June 29, 2016

Bond Investors specially in Europe and Japan at risk to lose money

There's little that robs market valuations more than "stagflation," that 1970s-style combination of a stagnating economy and rising inflation.

I highlighted the ongoing threat of a stagnating economy last week, writing:

"The past few months have given us increasing indications that secular economic stagnation is the 'new normal' these days -- and could be a mainstay here and abroad for some time to come. ... Mature, developed countries like ours are likely stuck in a new era of sluggish growth."
-- Doug's Daily Diary

And I'd like to focus on the second part of stagflation -- rising inflation.

Our Federal Reserve has continually repeated that inflation "is below our target." But I believe that the central bank is wrong yet again.

It's true that U.S. investors have long been conditioned to see ridiculously low interest rates, while Europe and Japan's negative real rates represent mal-investment and the mother of all bubbles to me. (The only real question in my mind is when the bubble will burst.)

With more than $10 trillion of European and Japanese sovereign bonds now sporting negative interest rates, it seems likely that investors believe rates will never rise again. In fact, few investors (except for those burned by bad credit analysis) have suffered capital losses on bonds in more than 35 years.

As a result, few people probably even realize that it's possible to lose money on bonds. But at current prices, it's possible to lose a lot of money on bonds, especially when you consider the scant nominal interest that you'll receive if you hold debt to maturity.

But while bond-investor sentiment is skewed in a bullish direction, the latest economic figures suggest accelerating inflation -- including some price increases in areas that no one's thinking about. Consider the evidence:

U.S. Wage Pressures

The latest figures show that U.S. wages are rising at a 2.Even workers at Atlantic City's casinos (not exactly a growth industry) are planning to strike for higher pay.

The Economist's Take
The Economist computes two inflation indices: "food" and "all items." Food inflation has risen to 10% over the past year, including big gains in soybean meal used for feeding pigs. (There's been an amazing amount of speculation in soybean-meal prices in China.)

Meanwhile, The Economist's all-items inflation index turned positive last week for the first time in several years. The latest reading has inflation up 1.3% for the past year and running at a 3.3% rate over the past month.

Inflation in Unusual Places

Some long-quiet prices such as insurance premiums are suddenly bubbling up.

Low interest rates kill insurers' investment income, and insurance firms have run out of capital gains on their bond portfolios. They have to settle for coupons plus a high risk of capital loss. If underwriting ever moves to a loss, that would mean big trouble for the industry.

My auto insurer (USAA) recently took matters into its own hands, notifying me that my premiums will rise 11% over the next year. I'm sure I'm not alone.

The price of life-insurance policies should also skyrocket, and a lot of annuity income may come in well below the level forecast, putting more pricing pressure on insurers. Put simply, prices are likely going to rise -- possibly meaningfully -- for all insurance products.5% annual rate and look to be accelerating.

Fiscal-Policy Inflation

There's a lot of talk these days about the need for government to stimulate the U.S. economy with more fiscal policy, especially on infrastructure projects. (I touched on this subject in Tuesday's opener).

However, fiscal policy has three lags -- the recognition lag, the action lag and the impact lag. We're now into the second of the three lags, and government spending should pressure factor costs. In fact, one factor -- construction labor -- is already in short supply.

The Bottom Line

Many investors might be shocked to learn in the times ahead that there's actually risk in their perceived "risk-free" bond portfolios.

However, I believe that the times they are a changing, despite Thursday's still-low interest rates and inflation levels. For many who hold fixed-income investments, that could be a new -- and unprofitable -- experience.

Bond investors will lose a great deal of money if rates go up by even 1%. 

via thestreet