Please find below the latest update from Adrian Tout from his regular newsletter, “Trade the Tape”.

Please note that this is for general information only and should not be considered personal financial advice.

The purpose of publishing these newsletters on the Ethical Offshore website is to provide investors some simple, easy to understand technical details on why the US markets are behaving the way they are at the moment, what has occurred to get them where they are, and what actions may influence where they end up in the near future.

The way Adrian Tout explains all this, in simple terms, I believe is good reading for any investor to get a better understanding of what is happening within the financial markets, what risks to be aware of and how to take advantage of these market conditions for your medium to longer term investment journey.

August 6, 2023 – Adrian Tout

Buffett is Buying Bonds

• Why fixed income is very well placed here

• Buffet is buying tens of billions in bonds

• Quick update on my 2 favoured bond ETF’s

Warren Buffett is pouring tens of billions of Berkshire money into short and longer-term bonds. 

And I’m not surprised…

For example, July 9th I offered this post “Think About Adding Bonds”

Shorter term bills were offering investors ~5.50% and the longer-date 10-year bond above 4.0%

That’s extremely attractive.

Here’s another way to frame it… 

With the S&P 500 trading close to 4600 (at the time) – the Index would need to trade ~4850 over the next 12 months to offset what you can receive risk fee. 

Now with earnings expect to come in around $220 this year – and perhaps $235 next year (which assumes we avoid a recession) – that’s 2024 PE of ~21x

From mine, that’s a high bar (and not without risk)

For example, if we are to suffer a recession in 2024 (my base case) – then earnings of “$235 per share” will not materialize. 

Do you think we can rule-out either a recession or slow-down?

I don’t. 

So why not secure between 4.00% and 5.50% with some of your portfolio?

That’s exactly what Buffett’s Berkshire Hathaway decided to do… 

Smart. 

US 10-Year Above 4.00%

Warren Buffett told CNBC he is actively adding exposure to both treasury bills (shorter duration); and longer term bonds. 

In an interview with CNBC’s Becky Quick last week – Buffett said:
 

“We bought $10 billion in U.S. Treasurys last Monday. We bought $10 billion in Treasurys this Monday. And the only question for next Monday is whether we will buy $10 billion in 3-month or 6-month” T-bills.

For those less familiar – T-bills are shorter-term. Bonds are longer duration. 

Personally, I think Buffett’s timing is quite good. 

And whilst I think there is every chance yields could trader higher (i.e. bond prices fall) – Buffett is securing very attractive risk-free long-term returns. 

If nothing else, it also acts as a great hedge in the event things turn negative. 

And if we do happen to enter a recession next year – the capital appreciation on those bonds will increase meaningfully. 

But let’s take a look at the all-important US 10-year yield:

Aug 6 2023

Last week, these yields traded as high as 4.22% – as high as we’ve seen since October last year.

Towards the end of the week – they pulled back closer to 4.0% (which resulted in stocks catching a small bid)

Again, my feeling here is they could easily go higher.

For example, one scenario is these yields surge above 5.0% (also ~61.8% outside the distribution I’ve flagged) – which would likely see stocks trade meaningfully lower.

I would be surprised if that were the case – but you never know. 

However, this is a bet billionaire investor Bill Ackman is willing to make… 

Bill Ackman sees Long-Term Yields Surging

Ackman thinks bond yields still have a long way to go… 

He believes inflation will be far more persistent than what the market is pricing – betting the US 30-year yield will trade at 5.50%

Today the US 30-year treasury trades at 4.20%

Put another way, Ackman sees bond prices crashing… 

From CNBC:
 

“We implement these hedges by purchasing options rather than shorting bonds outright,” Ackman said late Wednesday. “There are many times in history where the bond market reprices the long end of the curve in a matter of weeks, and this seems like one of those times.”

Ackman argued that if U.S. inflation is 3% in the long term instead of 2%, 30-year Treasury yields could hit 5.5% “and it can happen soon.”

“I have been surprised how low US long-term rates have remained in light of structural changes that are likely to lead to higher levels of long-term inflation, including de-globalization, higher defense costs, the energy transition, growing entitlements, and the greater bargaining power of workers,” he said.

Ackman pointed to several factors including the desire of China and other countries to decouple financially from the U.S., growing concerns about U.S. governance, fiscal responsibility and political divisiveness — the latter three issues prompted the latest Fitch downgrade.

