Friday Haymaker
In The Ring - December 1st, 2023
Getting Real with the ReAL
“Many investors do not seem yet to realize or believe something we have said repeatedly over the past two years: The only thing keeping the US government solvent was the very inflation the Fed has spent the last two years trying to fight.” -Luke Gromen, author of Forest for the Trees
“All the mind's activity is easy if it is not subjected to reality.” -Marcel Proust
The goal of every rational bond investor should be to generate a positive return, net of inflation. This is often referred to as the real return a bond produces. The reason I say “rational” is because, in the post-Global Financial Crisis era, the deepest-pocketed debt-market participants — those would be the world’s leading central banks — did not behave rationally. They were willing to buy trillions of negative yielding bonds, at one point. Even in the U.S., which didn’t indulge in the lunacy of negative-yielding credit instruments, despite former (future?) President Trump’s haranguing, bond yields fell to Lilliputian levels.
Consequently, even when inflation was low there was precious little in the way of real yields on offer. In fact, they were also negative, at least on shorter maturities, including in America. Once inflation surged post-Covid, real yields went deeply negative.
Even today, after one of the most aggressive rate-hiking campaigns in history, yields on longer-term U.S. Treasury (UST) bonds are minimally above the 12-month trailing rate of inflation. Much more flattering, though, is to use the recent three-month rate of inflation that some feel is now running below 2%. That makes a 10-year UST at a 4.4% yield a solid value. (For those who buy their goods and services in the real world, rather than the one government statisticians inhabit, I understand your anger at the thought of a sub-2% CPI.)
The attraction of a 10-year UST, of course, assumes inflation stays subdued. To be fair to the bull case for long USTs, if there is a recession, as I expect, inflation should trend even lower. That could push yields down to 3% on the 10-year, or possibly lower.
There are several problems with this scenario, however. One is now that bond investors have been badly burned by the supposedly transitory CPI eruption, seeing inflation running at nearly a double-digit rate in 2022, they may be reluctant to assume an extended period of “low-flation” is a certainty. They may even suspect it’s “that ‘70s show” all over again, where inflation dips briefly during economic downturns but then comes roaring back.
The other, as I’ve noted frequently in recent months, is the likely policy response to the next recession, whenever it comes. This might be another blast from the distant past of the Nixon/Ford/Carter years. Politicians and central bankers may not resort to Modern Monetary Theory, as they essentially did during Covid, but they are unlikely to let a cathartic, but extremely painful, deleveraging process play out.
The biggest hurdle, though, is what a growing number of brainy folks are admitting out loud: the near certainty of the Fed being forced to buy trillions of USTs in the next recession. Of course, it would use its Magical Money Machine, the legerdemain behind QEs, to fund this U.S. government bailout. For example, Danielle DiMartino Booth is about as close to a perma-bull on USTs as you can find. Yet, she recently wrote that, should Donald Trump be re-elected, or a Blue Wave sweep the country instead, she’ll advise clients to sell their long Treasurys. She’s conceding that either outcome would likely produce extremely inflationary policies. No matter who is in the Oval Office, or running the Fed, it will take tremendous fortitude to resist the “easy” way out that inflating away debts seems to offer.
The potential for a $4 trillion deficit during the next recession is very plausible. Funding that will be the ultimate bridge (financing) too far. It already appears that the Fed and the Treasury feel they can’t issue nearly as many longer-term bonds as they would like to in order to avoid continually shortening their liability profile. Perhaps it’s been that way for years, which leads me to a bit of an apologia.
In the past, I’ve been highly critical of the U.S. Treasury’s failure to lock-in low yields back in 2020 and 2021 when they were in the 0.6% to 1½% range. During 2020, Stephen Mnuchin, the Trump administration’s Treasury Secretary, failed to do so (not Janet Yellen, as I may have erroneously written). Starting in 2021, once Janet Yellen took over the reins at the Treasury, Ms. Yellen definitely missed this opportunity. However, Luke Gromen, who has been one of the most strident critics of the U.S. government’s finances, believes they may not have had any choice. There may well not have been enough demand at the long end to absorb the deluge of supply. The more I think and read about it — including the September 2019 “repo crisis” — the more I lean to the conclusion he’s right.
If so, this further underscores the fragility of the UST market. It also emphasizes that those looking to lock-in real yields for years to come should venture overseas. Emerging market (EM) debt has been my go-to in this regard. The closed-end funds that focus on this have risen 10% to 12% since the late October bond rally began. This has nicely out-legged the 6% move by the 10-year T-note.
CEFs remain by far the easiest way for retail investors to participate in what I believe will be a multi-year outperformance of EM bonds versus U.S “govies”. However, it is critical to target the healthiest countries. In some cases, the names may surprise you.
Accordingly, I thought it would be helpful to briefly examine the country that is so into “real” that its currency is known by that moniker (though it is pronounced reAL). This is none other than Brazil, once a land of high inflation and out-of-control government spending, two sides of the same depreciating coin. (For paying customers — we love you, one and all! — we’ll relay a timely and in-depth article on the Brazilian bond opportunity by my partner Louis Gave at the end of next week’s Making Hay Monday. By the way, Louis was just the subject of a Barrons’ cover story on attractive international investments.)
This is not a recommendation for readers to buy individual Brazilian government bonds in reals, even though I would personally like to do so; the reality is that it is nearly impossible for U.S. investors to do this, at least with custodians such as Charles Schwab. Even for investment advisory firms, such as Evergreen Gavekal, it’s a no-go. Nevertheless, I thought a quick review of the attributes would give you a sense of why I am enamored with the closed-end funds that traffic in them.
Presently, the 10-year Brazilian government bond yields 10.5%. Based on its present 5% inflation rate, that’s a 5½% real return. This is in comparison to the current ½% or so net-of-inflation return on the 10-year T-note.
Brazil is also running considerably smaller budget deficits than is the profligate U.S. of A. That’s been the case in recent years, which is why Brazil’s government debt to GDP is around 80% versus 120% in the U.S. This gap is projected to continue to be in Brazil’s favor.
Like most currencies, the real (reAL) is deeply undervalued versus the U.S. dollar. Moreover, Brazil is running hefty trade surpluses. This is in stark contrast to the U.S., which runs the world’s biggest trade deficits.
At this point, I can’t share the specific ticker symbols on the EM debt funds I think look especially interesting. However, I hope to be able to do so in the not-too-distant future.
Another way to play Brazil specifically is to buy their bonds denominated in U.S. dollars. Those should be easier to buy through brokers like Schwab. You give up a lot of yield — 6.4% vs 10.5% — but you do eliminate currency risk… and upside.
On that latter point, I believe buying EM debt CEFs might offer the bond market equivalent of a triple-double* in basketball: double-digit yields, double-digit discounts to NAV, and double-digit potential future returns from undervalued currencies eventually soaring relative to the USD. This should lead to another double — double-digit total returns (yields plus price appreciation) for several years.
That is definitely a higher-octane way to invest for yield and attempt to lock-in high cash flow for years to come. As noted above, they’ve run a lot lately; consequently, waiting for a retracement is likely wise. For any who can’t resist doing some buying, do so lightly. A 5%, or so, reversal wouldn’t surprise me in the least… and I don’t want it to surprise you, either!
*A “triple-double” in basketball is a player who achieves the extraordinary by producing at least 10 rebounds, points and assists in a single game.