If you followed Gary Shilling’s advice for the last 30 years, you would be very wealthy.
Shilling runs the New Jersey-based economic consulting firm the bears his name, A. Gary Shilling & Company, and he is the author of The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation, published in 2010. He spoke last week at the Boston Security Analyst Society asset allocation conference in Boston.
Since 1981, Shilling has consistently advocated owning long-dated Treasury securities. In his talk, he reiterated that advice as one piece of his three-part asset-allocation strategy for the coming year.
In 1981, Shilling said we were “in for the bond rally of a lifetime.” Since then, a strategy of rolling a 30-year zero-coupon bond outperformed the S&P 500 by 6.3 times.
Shilling’s thesis was centered on the macro-economic theme that has underpinned his recommendations for the last 15 years: deflation. Shilling’s previous book, Deflation: How to Survive and Thrive in the Coming Wave of Deflation, was published in 1998.
Let’s look at what Shilling said is going on in the world and what he said it means for portfolios.
The global landscape
Since 1749, according to Shilling, inflation during wartime periods has averaged 5.6%, aided in part by aggressive government spending. But during peacetime, productivity growth has kept inflation low or nonexistent. Military spending is approaching a post-war low, he said, and deflation is imminent.
“We would have had it sooner,” he said, “had it not been for massive monetary and fiscal stimuli.”
Shilling said policies are heading other way: taxes have increased, higher taxes are being collected due to an improved economy and the 2009 stimulus package has worn off.
“Now we have fiscal drag, instead of fiscal stimuli,” he said.
Slow growth underlies our economic woes, Shilling explained, and it is due to continuing deleveraging following the financial crisis. It normally takes a decade for deleveraging to complete following a crisis, he said. We are eight years into it, and “it may take more than two more years.” Meanwhile, the U.S. economy is operating at a “half-speed expansion”
Meager wage growth is dampening growth, according to Shilling. Profit margins have shot up, but only through corporate cost cutting. That’s fine for businesses, he concedes, but the flip side is depressed wages and income. The bottom 90% of wage earners have paid the highest price, he said. Median real wages have been basically flat since the financial crisis, according to Shilling. Without increased consumer spending, slow growth and deflation are certain.
“There is no other factor in the economy that can spur growth,” he said.
Shilling doesn’t expect the rest of the world to drive U.S. growth. China is slowing, he said, and its reported 7.3% growth should not be trusted. China’s PMI numbers are declining and reelectricity consumption is growing at only 4.3%. Japan has been in deflationary depression for 20 years, he said, and is in depression now. Europe is barely growing.
Slow to negative growth on a global basis leaves three results: declining commodity prices, deflation and competitive devaluations.
Declining commodity prices
According to Shilling, the CRB commodity index has been declining since early 2011. It surged in 2002 when China joined the WTO, but since then, China has been consuming a large percentage of global natural resources. As a result, commodity producers expanded production – for example, Brazil built readied copper mines– and closed the gap between supply and demand.
Declining commodity prices are not a new phenomenon. Shilling said that since mid-1800s prices have been declining despite spikes coinciding with wars, and excess demand has consistently been met by improvements in technology.
“Human ingenuity beats shortages,” he said, “always has, always will.”
Shilling admonished some in the audience who raised their hands when he asked if commodities are an asset class. “They aren’t,” he said, “at least on the long side.”
Awareness that commodity prices were in a secular decline was limited, he said, until crude oil prices “went off the cliff.” Cartels are formed to keep prices above equilibrium, Shilling said. The role of the lead member of a cartel is to deal with cheaters by cutting back on its supply. The Saudis got tired of playing that role, he said. Shilling disagree with the popular belief that the Saudis are trying to “put a hit” on the American fracking industry by lowering oil prices. Instead, he said, the Saudis are playing a game of “chicken” – lowering prices to penalize cheaters.
How low can oil prices decline? Saudi Arabia supposedly needs $90/barrel to balance its budget, but Shilling said that the prices that oil producers need to balance their budgets are irrelevant. It’s not the “full cycle” cost of producing energy that matters, either. The “chicken-out price” is the marginal cost of producing oil, according to Shilling. (Some countries like Russia, however, will continue to produce oil below marginal cost because they need the foreign currency).
The “chicken-out price” is $10 to $20/barrel for the Saudis, he said, about the same as it is for existing fracking operations.
