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Haste Ye Back

Eric Freedman
CAPTRUST Chief Investment Officer

This summer, I was fortunate enough to travel to Scotland with my dad, brother, and a good family friend, Neal Greenfield. It was a trip I had delayed for too long — new babies, business school, and the financial crisis all contributed to its postponement, each with good reason. At last, on August 18, I found myself in Ayrshire, weary from a redeye flight and devoid of sleep (compliments of a fellow passenger’s cackle at every line from the recent movie version of The Three Stooges; my dad — affectionately referred to as the “Commish” for his selfless event planning — and I marveling at Curly’s enduring comedic prowess at 30,000 feet) but happily teeing up a new and soon-to-be-lost Titleist alongside the Ailsa Craig on Scotland’s southwest shore. I could only hope that the trip would match my long-built expectations and was determined to live every moment to the fullest. Especially considering that my honey-do account would be at an all-time surplus upon returning home. Our day at the Turnberry Golf Resort inaugurated a journey across the beautiful Scottish countryside, with my brother skillfully maneuvering a standardshift passenger van to eight different links courses. 

Leaving Turnberry and reflecting on my par on 18 not being good enough to bring the youngsters (my brother and me) a victory over the seasoned veterans (thanks to Neal’s clutch birdie), we passed a sign with the message “Haste Ye Back,” which the Beverly Hillbillies may loosely translate into “Ya’ll come back now, ya hear?” It left us with a warm feeling every time we saw signs donning those three words, succinctly capturing the genuine Scottish hospitality no matter where we went. Caddies, waitresses, passers-by on the street; it didn’t matter whom we encountered, the Scots made us feel at home, except, of course, when an errant golf shot landed in the rough — a rough thickened by the second-wettest quarter in the United Kingdom since recorded history began in 1910.1 While we enjoyed excellent weather, the record spring rains lengthened what was already brutally high grass, causing us to export more golf balls than we would have liked. 
The U.S. witnessed its own record in the third quarter, with the 10-Year Treasury hitting an all-time low in late July, touching 1.39% intraday. Uncertainty over Europe, the Chinese slowdown’s extent, as well as a consistent thirst for yield in any form, drove up bond prices and, by definition, drove down bond yields. My colleague Hunter Brackett covers this development’s implications for fixed income in this Strategic Research Report, but low bond yields also carry a significant impact across portfolios. 
The most important consideration is total return expectations; since most asset allocations, ranging from insurance companies, pension funds, and individual investors to sovereign countries, have notable bond allocations, all else equal, lower nominal (or non-inflation-adjusted) interest rates imply lower total returns. We don’t rule out a rise in bond prices given major events unfolding over coming months — U.S. election season, the fiscal cliff, a more subdued corporate profit tone, and ongoing European deliberations — but should the global economy “muddle through” or even surprise with growth exceeding expectations, bonds will not enjoy much of a yield cushion. 
Figure 1 compares 10-Year U.S. Treasury yields to their equivalents in Germany, Japan, and Switzerland, demonstrating two important points. First, one can see that the yield cushion for all four sovereign countries’ bonds has contracted materially in recent years, with only the U.S. 10-Year above 1.50% at September’s end. Second, precedent exists wherein bond prices could move higher despite historically low yields. However, since nominal bond yields are bound by zero, at some point, total return expectations must come down as bond yields approach this absolute zero boundary. 
While no one can know definitively when bond yields will bottom, the closer we approach zero, the faster investors need to “haste back” their total portfolio return expectations. If bonds move lower in yield (and higher in price), investment theory suggests that a more muted total return expectation should be applied to all asset classes. The theory is best explained by the great Warren Buffett in a 1999 Fortune magazine article, which 13 years later remains one of the most popular media investing interviews of all time. (Please realize how clichéd it is to quote Mr. Buffett in this industry, so you know it’s gotta be good.) Mr. Buffett said that “interest rates… act on financial valuations the way gravity acts on matter. The higher the rate, the greater the downward pull… so if the government rate rises, the prices of all other investments must adjust downward, to a level that brings their expected rates of return in line.”2 
