Spring Quarterly Commentary
April 27, 2015
by John Prichard, Miles Yourman of Knightsbridge Asset Management
“You asked me what’s going to happen…I don’t know what’s going to happen. I regard it all as very weird…if interest rates go to zero, and all of the governments in the world print money like crazy…and prices are going down? Of course I’m confused. Anybody who’s intelligent and is not confused doesn’t understand the situation very well. I think in fact that, if you find it puzzling, your brain is working correctly.”
Charlie Munger, Vice-Chairman of Berkshire Hathaway Chairman of Daily Journal Corporation
Charlie Munger, firmly ensconced in the investor hall of fame, remains, at age 91, one of our favorite purveyors of worldly wisdom on subjects investment related and otherwise. He is also known to be blunt and humorous, offering the above response to a question regarding money-printing, interest rates and unintended consequences at the Daily Journal shareholder meeting a few weeks ago. When a genius like Charlie is confused…then things indeed are confusing.
One of the more striking features of the crazy, confusing world in which we live is the appearance of negative nominal interest rates across wide swaths of Europe… something that would have seemed impossible just a few years ago. In fact, just a few years ago at the annual Berkshire Hathaway meeting, Charlie Munger and his partner, Warren Buffett, showed off a trade ticket from ‘08 which demonstrated that someone had bought Treasury bills from them at an implied negative interest rate. The fact that someone was actually willing to accept a negative interest rate in order to obtain the safety of Treasuries was held up as a piece of financial history and a sign of just how crazy the crisis was. Well here we are again, just seven years later and the world looks much crazier.
Instead of a slightly negative yield on an isolated trade during a panic, we now have seven percent of the developed world’s government bonds trading at negative nominal rates. No longer are negative nominal rates confined only to short-term maturities; Switzerland recently issued ten-year bonds with negative yields. As the textbooks are literally being re-written, we hear reports of oddities like the Spanish mortgage linked to (now negative) Swiss rates where the bank currently pays the borrower interest on his balance1! The amazements are not solely confined to the Continent; the U.S. 30-year bond just hit 2.44%, its lowest yield in the history of the Republic, and Mexico just sold a 100-year Euro bond priced to yield 4.2%. To restate, some investor ostensibly trusts that Mexico, 100 years from now, in 2115, will pay them back in a currency introduced into physical circulation thirteen years ago, in 20022. It is somewhat of an open question as to whether the Euro will even exist in 13 years, let alone 100. Wouldn’t you be worried? Prospective investors in Mexican “Centuries” ought also be worried that interest rates, or even worse, inflation, might pick up sometime between now and the 22nd century. Owners of bonds with negative yields and Mexican 100’s likely don’t intend to actually hold until maturity, and so these “investments” to us smack of “greater fool” reasoning and make us nervous…though, like Charlie, we find it difficult to pinpoint the exact direction of approaching danger.
So what do negative nominal rates mean and why are they so crazy? A negative nominal rate means you’ve agreed to receive back less money than you’ve lent out…i.e. I give you ten and you promise to return nine. The issue is not that investors are forced into losing purchasing power; this happens regularly whenever the inflation rate is greater than the nominal rate, as happened in the ‘70’s. It also is likely occurring in your bank account at present. The crazy part is that some bond investors now choose to lend money and not receive it all back, when they could instead do nothing and keep all their money. Why lend 102 Francs to the Swiss government in order to receive back 100 in two years when you could instead put 102 Francs in your sock drawer and in two years still have 102? This is why negative nominal yields are so shocking and were previously thought impossible- why would anyone agree to lose money? The answer becomes more clear when you think about the difficulty of putting 102 million Francs in a sock drawer. Is this really an alternative? In practical terms, one would have to pay for the storage of this money. And one would probably want to hire a guard… and also have insurance just in case. After those costs you’re not going to receive your full 102 million Francs back, even if you try to do “nothing”. Finally, if you change your mind and decide you want to do something else with your money, it would probably take time and considerable effort to retrieve 102 million physical Francs from our giant, fortified sock drawer, deposit them in a bank, transfer them to a broker, and from there buy stocks or other assets. Ownership of a government bond solves all of these problems (safety, ease of convertibility/transfer) at what the market apparently deems a cheaper rate3. Hence, we tend to see those negative nominal interest rates as actually being zero, minus a convenience fee. If rates do get much lower, perhaps we will see a bull market in Scrooge McDuck-like vault building.
Another area of market attention is the energy sector, which continues to be affected by low oil prices. Given our contrarianism and how much oil/energy stocks have fallen, why haven’t we initiated a new energy position? Simply put, while today’s oil price may one day prove to be a bargain, we see evidence that oil and energy stocks are not exactly contrarian plays. This phenomenon is perhaps best illustrated in the words of an investment manager who was quoted as saying, “We continue to see significant client interest in the energy sector. We think it is a great contrarian play.” Clearly the speaker doesn’t understand what it means to be contrarian. Reports of investment houses raising energy-specific funds abound. Anecdotally we encounter non-Wall Street types who express great interest in establishing energy positions. The contention that going long energy is actually a consensus play is supported by the chart below showing that, despite the value of the energy sector being lower than in the recent past, assets have been flowing into energy ETFs since oil’s defenestration. Against this backdrop, we don’t think energy is currently a contrarian play, and remind readers that we didn’t always live in a 100-dollar-a-barrel world, and might not return to one for a long time, if ever.
While we caution that anything could happen, we think it is probably worthwhile to wait before placing further energy bets. Banks are just now starting to re-assess the borrowing bases for energy companies, which could