Dennis C. Butler, President
of all guest columns written by Dennis C. Butler, CFA
he Germans are calling it Zeitwende, or a turning point in history. As happens with wars, the armed conflict now taking place in Europe promises to transform long-established practices, relationships, and attitudes for a long time to come. The most immediate impact has been a change in the defensive stance of Western Europe, almost, literally, overnight. The assumption that deepening trade relations among states would mitigate against adventurism has been proven false, now that a large and militarily-powerful neighbor to the East is no longer reliable and predictable under its current leadership. As a result, NATO countries will soon be spending much more heavily on military hardware and readiness on an ongoing basis. For Germany in particular, whose post-war history has been pacifistic, this represents a radical departure. Reunited during the collapse of the Soviet empire, Germany is now re-arming because of Russia’s attempt to expand its dominion anew, a step once held to be unthinkable, especially among the German people.
Globally, the Zeitwende may have even more profound implications in the long run. The international economic sphere has been disrupted, most directly in Europe. In recent decades, the Continent has become heavily reliant for its energy needs on Russia, the world’s third-largest producer of hydrocarbons — coal, petroleum, and natural gas. Russian supplies 40% of Europe’s gas needs (50% of Germany’s), and 25% of its petroleum requirements (33% for Germany). 50% of the coal burned in Germany comes from Russia. Consumers and industry are facing skyrocketing prices for these commodities as well as for electricity, and hydrocarbon- or energy-intensive businesses such as fertilizer and aluminum have had to curtail or shut down production. Attempts to convert European economies to green energy sources have not proceeded quickly and far enough to reduce the dependency on hydrocarbons, hence the continuing reliance on Russia and the dilemma currently facing Western Europe. Because hydrocarbons trade in international markets, the reduction in Russian energy shipments due to blockades, and the possible cut-off of its exports to Europe, have pushed up prices everywhere. (Note: U.S. petroleum and gasoline prices came close to hitting new highs this year.) This comes on top of a tight market resulting from resurgent demand and a lack of investment; energy prices had already risen significantly before the Ukrainian war began.
The war has also impacted trading in other important commodities. Both Ukraine and Russia are big producers of grains, together accounting for one-third of the global wheat trade. (Ukraine is known as the “breadbasket” of Europe.) Already, poorer nations are suffering from food shortages as disruptions of supply drive up prices. Russia is the second-largest producer of aluminum (the price of which has recently hit records), and Russia and Ukraine together dominate the supply of neon, a gas critical in the manufacture of the silicon chips used in computing equipment.
Some observers are now maintaining that the decades-long trend of “globalization” is coming to an end. Due to the impact of the Covid pandemic and national responses to that health crisis (such as China’s closure of port facilities and lockdowns of entire cities), industrial nations were already re-assessing their supply chains and sourcing of key inputs such as the rare earth elements used in a multitude of technological applications. Concentration had also raised alarm bells; the technology industry, for example, is reliant on Taiwan for 50-90% of certain semiconductor chip products. Russia’s hostility towards neighboring Ukraine has reminded people that China nurses similar grievances with respect to the island it claims as a “province.” Even low-tech industries such as furniture have supply chains stretching to China and Viet Nam that caused product-availability problems when the pandemic interfered with ocean shipping. Ukraine itself is the source of wiring assemblies used in truck production, causing at least one German manufacturer to shut down assemblies since hostilities began. The Ukraine conflict, and Russia’s apparent use of its market position in certain commodities as a coercive tool, have accelerated the re-evaluation of the globalized industrial regime. A re-ordering of world production and trading patterns may be underway before our very eyes.
We are skeptical of a permanent renunciation of global integration — after all, it is a process that arguably has been underway for millennia, though with many interruptions and major setbacks — but even a relatively short-term halt could have unaccustomed consequences. Partly due to global sourcing and supply chains, American industry has been running historically high profit margins: 10-11% versus 5-6% in the past (margins that are reflected in elevated stock valuations). Consumers have also enjoyed lower prices on imported goods. The downside has been a gutting of U.S. industrial capacity, and either a shift to lower wages for a significant part of the American workforce, or little or no wage growth, as well-paying manufacturing employment disappeared, forcing workers into typically minimum wage service sector jobs. A “reshoring” of manufacturing could very well benefit U.S. workers, but at the cost of higher prices in stores. We would also add that some re-thinking of offshoring had been occurring “naturally” as production costs in foreign manufacturing centers have increased in recent years (higher wages in China, for example), offsetting some of the cost advantage of outsourcing production abroad.
Reactions to the quarter’s events in the financial markets have been diverse. Not surprisingly, commodities have seen intense action, but stock market behavior has been, overall, remarkably muted. There was an initial sharp reaction to the invasion of Ukraine on February 24: in the U.S. the S&P 500 fell 15% from its January peak, and the NASDAQ dropped over 20%. Some of those declines occurred during the buildup to the invasion as markets began to discount the risk of conflict. Nevertheless, the indexes have been recovering in fits and starts. The benchmark S&P 500 index finished March down 4.6% year-to-date; the Nasdaq fell about 9% over the period, both well above their low points, but still the worst quarter in two years. Wars generally have a mixed effect on the stock market (at least in the U.S. where conflict has not taken place on home soil for a very long time). Fear and uncertainty take their toll, but spending boosts and increased industrial activity tend to be favorable for profits and stocks. Bonds, on the other hand, have fallen, and interest rates have risen in response to higher reported inflation both before and after the Ukraine invasion, with one index of U.S. treasury securities dropping 5.6% in the first quarter, a record decline. Even the normally staid market for municipal bonds suffered its worst quarter since the 1980s, falling 6%.
