The Folly of Bonds & the Irony of the Next Internet

If you think bonds are a fortress of safety as most Americans still do, you may want to rethink that assumption especially if you know someone who is depending on bond coupons in retirement. The flow of funds from investors into fixed income funds has been dramatic. Last year almost $400 billion went into fixed income funds, up from approximately $5 billion at the turn of millennium according to Stratigas. While that may not sound big compared to seemingly endless government spending today, it is very significant in terms of how much the public has to invest. Contrast that number with the peak levels of equity investing during the internet bubble which were only about half of last year's fixed income flows.

Even more surprising than the absolute flow of funds is the value proposition bondholders are endorsing. Consider the Treasury market: Today investors are lending the US government their capital for 30 years at less than 5% just for the promise of getting their original investment back. While inflation may look tame under the bastardized measurement that is still called CPI, classic measures of inflation as cited by John Williams suggest inflation is already approaching 10%. That means today's bond investors are signing up to lose purchasing power. Deflation will likely prevail in real estate but in most other segments of the economy inflation is here despite what the media claims. As example ore prices are up almost double in Asia which will cause steel costs to rise by one-third. Steel producers are saying they will pass this along. In food, we saw wholesale prices increase this spring at the fastest rate in over twenty-five years, and around NYC even services such as train fares are up 25%. Whether inflation is demand induced or currency induced does not matter – the fact is that inflation is already showing up in many areas and will likely spread and intensify. This will inevitably lead to rising rates or a weakening currency and neither outcome is good for bondholders.

Perhaps equally concerning to bondholders should be the historical performance of bonds. US bond investors are coming off of what CPI claims are several decades of positive real returns. The last time such a string occurred, the ensuing four decades produced negative bond returns.

So consider those points for a moment: With bonds we have a historically crowded trade in an asset class that has just put up some of its best historical returns in the last century. Moreover bonds' most important input is now becoming a headwind after thirty years of tailwinds. What could possibly go wrong?

While some bondholders may be chasing performance, ironically flows into bonds as well as hoards of cash may be intended as just the opposite. Today we are witnessing a generational shift in risk appetite.

Risk appetite crescendoed in the .com bubble where investors were not concerned with preservation of capital but were completely transfixed by the allure of wealth creation. Hundreds of businesses were funded without revenues or a path to profitability because investors were willing to lose it all in the hope their internet business may "hit it big". As that bubble popped and investors saw their money vaporize, they made the conscious decision to reduce risk. This lead to a first round of questioning: "What is safe?" Recalling simplistic charts investors seemed to buy into the notion that stocks are high risk / high return, bonds are medium risk / medium return, and dollar-cash (i.e. money markets, bank savings accounts, CDs, etc.) are low risk / low return. That perception led to the aforementioned flow into bonds (as well as with much of the flow into real-estate where the mantra became "real estate will always be worth something") but such Wall Street risk-mantra may prove to be little more than window dressing in the game of wealth preservation.

Today the dominant investment theme unfolding before us continues to be the swing of the investment pendulum in its arc from nearly insatiable risk appetite to the opposite extreme seeking wealth preservation above all.

As bonds come full circle into the painful headwinds of inflation and Europe's problems spread beyond Greece just as America's spread beyond sub-prime, investors will again ask "What is safe?" This round of self-examination will likely lead the public back to history as our guidepost. The conclusion of American investors may be that of European investors today. Europeans are awakening that safety is not "cash in the bank" but gold. German citizens are furious over being handed responsibility to bail out a nation that retires earlier, receives more benefits and pays fewer taxes than the German people themselves. Even more unsettling to the Germans is that Ireland's debts are more than double Greece's while Spain and Italy's are nearly triple those of Greece.

The Germans have seen this movie play out before and remember the inflationary outcome that ensued when Germans were shouldered with debts too large to repay. In the last go-round German debt was punitive to individuals and institutions that saved in bonds or paper currency. Such paper assets were eventually recognized to be the real "asset without intrinsic value" as the rich who saved in bonds saw their worth implode and their status move towards that of the nation's poor.

Today we see news stories of Germans aggressively buying gold, of record volumes from Spanish bullion brokers in May and the statement from the Viennese mint that by May 12th it had already sold 10% more gold than it had in the entire 1st quarter. European citizens aren't the only buyers – analysts are estimating that central banks may add another 200 tons to their vaults this year while Chinese citizens appear poised to exceed their record purchases from last year.

The common viewpoint of these disparate groups is that they are not on a mission to make money but simply to preserve their wealth. They each choose gold because it has stood the test of time as a safe haven for wealth preservation predating even the fall of man. The classics department at my high school Episcopal Academy recently pointed out that a month's minimum wage eared over 2,000 years ago was payable in an ounce of gold. Minimum wage today is about $1,250. That suggests gold has preserved essentially 100% of its owners' wealth over two millennia. Contrast that to the value of a bond from the walking bankrupt, or the dollar that has lost 95% of its purchasing power in less than a century … and what do you feel is safer?

Surely this discrepancy between the steadfast value of gold vs. the ephemeral value of paper assets was what led our founding fathers to make comments such as:

"Paper money has had the effect in your state that it will ever have -- to ruin commerce, oppress the honest, and open the door to every species of fraud and injustice."

George Washington, 1787

As Dave Ellison, president of FBR Funds said, watching events unfold in Greece today is a preview to how markets will behave here. If that proves true, we will see a day where Americans exhibit an urgency to reverse their upside down "safe asset allocations" that are loaded with bonds and cash but have close to zero allocations in gold.

Is gold risk-free? Of course not as today could actually mark the all-time high in gold although I consider this highly unlikely. But instead of measuring risk in the business school construct called standard deviation, if we measured risk by the loss of purchasing power as Peter Bernstein suggested, gold shows itself to be lower risk than bonds or dollar cash per thousands of years of data.

The absolute irony of this? As people recall these lessons from history we will see increased allocations to gold. But without a printing press to make gold and with gold production already past its peak, supply will not be able to keep pace with demand. If this happens the 1% of financial assets that are gold will be repriced higher. The final chapter of the cycle will be a climatic grab for wealth preservation as the value of bonds and their underlying fiat currencies compress. At that point "the next internet" of relative wealth creation in a capital starved world will ironically proved to have been the mirror opposite of the late 90's, namely the search for safety. Major beneficiaries of the search for safety will be gold and silver … possibly marking the only time in our lives where the safest assets offer some of the most breathtaking upside as well.

Drew Mason 

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