). Lastly, to be clear, you don’t own any long-term bonds.
The U.S. stock market index that you probably see on the news is dominated by large technology stocks which will likely do poorly under the scenario that I have outlined here. We may see the U.S. stock market index simply stagnate on the surface (move sideways) while under the surface it is really a combination of half the stocks soaring while the other half are being abused. However, if an interest rate rise gets out of control (spiking too high, too fast), this could drag all stocks down. We are not there yet for this latter scenario but I will certainly be laser-focused on this risk.
In conclusion, I have you positioned defensively here but I see pockets of opportunity from rising rates. You want to sell when the waters look fine and buy during the storm. This is exactly the strategy I have at work here.
Thank you for your business. I appreciate it. I welcome your referrals of family, friends, neighbors, and co-workers. There are opportunities and rough waters ahead. True Vine Investments can help them navigate successfully.
Joshua Hall, ChFC