Financial historians looking back at the beginning of the third decade of this century will undoubtedly see a period characterized by almost unimaginable amounts of liquidity — financial firepower — looking for a home. Fed by central bank actions to counter the impacts of health crises and economic shocks, as well as a booming economy, and, as we now know, a sizable dollop of cash from less savory sources, money flowed into every conceivable asset: stocks, bonds, real estate, superyachts, sports teams, and more. Multiple bids for homes at above asking prices and same-day closings were a sign of the times. Financial sector operations and products sprouted like weeds as they fed on the cash bounty, and managed funds — such as “private equity” and hedge funds — attracted capital and grew to the point of bloatedness, intent on buying something — anything — that would produce a yield. In other words, this period will be looked back on as a great time to be a seller of assets.
The ultimate outcome of this frenetic activity may well be another Zeitwende. In the forty-year period from the early 1980s-2020, annual inflation in the U.S. gradually declined from about 15% to roughly 1%, following an undulating pattern with lower peaks along the way. Accompanying this deflationary trend was a bull market in bonds that took interest rates from the 15-20% range down to zero (and in the case of some foreign sovereign bonds, below zero). Falling rates were a natural consequence of declining inflation because low inflation means that a fixed income stream is more valuable — since purchasing power will not be eroded as quickly — going forward.
Some observers believe the trend has reversed and that we are now entering an era of higher inflation and rising interest rates as factors which had held down inflation — globalization, the entry of new populations into the global work force, relatively stable energy prices — become a thing of the past. While the evidence is still scant, it could support this view. Inflation started to rise in the spring of 2021 and reached an annual rate of 7% late in the year, the highest since 1982. The jump in inflation caused a great deal of consternation on Wall Street and in the financial press, which feared the Federal Reserve had fallen behind in its inflation-fighting duties. Market interest rates rose to multi-year highs as well, as would be expected given the increasing price pressure. Having hit a low of around 0.5% in 2020, and at just 1% as recently as last summer, the U.S. ten-year treasury note reached 2.5% in the first quarter. Astonishingly, the two-year treasury note’s yield rose almost one percentage point just in the month of March to about 2.4%. Remember that a rise in bond yields means that prices for the fixed-income securities have fallen.
We have been warning about the bond market for years, arguing that the returns being offered were not worth the risks assumed. Paying top dollar for a ten-year bond yielding 0.5% means that a miniscule price decline would wipe out any yield advantage over shorter term investments, and, were it to be sold, result in a capital loss. If held, the buyer would eventually get their money back at the end of ten years, but would still have only a paltry 0.5% return to show for it. As noted above, fixed-income buyers have already suffered significant price declines with the rise in rates. Since those higher rates are still quite low historically, it is conceivable that losses could mount even further.
No one can say with confidence whether a new long-term interest rate cycle mirroring the one most market participants have known is correct; only time will tell. Our remit is to protect capital, whatever the future brings. Along those lines, looking at the two-year treasury note presents an intriguing picture. At 2.5% its yield remains far below both its 30-year peak of nearly 10%, and long-term average in the 4-5% range. Nevertheless, it is far more interesting as a potential investment than the 0.15% it offered only a year ago, or short-term bills currently yielding 1% or less. Regardless of where rates may be headed, a case could be made for tying up some capital for two years with no credit and little price risk for a yield that is a multiple of that currently obtainable from money market funds, especially in an environment as volatile and uncertain as the one we now face. Far be it for us to express excitement over a 2.5% return, but at long last investors may have an opportunity to get paid to park funds in a safe place until something better comes along.
Dennis C. Butler, CFA, is president of Centre Street Cambridge Corporation, investment counsel. He has been a practitioner in the investment field for over 37 years and has been published in Barron’s. He holds an MBA from Wharton and a BA in History from Brown University. His quarterly newsletter can be found at <www.businessforum.com/cscc.html>.
“Current low valuations reward the long-term view”, an article by Dennis Butler, appears in the May 7, 2009 issue of the Financial Times (page 28). “Intelligent Individual Investor”, an article by Dennis Butler, appears in the December 2, 2008 issue of NYSSA News, a magazine published by the New Yorks Society of Security Analsysts, Inc. “Benjamin Graham in Perspective”, an article by Dennis Butler, appears in the Summer 2006 issue of Financial History, a magazine published by the Museum of American Finance in New York City. To correspond with him directly and /or to obtain a reprint of his featured articles, “Gold Coffin?” in Barron’s (March 23, 1998, Volume LXXVIII, No. 12, page 62) or “What Speculation?” in Barron’s (September 15, 1997, Volume LXXVII, No. 37, page 58), he may be contacted at:
Dennis C. Butler
Centre Street Cambridge Corporation
Post Office Box 390085
Cambridge, Massachusetts 02139
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Revised: April 11, 2022 TAF
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