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Bonds, Rates & Rotation

Updated: Aug 20, 2021

$1.9 Trillion Stimulus Bill and $3 Trillion Infrastructure Bill

There has been a lot of noise coming from Washington D.C. regarding the $1.9 trillion stimulus package. It has passed the house and went to the Senate. The Senate then removed the $15 minimum wage due to the parliamentarian rule. Therefore, it is now going back to the house to be approved. Likely by March 12, 2021, President Biden will sign it into law.

The next big package is going to be the infrastructure bill. The current administration anticipates having a proposal out this month; however, it seems that there's not as much enthusiasm to get another $3 trillion infrastructure spend. However, both Republicans and Democrats are for this bill.

The Recovery and Spending is Putting Upward Pressure on Bonds

The federal government's amount of money that they are creating and borrowing increases on the curve's long end. The Feds are still doing their asset purchasing, and there is treasury money sitting there since the previous stimulus bill, but it will eventually be spent down. Therefore, there is a 12% increase in the money supply.

If you subtract the ten-year and the five-year treasuries to get inflation expectations in the medium to long-term, it's the highest since that number was recorded, about 2005. On a relative basis, we see the expected inflation is higher than it's been for the last 15 years.

Bond Prices and Interest Rates

If interest rates go up, bond prices go down, and if interest rates go down, bond prices go up. The 7-10 year treasury bonds are down 4.5%, and the S&P 500, at the time of this screenshot, was a positive 4.8- 7%. So, bonds are the way to preserve and remove the downward movement but have not been working so far year to date.

If you're in an Exchange Traded Fund (ETF) that trades the 20-year maturity, you can see it is down 11.4%.

Inflation Expectations

Two weeks ago, we talked about the market value is and how stocks and bonds are valued the same way they value future cash flows. If the interest rate you're discounting those future cash flows increases, you'll see a drop in stock price. However, not all things are equal.

If inflation was more significant, then the risk-free rate increase doesn't necessarily have a price drop. For example, if you look at future cash flows, on the left, you see a company growing its profit by 5% every year, showing what cash flow would look like. You would discount that by the same factor. Let's say you were discounting it by 6% on the 10th. It would be 6 to the 10th power (610), and then the 9th would be discounted by 5% to the 9th power (59). So, not all stocks have this same pattern, and very few stocks have that pattern.

The idea is most of the earnings growth in a growth stock is way out in the future. If you're discounting it and your interest rate changes, you're going to see a sell-off in those growth stocks more than you would be valued. In simpler terms, the chart on the left shows earnings being paid currently, where the one on the right is the growth stock for you.

Effects on Present Net Value (Stock Price) of Earnings

If you were in long or short duration and interest rates did increase, the net present value of that stock would decline in both scenarios. You're going to see a significant drop in long-duration stocks, and you'll see a much smaller change in the short duration. On the other side, if you have falling interest rates, you're going to see a big jump in growth stocks, and you're not going to see a big jump in value.

Historically, value has consistently outperformed growth in the long-term, and that has not happened over the last 20 years because we've been in a bull market for bonds, meaning that we've been in a falling interest rate. Growth stocks dominated performance because of this effect.

How high can interest rates go? The fed has not started to yield curve control (YCC). However, it is likely coming because the U.S. is at $30 trillion in debt, and they cannot afford to pay just the interest with social security and medicare still on their hands. The U.S. has legal obligations that are not discretionary, so at some point, if interest rates get too high and the economy hasn't grown to a place where tax revenue is high enough to offset it, we are in trouble.

Tech Basket

Tech companies tend to be growth companies that have that long duration that I talked about above. A non-profitable tech company or a company with growth projections in the future and is not profitable now allows us to see and measure their duration. Also, inflation, which is the ability to pass increase costs, needs to have a shorter-term considering the rising rate environment.

Cost-Push — Ability to Pass Increased Costs to Consumers

What is the demand, and what is the structure people will use in their minds whenever they're budgeting out? If we see inflation, what are the things that are going to continue to be bought?

If commodity prices increase, you will see things being bought that consumers use every day, such as coffee and construction. Technology is one thing that may not be purchased because it has had difficulty pushing off inflation costs due to its deflationary effect. You can see this in the Radio Shack ad that we have mentioned before.

The ad shows a 20-year old $1,600 computer has 20 megabytes. Our phones are 1300 times that, and the drive we use in the office is nine terabytes. The amount of data that we use is all relative. Today's phones can do everything and more but don't cost as much as that computer. This is probably the area that we are unlikely to see many inflation costs being pushed out on the consumer.


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The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.

All indices are unmanaged and may not be invested directly. The economic forecasts outlined in this material may not develop as predicted, and there can be no guarantee that the strategies promoted will be successful.

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