HUMMONEY - Forest and Trees (Perspective)

- by Greg Lewin

Every once in a while it’s best to step back and survey the landscape. Today the central investment question is simple and straight forward:  which one of the following is lying - bonds, gold or equities? Because right now prices for all 3 are on a steady rise and quite frankly that doesn’t pass the smell test.

Let’s start with bonds: as bond prices rise yields fall.  There are 3 conditions which can affect bond prices and yields. First, in general as economies grow and business demand accelerates, companies need to borrow more money to support investments, inventories, workers, etc.  As increasing numbers of businesses compete to borrow, the cost of those funds rise, raising yields and therefore lowering bond prices.  A second condition which should lead to increased yields concerns not just the demand side but the risk side of the equation. In periods when business lending is perceived as risky either because of slowing economies, too much debt or possibly instability in geopolitics, yields again rise to compensate for the increasing risk of loan default. And now a third dynamic is in play.  The governments of the world simply want interest rates to remain low to give their economies time to recover. To execute this strategy they are using the brute force method of buying debt in the market place to, in effect, keep demand for bonds high and therefore keeping prices low.  

So let’s look at the score card: we know that world economies are weak so bond yields should be down, we know debt levels are high so bond yields should be up, we know government policy is to keep bond demand high so yields should be down, and lastly we know the government is borrowing and printing money to accomplish this, which implies more leverage in the system, therefore more risk in the system, so bond yields should be up. Two conditions suggesting yields should be up, and two suggesting they should be down. Since yields have steadily headed straight down we seem to have a deep appreciation of the poor fundamental demand and a shallow appreciation for the increasing risk in the system.

Our next subject is gold. Gold prices have risen steadily for the last 10 years.  Let’s explore why.  Gold prices have been argued to be an inflation hedge and although one could always speculate about what is next around the economic corner, the fact is that generally during these past several years inflation has remained quite tame and therefore seems not to be the main culprit. Currency devaluation is another often speculated villain and yet over the past 6 years the dollar versus a broad basket of currencies has not changed a great deal. Lastly, as I have written in the past, gold may simply and most accurately be a reflection of a level of fear in the marketplace. If that is the case the evidence suggests that fear is way up.

So our observations thus far are that the economy is slow, risks are rising and fear is way up.  Now let’s explore the case for the rising equity markets of the last year. . . . Enough said. Equities, bond prices and gold are all up.  Something isn’t right, but that is for you decide. Just remember that markets tend to revert back to states of equilibrium over time and these 3 markets appear to be nowhere near a state of balance at the moment. How this may resolve itself is the big question you must answer for yourself, so don’t get lost in the forest with all its trees. 

 ---The views expressed here are of the author, HUMMoney contributor Greg Lewin; currently a General Partner at TLF Capital, an investment management firm. During the past 26 years he has been a senior money manager or partner in Wall Street firms including Neuberger Berman, Charter Oak Partners and Sailfish Capital.