“I have also been puzzled as to why the (U.S. Treasury Department) hasn’t been financing our government in the longer part of the curve in light of materially lower long-term rates,” Ackman said. “This does not look like prudent term management in my opinion.”

Now Ackman could be right… however it will be disastrous for equities if he is. 

Further to what I outlined last week – the market is bracing for a deluge of new (longer-term) treasury bonds being issued from the US government. 

Deutsche Bank strategist Steven Zeng said in a recent research note he expected net bill issuance of $400 billion in June, followed by $500 billion between July and September.

In total, Zeng estimated $1.3 trillion in net bill issuance by the end of the year.

Investment firm Glenmede added that this influx of funds into Treasury securities in the coming weeks may have the adverse effect of reducing overall liquidity (e.g., as investors like Buffett take money out of the market to take advantage of these yields) 

Again, if true, that could be a negative for equities. 

Two Bond ETFs to Watch

Last week I was adding to my bond exposure as yields rose. 

In other words, I was taking the opposite side of the trade to Bill Ackman. 

I chose to do this via two bond ETFs 
 

• AGG – iShares Core U.S. Aggregate Bond ETF (note: similar ETF is LQD)
• EDV – Vanguard Extended Duration Treasury ETF (note: similar ETF is TLT)

Again, I talked about the composition of these (low cost) bond ETFs here. 

With the sharply higher move in yields – both ETFs were marked down to what I think are attractive (long-term) levels. 

1. EDV – Extended Duration Treasury ETF

Let’s start with the long-term chart for Vanguard’s EDV:

Aug 06 2023

When I issued the post ‘Think About Adding Bonds’ – I suggested there was no need to rush into this trade. 

My expectation was the Fed would not only raise rates – but also use more hawkish language – sending yields higher. 

However, US yields also got a surprise boost from the Bank of Japan, allowing their interest rates to go higher. 

The ETF subsequently dropped from $82 (when I wrote the post last month) down to around $78.91 at the time of writing. 

The long-term low for EDV is around $73 (which we could re-test if yields keep rising). 

However, I think adding some exposure around the current level is a good long-term risk/reward bet. 

Not only do you secure an attractive yield – there is the opportunity for capital appreciation should yields fall (opposite the increased risk of recession and/or economic slowdown). 

And if we see a price closer to $73 – I would add more. 

2. AGG – iShares Core U.S. Aggregate Bond ETF

The other ETF I added exposure to last week was AGG. 

This is quite different to EDV as it gives me exposure to high quality corporate debt. 

Aug 06 2023

AGG also moved sharply lower on the back of higher yields. 

Similar to EDV – I think this also represents a good long-term risk/reward bet at current levels. 

Again, it’s an attractive yield with the likelihood of meaningful capital appreciation next year.

Putting it All Together

Most investors will yawn at the prospect of buying a bond ETF. 

And I get it…

There is nothing exciting about owning fixed income.

But the game of investing isn’t supposed to be exciting. 

It’s meant to be lower risk and boring. 

Now given the staggering ~30% rally in equities over ~9 months – the pathway higher feels narrower. 

What’s more, it’s now laced with risks.

For example, if economic growth and the labor market continues to be strong – it justifies the Fed to continue with rate hikes.

On the other hand, if the economy shows signs of weakening (as we saw with the most recent labor report) – investors will once again start worrying about recession.

Recessions typically mean lower bond yields / higher bond prices. 

My view is economic growth slows into next year – where the ‘long and variable’ lags of the Fed’s higher rates start to bite. 

What’s more, I think banks continue to restrict lending. 

If I’m right (and I may not be) – then bonds are a good hedge. 

For example, longer-term treasury debt (EDV); and high-quality investment grade debt (AGG) offer investors strong yields and a hedge against a weaker economic outlook.

Now if the S&P 500 was trading around ~3800 and interest rates were closer to 3.0% – I would be betting on stocks.

But that’s not the equation… 

We now have the S&P 500 trading at 4478 with an effective Fed funds rate of 5.50%

With earnings per share expected to come in ~$235 next year – the asking forward PE isn’t attractive. 

For me, fixed income looks well-placed at this juncture. 

Regards
Adrian Tout

The above article is for information only. The views of the author or any people quoted are their own and do not constitute financial advice. The content is not intended to be a personal recommendation to buy, sell or hold any specific investment or to adopt a particular investment strategy. However, the knowledge that professional analysts provide can be a valuable additional filter for anyone looking to make their own investment decisions.

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