Of course, investment theory and reality can diverge over time, so it is not a given that all other asset classes will sell off if interest rates move higher. We have been adamant — in these pages and other client communications — that bond yields will remain low and sticky for some time. While we hear periodic inflationary cries (and have for five years), we continue to see the global economy as being too weak in the short term to stoke sustainable inflationary pressures, although we do see it as a potential risk should central banks continue accommodative monetary policy in the form of ongoing bond buying. Even given recent central bank activity, inflation expectations remain subdued. 
Figure 2 shows inflation expectations as measured by breakeven inflation rates, calculated as the difference between nominal and real (inflation-adjusted) yields for bonds from the same issuer and the same maturity. This difference, by definition, provides investors with a realtime gauge of inflation expectations. The rates are for 5- and 10-year breakeven rates; in other words, where the market sees inflation 5 and 10 years from now. As Figure 2 details, inflationary expectations have risen from the depths of the financial crisis in 2008 and 2009, but current rates are well within the long-term average of 2.5 to 3.0% and are still below pre-crisis levels. Also, while it’s hard to see on the chart, inflation expectations have reversed from the period immediately preceding the Fed’s September policy announcement of open-ended bond purchases. So while inflation could cause bond yields to move higher in a more rapid fashion, for now, we retain our view that inflation is a “high class problem.” We will be watching developments that may cause us to shift this long-standing belief. 
We see bond yields as being sticky at current levels, with downside risk to yields in the form of a market-unfriendly election, a failure to reach compromise on the fiscal cliff, a sharp global slowdown, and a variety of other negative catalysts and upside in the form of unforeseen inflation, quicker-than-expected growth, or asset allocation trends reversing from prior years’ bond-market dominance over stocks (see Figure 3). Given consistent demand for fixed income assets, the potential for an asset allocation shift out of bonds is real, although U.S. demographics and memories of 2008’s woes would suggest that such a shift would be gradual.
Given three possible scenarios, 1) a “muddle through” economy where bond yields hover at current levels with a bias for moving higher, 2) a “risk off” scenario where bond yields fall further, approaching the zero bound as investors seek safety, or 3) a “risk on” scenario where bonds are shunned in favor of stocks and traditionally riskier asset classes, portfolio returns could follow very different patterns, depending on their relative allocations. Regardless, only the second scenario would see bond prices head higher, which — despite economic and Buffett theory — may not result in all other asset classes moving higher as relationships. While fixed income portfolios may get one last hurrah higher, they get closer and closer to the zero bound. 
Please do not read this as me writing the bond market’s epitaph; quite the opposite. We still see a lot of risks in the global economy, including some in the very near term that cause us to recommend and retain a healthy exposure to parts of the bond market that run counter to current consensus views. My main message is that return expectations, for both bond-heavy and bond-light investors, need to be more subdued, given a lower nominal return world. Credit Suisse’s David Zion noted earlier this year that S&P 500 companies’ median pension return expectation was 7.79% at the end of 2011, in an environment where U.S. nominal bond yields stood at historically low rates.3 While we don’t think this is an unchallenging return assumption over a long period of time, shorter term it may be difficult to achieve depending on asset allocation and liquidity needs. 
Our last round fittingly took place at St. Andrews’ majestic Old Course, golf ’s birthplace. After a memorable day, Neal once again birdied 18 in front of a small crowd to give the old-timers a much-deserved multi-round, carry-over win following a solid finish from the Commish that morning — leaving the youngsters to ponder what could have been (and pick up the evening’s check). On top of the epic loss, I developed elbow tendonitis from having played too many rounds in too short a period (read: I am getting old), but that injury has neither garnered sympathy from my wife, Jamie, nor shortened the honey-do list. Still, the feeling standing on the Old Course’s first tee, playing Muirfield before the Open Championship next year, birdieing 18 at Troon, the jokes, the blinding rain, the non-conceded putts, eccentric caddies, driving on the wrong side of the road, the Scotts’ warm smiles, and a nip or two on the 19th hole will stay with me: Haste Us Back, indeed.