At the recent Schwab conference for investment advisers, Bill Gross, manager of the world’s largest bond fund, said we’ve entered a period of “financial repression.” What did he mean by this striking comment?
Gross noted that, from the end of World War II until the late 1970s, interest rates on U.S. Treasury bonds were persistently below the rate of inflation, generating negative “real” interest rates for bond investors. This condition was reversed when Paul Volcker became chairman of the Federal Reserve Board in 1979. From then until recently, bond yields remained comfortably above the rate of inflation. For that last three decades, it’s been easy to earn attractive returns from high-grade bond investments.
So whom does financial repression repress? Savers!
Take certificates of deposit. CDs issued by FDIC-insured banks are backed by the full faith and credit of the U.S. Treasury. CD yields typically offer a modest premium over Treasury securities having similar maturities. As I write this, Bankrate.com lists the most competitive rates for five-year CDs (not including special promotions) as between 1.6 percent and 1.9 percent, while the five-year Treasury is yielding 0.9 percent. That 1 percent “spread” between Treasuries and CD yields is pretty typical.
Many people now in their 80s and 90s have invested a significant portion of their savings in CDs, expecting to live off the interest. In a period of financial repression, the incomes of these savers are going to fail to keep pace with rising prices, which will place significant strain on their lifestyles.
Corporate bond investors will also take a hit. For the past three decades, one could achieve, with little risk, returns averaging 3 percent to 4 percent above the rate of inflation from medium quality, intermediate-term corporate bonds. Going forward, that differential is more likely to be 1 percent to 2 percent, meaning the cost of managing bond portfolios is likely to eat up much of the return from corporate bonds over the rate of inflation.
In last month’s column, “Pushing on a String,” I noted how low bond interest rates were likely to make fixed annuities and permanent life insurance poor investment choices. What’s important about Gross’ comments is that he stressed that this new period of financial repression is likely to be of extended duration. After all, the period of repression beginning at the end of World War II lasted three and a half decades, during which time bond investors took a bath.
Why are the guns of federal fiscal policy being trained on savers? Somebody has to pay off the burgeoning national debt. Recent election results have made it clear that promising to raise taxes, even on the “rich,” doesn’t win enough votes to get elected. And acknowledged policies of currency devaluation or rampant inflation so the federal government can pay back its debts with cheaper dollars would bring howls of protest. Instead, financial repression will achieve its effect over the long term, nicking a little at a time from the millions of (mostly) older Americans who have saved for retirement, paid off their mortgages and lived within their means. Call it a stealth tax, if you will.
The bottom line for investors going forward is that generating meaningful returns will require taking on more risk than they’re used to. Specifically, equities (stocks) will fill a more important role for income-oriented investors. Can a risk-averse investor stop worrying and learn to love stocks?
The volatility of stock prices is the hardest part about equity investing for the conservative investor. Memories of 2008 and early 2009 are fresh in most minds. From its high point at the end of October 2007 to the nadir on March 9, 2009, the S&P 500 index declined a jaw-dropping 55 percent. Fortunately, recent research has confirmed that the least volatile stocks provide the best returns while taking on less than market risk.
Here’s an illustration using widely available index funds. The most popular index funds follow the broad market indexes, particularly the S&P 500 Index. Vanguard runs one of the largest funds of this type, available as an open-end mutual fund (ticker VFINX); the biggest S&P 500 exchange-traded fund, or ETF, by far is the State Street “spider” (ticker SPY). A fund that focuses on a dividend growth strategy (somewhat like what my firm specializes in) is the Vanguard Dividend Appreciation Index Fund, available as both an open-end mutual fund (ticker VDAIX) and as an ETF (ticker VIG).
Let’s compare the returns and risk of the S&P 500 fund to the dividend appreciation fund over the past five years. First from a risk standpoint, VDAIX has demonstrated about 87 percent of the volatility of the S&P 500 fund. On the return side, VDAIX has generated a cumulative return of about 10 percent (1.92 percent annualized), compared to a 2 percent cumulative loss (-0.40 percent annualized) for the S&P 500 fund.
Another way fund analysts look at risk is by a statistic called “drawdown,” or how much a price fell from its peak to the following trough. In the case of VDAIX, the maximum drawdown from October 2007 to March 2009 was a painful 47 percent compared to the excruciating 55 percent drawdown of the typical S&P 500 fund during the same time frame. While it took VDAIX two full years to recover from its March 2009 low, the S&P 500 fund has never recovered and is still stuck below the high point it reached in October 2007. The highest value that the S&P 500 fund has reached since 2009 occurred in late April this year at 6 percent below the October 2007 level.
The Vanguard Dividend Appreciation Index Fund isn’t explicitly a low volatility strategy, but, by its nature, can be expected to be consistently less volatile than a broad-based index fund. With appropriate management, it’s definitely possible to improve on the return and risk of VDAIX.
When planning your retirement investment strategy, keep in mind the importance of including a low-volatility stock strategy to help generate adequate investment returns in an extended period of financial repression.
