The FPA manager on the current inflation situation and accelerating government fiscal policy risk.
Tom Atteberry is a portfolio manager for FPA New Income
1. As part of your investment process, you ask: "Are the current level of bond yields attractive ... relative to inflation?" We've seen inflation heat up in 2011, but we also see continued high unemployment and a sluggish economy, which would tend to keep a cap on rampant price increases. What expectations about inflation are you incorporating into your investment process? Do you have different expectations for near-term versus longer-term inflation?
In the past, inflation pressures have tended to be measured using capacity utilization, the supply of labor, and the amount of resource utilization in an economy. Items such as commodity costs, the impact of currency, and global utilization have not been major factors in the calculation. Today we feel that commodity inflation is playing a greater role in inflation. This increased role is being fueled more by international demand than domestic demand. The rapid industrialization of China, India, and other emerging economies is putting pressure on energy usage and food costs as worldwide diets improve.
From the currency perspective, given the large amounts of goods we import, any declines in the value of the dollar result in higher costs of all our imports. It is our view that the price of commodities will stay elevated. Depending on how the U.S. deals with its fiscal problems will have a large impact on the value of the dollar. From a near-term perspective, these elements will put upward pressure on inflation. Unless the global economy slows by a significant amount, our expectations for intermediate- to longer-term inflation trends will be the same as well.
2. Part of your investment process also asks if the current level of bond yields compensates for government fiscal and monetary policy risks (which also have implications for inflation). Recent debt-ceiling debates in the U.S. and sovereign woes abroad have put sovereign fiscal and policy risks into sharp relief. How would you characterize the current level of government policy risk? Are there any imminent governmental actions that you think could drastically increase or decrease that risk?
Government fiscal policy risk has accelerated as of late. The prospects of a credit downgrade are now at 50/50 according to S&P. If this downgrade were to occur, it would be because the federal government failed to come up with a credible plan to reduce the current budget deficit and implement a plan to reduce the amount of government debt relative to GDP. This inaction would mean, in our view, that these two problems continue to get worse.
The current level of Treasury interest rates does not compensate a prudent investor for that risk. The prime reason for the low level of rates is the fact that the Federal Reserve Bank is now one of the largest owner of Treasuries in the world. The Federal Reserve Bank has stated that its goal is to prop up the price of Treasury notes and bonds. This is being done by creating excess reserves in the banking system. Some are calling this practice printing money to buy Treasuries. In our view this is not a long-term strategy for keeping Treasury bond prices high or yields low. This type of manipulation of financial markets does not create fundamental value for these securities, which is why we find no value in intermediate to longer maturity government bonds.
3. Part of your investing philosophy is focused on achieving an absolute yield (including relative to inflation), yet another part is focused on capital preservation. However, in today's low-yield environment, getting a decent real yield seems to come only with much attendant interest-rate or credit risk. Are you finding it difficult to execute both objectives--capital preservation and absolute yield--in the current market?
With a Federal Reserve policy that is designed to flood the system with excess reserves (money), set short-term interest rates at a negative real yield, and tries to increase the level of core inflation, managing a bond portfolio to achieve not only an absolute positive return but one equal to inflation is difficult. That said, we start our process by making sure we can accomplish the absolute positive return first. If we can protect our clients' capital, we know that over the long term we will find investments that provide a return greater than inflation while not undertaking undue credit or duration (interest rate) risk. While this is difficult to accomplish from a real return perspective today, we can find bonds that pass both these tests. We find that to do this, we need to look to smaller issuers. These issues can still have attractive yields because of their lesser liquidity. We have been able to do our homework on these smaller issuers and get comfortable that the downside is adequately protected.
4. TIPS are one investment that offers explicit inflation protection, but we've also seen some real yields dip into the red in 2011. What is your take on the attractiveness of this asset class for inflation protection today?
Historically an investor should accept a real return from Treasury bonds and notes in the 2.5% to 3% range. At today's negative real yield for 7 year and less maturity TIPS, we see no value in these securities. At 50 basis points in real yield for a 10-year TIPS bond, there is also no value. The recent debate over the deficit has included discussions of reducing the cost of living adjustment in items such as Social Security payments. At this point, we are not sure if that would include how the CPI is calculated, which would result in reducing the inflation component of TIPS bonds. For these two reasons, we see no value in TIPS bonds today.
5. Your fund is almost entirely domestic based, though it can hold up to 25% in securities of foreign issuers. Given the inflation concerns weighing on the dollar, why such limited overseas exposure?
Non-dollar bonds could offer a good diversification away from the dollar and potentially of better government fiscal policy. The challenge is to combine better finances with a level of yield that compensates us for interest rate risk and the added complexities associated with investing in a foreign country or company. That being said, we continue to research this area of the bond market for potential opportunities.