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2Q 2018 Quarterly Investment Letter

Writing a quarterly letter is becoming very difficult as this “Great Bull Market” makes steady advances. More than a few years ago, I decided not to write a market summary and review for the previous quarter. Instead, I was determined to write about Curran’s expectations for future quarters with a focus on a longer time horizon.

For those of you who have been routinely reading my quarterly letter, it must seem as though I am a “broken record”. I have been optimistic and advised our clients to buy and hold equities through and since the Great Recession. I suppose I worry about it, because I really want you to read what I have to say, even if you know in advance that I will recommend stocks for the long run. I am sure you know how important I believe it is to invest for the long run. Hopefully you understand how inefficient it is to “time” the market.

Rather than continue emphasizing how important it is to own stocks, I want to provide a view of fixed income that is different from the consensus.

First it is important for me to emphasize how I believe fixed income is an important component to most investor’s asset allocations.  At Curran, most of our clients hold about 30% of their total portfolio value in fixed income securities.

The primary reason we do so is to reduce portfolio risk through diversification. A secondary reason could be income, but in today’s rate environment, significant real income (adjusted for inflation) is not attainable except in low-quality long-term bonds. We never buy longer-term bonds because their interest rate risk is substantial.

Fixed income markets, like stock markets, are subject to their own price changes as interest rates rise and decline.  Price changes are greatest in long term bonds.

All fixed income investors should be able to understand interest rate risk. Rate risk applies to all bonds to include United States Treasuries.  Duration determines how much a bond will increase or decrease in value as rates move up and down.  We normally use 1% changes in rates to demonstrate price changes.

Remember: when rates go up, bond prices go down; when rates go down, bond prices go up.

Let me briefly explain why we do not buy long-term bonds.  To begin, consider the following:

Long-term in fixed income includes maturities of 10 years or longer.  Some consider 10 years to be intermediate-term.  Curran considers 10 years to be long-term. 

As of August 1, the yield on 10-year United States Treasuries is 2.98% and on 30-year maturities the rate is 3.12%.

If interest rates were to increase by one point to 3.98% on the 10-year and 4.12% on the 30-year, their prices (value) would decline by approximately 9% and 20%, respectively.

Why would anyone take on risk of that magnitude for a 3% return?  Curran certainly does not. 

The most conventional of the reasons cited for buying bonds is that they are safe, provide income, and guarantee and/or promise to pay back the principal investment at maturity.

Let’s address income first.  Year to date inflation has averaged 2.5%.  In June it was 2.9%.  Long-term United States Treasuries are yielding only slightly more than the current inflation rate. 

Inflation peaked in 1980 when it was 13.58%.  Since then, the average inflation rate has been 2.79%.  Again, current interest rates provide little real income when compared to average inflation.

The picture is much worse when considering the average inflation rate since 1910.  Long-term inflation has averaged 3.22%.

Now, let’s look at the purchasing power of a bond when it matures.

If we experience average inflation (2.79%) over the next 10 to 30 years, the purchasing power of $1 in ten years will be 87 cents and in 30 years it will be 54 cents.  The next time a risk averse investor says “but I will get back my original investment at maturity” remember, it will not be worth nearly as much as it was when originally invested.

Is it any wonder why so few gather sufficient assets over a life time to secure a sustainable income through retirement? Being safe comes at a cost to future purchasing power.

There is growing concern throughout the world that pension funds are underfunded. Most blame is placed on governments and companies.  The consensus opinion is they are not making sufficient contributions to fully fund pension promises.

  • Perhaps there is another reason?  Equities allocations for the P7 markets have decreased by 11% in aggregate during the past 20 years (57% to 46%). P7 includes those countries with the most pension fund assets to include the United States.
  • The Netherlands (43% to 50%), Japan (50% to 56%), and the U.K. (30% to 35%) are the three markets that have increased allocations to bonds by the largest amount during the past 10 years.

Asset returns are critically important to understand if we are ever to reach a point of real financial security as individuals and as a nation.

NYU Stern School of Business has calculated the compounded future value for $100 from 1928 invested in the S&P 500 (stocks), 3-month Treasury bills (cash) and Treasuries (bonds).

Before inflation:

By the way, $1 in 1928 is worth about 7 cents today.  Attempting to secure financial security in fixed income simply does not work well.  It makes people feel good.  But like many things in life, real value is in achievement and not simply feeling good.  Feeling good is easy.  Achievement is not easy.

Achieving financial security is not easy but it really feels good when reached.

This material was prepared by or obtained from sources that CIM believes to be reliable, but CIM does not guarantee its accuracy. The securities identified do not represent all of the securities purchased, sold or recommended and the reader should not assume that any listed security was or will be profitable. Market indices referenced are unmanaged and representative of large and small domestic and international stocks and bonds, each with unique risks. Information about them is provided to illustrate market trends and does not represent the performance of any specific investment. You cannot invest directly in an index. Past performance cannot guarantee future results.