Time to rethink assumptions about interest rates--and income investing strategies

06/22/2010 8:30 am EST


Jim Jubak

Founder and Editor, JubakPicks.com

Reality has a nasty way of throwing investors’ assumptions onto the rubbish heap.

Take this one: The massive stimulus packages, central bank interventions, and government budget deficits will lead to a surge of inflation and rising interest rates.

That may still turn out to be true in the long run but the long run is showing a disconcerting tendency to recede into the distance these days.

It’s worth asking if the arrival of higher inflation and higher interest rates is now sufficiently delayed that the period between now and then deserves its own set of investing strategies. What kind of strategy? I’ll try to lay out the general outlines of one in this post.

Is it going to take so long for higher inflation and higher interest rates to arrive that we need to be doing something concrete in the disconcertingly different present instead of just standing around waiting for that future to arrive?

It’s certainly a possibility worth taking seriously after the news of the last week or so. First, we’ve had a U.S. consumer price inflation report that showed prices are going up so slowly than inflation is for all intents and purposes non-existent. (For more on the May inflation rate in the United States see my post http://jubakpicks.com/2010/06/17/core-inflation-up-at-just-a-0-9-annual-rate-in-may-keeping-the-fed-on-hold/)

Second, we’ve had projections that show economic growth in the Euro Zone stuck at less than 1.5% for a considerable period thanks to a stubbornly persistent euro debt crisis and the budget cutting that is flowing from it. (For more on how slow growth could get see my post http://jubakpicks.com/2010/06/11/so-virtue-is-its-own-reward-not-when-it-comes-to-budget-cuts/ )

And third, we’ve had a study from the San Francisco Federal Reserve that put off U.S. interest rate increases into 2012. (For more on this study and why it’s worth taking seriously see my post http://jubakpicks.com/2010/06/15/could-the-fed-keep-rates-at-0-into-2012-some-at-the-fed-think-it-should/ )

It’s one thing to follow an investment strategy based on a trend that is projected to arrive at the end of 2010 and quite another thing if that trend is set to arrive 18 months from now.

So, for example, if you think that inflation is going to kick up strongly as early as early 2011, then it makes sense to be buying gold and other commodity inflation hedges now. So what if gold doesn’t pay any dividends or interest? So what if commodity prices won’t go anywhere good if economic growth slows?

The payoff is close enough so that being early by a couple of quarters isn’t too expensive.

But how about if higher inflation is way off into 2012? The expense of being early is much greater since the waiting period is longer. And if economic growth is actually lower than expected for much of this period, then investors pursuing this strategy aren’t just costing themselves interest and dividend payouts by being early, they’re likely to take a loss on their commodity hedges too.

But the strategies that most require rethinking are those based on a belief in a relatively quick move toward higher interest rates as a result of the vast expansion of money supply that was part of the effort to stave off a global recession.

I’d break the need to rethink that assumption into two parts.

First, the developed economies of the world.

It’s increasingly clear that low interest rates are with us in the United States, Europe and Japan for a while—because economic growth is so slow and the economic recovery in these economies is so uncertain. Central banks in these economies aren’t going to rush to raise their benchmark interest rates any time soon because that might be enough to stall any recovery.

This situation can’t go on forever.

The long-term budget deficits in these countries can’t—except maybe in Japan—be funded internally. That means interest rates will have to rise eventually to attract the overseas capital that these countries need. That can happen quickly as it has with Spain where yields on 12-month bills have climbed by 0.7 percentage points—or roughly 40%--in the last month, or slowly as looks likely with the United States. But eventually it will happen.

It’s just that eventually is further off than we expected a year ago.

What are the consequences of this?

The danger of higher interest rates decimating bond portfolios is still real—but it is more distant than we thought.

If low interest rates are going to be with us for a while, income investors who are planning to retire on portfolios of bonds and dividend stocks aren’t going to find lots of opportunities to lock up the high yields they were counting on.

And if interest rates are going to stay at current abnormally low rates for longer than investors expected, yields that they once would have shunned as too low or easy to pass up because better yields are just around the corner will look really attractive.

In these developed economies it means stick with high-yielding master limited partnerships like Oneok Partners (OKS) at a 7.09% yield and Magellan Midstream Partners (MMP) at a 6.28% yield for longer than we once might have expected. It means give serious consideration to stocks like Verizon (VZ) or Total (TOT), both also in the Dividend Income portfolio, if they have a high yield (6.51% and 5.56%, respectively) even if their growth prospects aren’t stellar.  It means give serious consideration to stocks with growth potential as income vehicles even if their yields are just 3.61% as in the case of Abbott Laboratories (ABT).

Second, the developing economies of the world.

Part of our earlier assumption about interest rates is in the process of coming true for these economies. The central banks of Brazil and Indonesia and India are raising interest rates now to put a stop to inflationary trends. In these economies the timing of interest rate increases—mid 2010—are pretty much what we were anticipating for the developed world a year or so ago.

But part of our earlier assumption is turning out to be very wrong. Although interest rate increases are arriving on schedule in 2010, they look like they’re likely to end much earlier than anticipated. Brazil, for example, could be done with its series of interest rate increases as early as the fall of 2010.

There are two reasons that interest rate increases in developing economies are moving so much faster to an end than looked likely a year ago. First, central banks in these economies—with the notable exception of the People’s Bank of China—have been emboldened by high domestic growth rates to move quickly and decisively to raise interest rates and stomp down on inflation. Many of these banks realize that their countries have made huge strides in impressing global financial markets with their financial discipline in recent years—Brazil, for example, has won its first investment grade credit rating ever—and they seem determined not to step backwards.

And second, the economic slowdown or sluggishness in the world’s developed economies has made interest rate increases in the developing economies extraordinarily effective. Brazil’s central bank, for example, has gotten a helping hand in damping the Brazilian economy from the slowdown in the country’s European export markets. With that kind of help, central banks haven’t had to force their patients to swallow the full course of medicine.

What are the consequences of this?

If developing economy central banks will put an end to their interest rate increases in late 2010 or early 2011, it means that investors will be looking at peak yields in these financial markets with the prospect of steady or even better yet declining interest rates in later 2011 and onward. (Declining interest rates will push the prices of existing yield vehicles, with their higher than current yields, higher.

Add the prospect of declining interest rates to a trajectory that suggests that while credit ratings are falling in the developed world, they’re rising in the developing world and you’ve got a very real possibility of significant capital gains from developing economy income securities.

I don’t think you need to rush to buy those developing economy yield vehicles quite yet. Central banks in those economies are still raising interest rates and I think that gives investors some time to research those markets looking for yield.

Which is good. Because finding high-yielding stocks and bonds in those economies is hard and time-consuming—especially if you want to get a handle on the risk of anything before you buy it.

I’ve got my eye on five possibilities right now. I’ll report back when I’ve finished my research in the next few weeks.

Full disclosure: I don’t own shares of any company mentioned in this post.
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