“We really have a long way down before someone chickens out,” he said.
Consumers will be the winners of low energy prices, Shilling said, but so far they are not spending that money. Retail sales for January were down 1.1%. Outside the U.S., a strong dollar has offset the increase in consumer income. The losers are oil producers. Shilling said 17% of junk bond are energy producers, and many smaller ones are hugely leveraged and have radically reduced capital spending. About $25 billion has been cut out of budgets for future spending, according to Shilling, and current U.S. production is still increasing despite this.
“A commodity price decline was already underway,” Shilling said, “due to excess supply versus decline. The energy-price collapse simply accentuated that.”
Shilling noted he is “probably the world’s oldest living deflationist.”
Deflation is “already here,” he claimed, with 26 of the world’s 34 major economies in or close to deflation. That number will increase when data is released for January.
As a result, Shilling said, bond markets are facing negative nominal interest rates. Finland just issued a 5-year note at a negative yield, as did Switzerland with a 10-year issue and Sweden with a 4-year issue. Germany, Australia and the Netherlands are among countries with existing debt that trade at negative yields.
Shilling gave four reasons for negative nominal yields: bank liquidity (i.e., banks must own sovereign debt, regardless of its yield); positive real yield (due to negative inflation); a worse alternative (deposit rates are negative in many markets); and the ECB buying securities, meaning that yields will get more negative.
The U.S. CPI ex-energy has been declining month-over-month, Shilling said. According to Shilling, the CPI was negative briefly during the financial crisis and in the mid-1980s when Saudis flooded the oil market, and it will soon be negative again,
“I think deflation probably will last and will spread beyond energy prices,” he said, “because of global weakness.”
If he’s right, then Shilling said the U.S, will end up in deflationary trap similar to what Japan has experienced over the last 20 years. Deflationary expectations will cause consumers to delay purchases in the hope that future prices will be lower.
The currencies of commodity-producing countries have been weakening recently, Shilling said, citing Australia, New Zealand and Canada as examples. The euro is being “deliberately trashed” by the ECB, he said, which is looking to spur exports.
The follow-on will come from nearby currencies, Shilling said. South Korea is devaluing in response to Japan’s actions. While most central banks are devaluing through quantitative easing, some are cutting interest rates to weaken their currencies.
We now face an environment of “universal devaluations,” Shilling said.
The only winner is the dollar (except for Switzerland and Denmark who, he said, cannot devalue because of trading relationships). “We are stuck,” he said, with a strong currency.
Shilling still recommends the long-dates U.S. Treasury bonds. Forecasts by economists have been for rising rates, he said, going back as far as 1981. But those forecasts have been consistently wrong.
“I think the 10-year is going to 1%,” he said, “not 2.9% as economists forecast.” That would result in a 12% return over a one-year horizon.
It’s not just because U.S. Treasury bonds are safe haven, he said, but also because their spread is high relative to all other sovereign bonds. The yields on European sovereigns are too low, according to Shilling, and will get arbitraged away by declining U.S. rates.
The 30-year Treasury bonds will go to 2% by the end of this year, according to Shilling. It was 2.75% at the beginning of the year. That would produce a 19% return on a coupon-bearing bond and 27% on zero-coupon bond.
Shilling recommends that investors favor the dollar versus virtually every other currency: the euro, yen, Sterling, and Australian, New Zealand and Canadian currencies. The dollar may not rise to its 1985 peak against a trade-weighted basket of currencies, but its rally has been “relatively modest” so far, he noted.
Investors should short commodities, particularly copper, he said.
According to Shilling, equity positions should be concentrated in defensive stocks: utilities, health care and consumer staples – all of which beat S&P 500 last year. Stocks have been supported by Fed policy, Shilling said, which has resulted in low volatility and a low dispersion of returns. As a result, actively managed money, including hedge funds, underperformed index funds. Stocks overall, he said, are still expensive, based on the Shiller CAPE ratio.
“With Fed out of the picture, we are going back to much greater dispersion and volatility.”
Shilling said investors should prepare for a risk of a “shock” that could result in a worldwide recession and a bear market. The most likely candidate, he said, is a fallout from low energy prices. That would change his investing outlook from “risk on” to “risk off.” But the only change to his investment recommendation would be to avoid all stocks.
Read more articles by Robert Huebscher