Last weekend we, along with a few hundred other garden enthusiasts, visited the famous gardens of hedge fund impresario Michael Steinhardt, located in the NYC suburbs. My wife and I realized this was not your typical mega-estate when an attendant told us to park in front of a wooden fence that was part of the enclosure for four camels and two zebras. There are also llamas, giant tortoises, and a pond that accommodates a dozen pink flamingoes and monkeys who inhabit an island in the middle of the pond.
The gardens—fifty acres or so—are unusual, as much for what they lack as for what they contain. There are no English–style garden rooms or mixed herbaceous borders, no Victorian bedding out, no fancy geometric parterres, no picturesque cottage garden, herb garden, rose garden or knot garden. What it does contain is an orchard, a splendid pinetum (collection of conifers), a huge array of specimen maple trees, a wonderful rock garden and sprawling naturalistic water gardens grouped around a network of ponds and streams. Where it excels is in integrating garden elements into the surrounding forest. This is extremely difficult to do; I have seen other efforts that fell flat and looked ridiculous. The key to success seems to be to avoid certain common garden plants – such as hostas, bleeding heart, and rhododendrons – that just don’t look right in a northeastern forest.
Which got me to thinking about Steinhardt’s career. I reached deep into my memory bank and recalled a remark he made about the financial markets round about 1980 or 1981. At the time “everyone knew” that high inflation would continue indefinitely; wise economists explained to anyone who would listen that, even if a concerted effort were made to rein in inflation (which would be politically impossible because it would cause a recession) it would take at least five years to accomplish. Accordingly, far-sighted corporations bought inflation hedges. In 1976 GE acquired Utah International, a producer of coal, copper and uranium; five years later Fluor bought another miner, St. Joseph’s Mineral Company. Wall Street also belatedly adjusted to the “reality” of secular double-digit inflation by dumping bonds. In the first six months of 1982 the 30-year Treasury bond had an average yield of 13.75%, up from 8.4% in 1978 and 7.2% in the early 1970s.
I recall Michael Steinhardt remarking that this interest rate surge created a truly extraordinary investment opportunity. You could lock in a 14% return – 40% above the long-term return of equities – for 30 years, with no credit risk. After being tortured by a thirty-year bond bear market, investors were extremely slow to recognize that inflation crested in 1980 and disinflation was the new normal. Bond yields peaked in the autumn of 1981 at 14.7%, just as Paul Volcker was engineering a severe recession that would slash inflation from 13.5% in 1980 to 3.2% in 1983. Because investors feared a return to high inflation, real interest rates remained extremely high in the first half of the 1980s.
Why Should We Care?
Because there is a good chance we are in a similar situation now. “Everyone knows” the world is threatened by deflation, which is why central banks in Europe and Japan have QE programs and the Federal Reserve—six years into an economic expansion—still cannot get up the guts to raise interest rates from zero. Inflationary pressures are starting to build. The employment cost index is accelerating while productivity growth —harmed by Obamanomics’ sins of commission (over-regulation, excessive taxation) and omission (no tax reform)—is running at around half the 2004-2006 pace. Meanwhile the deflationary reprieve provided by plunging oil prices and a soaring dollar is starting to reverse, and Europe is growing again.
Financial markets are starting to price in the new non-deflationary reality. Bund yields have surged and Treasury Bond yields have climbed from 1.9% to 2.23%. Which creates risks for equities. With profits growing slowly (flattish this year; up 8-10% in 2016) stocks look expensive on most metrics. As Chair Yellen said today, equities only looked inexpensive when compared to current bonds yields (but not if yields rise to 3% or 4%). In this environment “bond substitutes” such as utilities, staples, and REITs will perform poorly; financials that benefit from higher rates (banks, asset managers) are likely to outperform.
Copyright Thomas Doerflinger 2015. All Rights Reserved.