Dan Fuss’ career in the bond market has spanned over 50 years. During that time, Fuss has spoken regularly at CFA luncheons. Last week in Boston, he began by warning that what he had to say would be markedly different from any of his previous talks.
Fuss is vice chairman of Boston-based Loomis Sayles and manages the firm's flagship Loomis Sayles Bond Fund (LSBDX).
Fuss analyzes the economy and the bond market along four dimensions – the “Ps” of peace, people, politics and prosperity. Those considerations, however, no longer suffice to explain the market’s underlying dynamics.
A fifth dimension now dominates his thinking: the expanded role of the world’s central banks over the last two years.
I last heard Fuss speak in October 2013, when he predicted that rates would rise – causing his fund to miss the full benefit of last year’s bond rally. In April 2012 he made a similar, but incorrect, prediction.
Let’s look at Fuss’ current forecast for rates, his assessment of his four Ps and how the role of central banks has changed his thinking.
Peace or lack thereof
Peace – or lack thereof – is far and away the most important force shaping future outcomes, Fuss said, with an impact that extends beyond the markets. The U.S. Treasury’s borrowing requirements are dictated by the federal deficit, over which defense spending exerts an outsized influence.
Defense spending as a percentage of GDP has been coming down gradually over the last few years, Fuss said, and will be approximately 3.3% for the current fiscal year. The most recent budget proposal notched it up a bit, he said. Fuss attributed the decline to a decrease in the size of our armed forces and equipment to support them.
“Defense spending has not placed pressure on the budget,” he said, “despite the fact that a deficit is forecast.”
But how realistic is the proposed defense budget? According to Fuss, things changed about a year and a half ago due to the developments in the South China Sea, which were followed by events in Middle East and then by the uprising in Eastern Europe. “This could require an expanded call on the military,” Fuss said.
“From a laymen’s view,” he said, “the forecast is very unrealistic by as much as 1%. The external pressures on the U.S. and the rest of the world have grown remarkably in the last two years.”
The result is that the Treasury will need to borrow more money to finance a larger deficit, but Fuss said he doesn’t know how much more.
People
Demographics weigh heavily on Fuss’ thinking. He noted recent news reports that pensioners in the United Kingdom will face a lower standard of living and that population growth was driving an increase in healthcare costs in parts of Asia.
Fuss discussed the history of entitlement programs, beginning in 19th century Europe. The implementation of those programs in the U.S. had been very successful, he said, until the 1960s. That was when, in the U.S. and many other large developed countries, population demographics changed. Instead of a pyramid, with a smaller number of old people at the top and large numbers of the young at the bottom, a bulge emerged in the center. As that bulge – representing, in part, the baby boomer generation – moved upwards, entitlement programs were pressured. Japan’s demographics are worse than those in the U.S., Fuss said, and Europe’s are close to Japan’s.
Intensifying the issue, Fuss said, the benefits offered by social programs have expanded coincidentally with worsening demographics.
“The real thing is not defense spending,” Fuss said, “it is spending on ourselves.” His concern is the demand entitlements place on the budget, and he carefully noted that he was not making a political statement.
This is mostly an issue for future generations, according to Fuss. It is unlikely that benefits will ever be reduced, according to Fuss, although Social Security is easier to reform than Medicare. “At the current pace of cost progression, which is not very heavy, the percentage of GDP going to support old folks and others is going to rise and we can’t do much about it,” Fuss said.
As a result, the government will need more revenue (i.e., higher taxes) or greater Treasury borrowing – the latter, he said, is a “slam dunk,” given low interest rates.
Barring a major change, Fuss said the U.S. won’t run a budget surplus; the Treasury will make further demands on the capital markets.
Politics and prosperity
Fuss said the U.S. economy is in a “reasonable recovery,” and he forecast approximately 3% real growth. Outside the U.S., however, growth is hard to find.
Fuss expects growth in Europe to be flat to -0.1%, and Japan to be “flat at best” (real growth per capita, however, will be positive). Other parts of the world are growing but slower than in the past, he said. “The world is slowing.”
Fuss said that Treasury borrowing will be influenced by federal revenue. During the second half of the 1990s, he said, the percent of workforce receiving a paycheck after withholding rose, according to Fuss. That was never fully explained, he said, but it was true for both men and woman. Starting in 2000 “it went other way.” Now, Fuss said, for certain cohorts of the population, it is turning again and after-tax pay is increasing. “Quite remarkably,” he said, “pay is growing for older folks, as well as for the cohort just younger than them.” For other cohorts, however, Fuss said pay continues to decline.
Barring a repeat of the second half of the 1990s, Fuss said we’re going to live with a Treasury deficit and more borrowing. It will be worse if the economy weakens, he said, and it is unlikely the Fed will tighten in the context of geopolitical stress. “The world is a less friendly place.”
As an example of that unfriendliness, Fuss assigned a lot of significance to events during the formal ASEAN meeting in Tokyo in December 2013. The Bank of Japan said that it had set up 10 bilateral currency swap loans with each ASEAN member immediately after China made ominous statements about South Asian Seas. The Bank of Japan, according to Fuss, said its move was in case of a substantial withdrawal of funds from other countries and to avoid a repeat of 1998 Asian crisis. Indeed, Fuss stated, there was a lot of distress in Thailand, including rioting, which caused it to draw on those lines.
Those developments were a harbinger of an emerging crisis in Asia, one of several hot spots that concern Fuss.
The central bank factor
In the U.S., interest rates are at or near an all-time low, Fuss remarked, and are coupled with low unemployment and low inflation. The Fed knows that higher rates will pose a debt-servicing burden on the Treasury, Fuss said.
“My guess is that our central bank will keep pointing toward employment and to low inflation for now,” he said, “and it will say ‘we’re not quite there.’”
“My suspicion is these are very responsible people who are well aware of the situation in the rest of the world and will lag their response,” Fuss said. The only thing that might stop the Fed from maintaining lower rates would be Congress forcing them to act otherwise.
“At some point rates will start up,” Fuss said. “Darned if I will sit in 30-year Treasury bonds.” Fuss will substitute specific risk for market risk in the meantime. He also said the bond market is far less liquid than five or ten years ago.
He is maintaining a duration in his fund approximately five and an average maturity of 6.5. But, he said, three years ago, its maturity was 13 and it has been as high as 19 “a long time ago in a less protective time.” Approximately 20% of his fund is rolling over in short Treasury securities. He admitted that was not a “smart idea” in 2014 and acknowledged he missed an opportunity in long-term Treasury bonds.
“The events of the last two years have been scaring us,” Fuss said.
Read more articles by Robert Huebscher
Dan Fuss’ career in the bond market has spanned over 50 years. During that time, Fuss has spoken regularly at CFA luncheons. Last week in Boston, he began by warning that what he had to say would be markedly different from any of his previous talks.
