July 24, 2018 glacierinvest

Reality can be a tricky concept for most of us. We’ve all heard the saying, perception is reality. That may be true for an individual or group of individuals, but it may not actually be the case in the real world. Separating our biases from reality and viewing the world as it truly is is challenging. Whether we’re influenced by politics, religion, education, our profession or anything else, we have inherent biases that shape how we view the world and how we respond to certain situations. Additionally, we develop blind spots that we often aren’t even aware we have. All of these factors contribute to a foggy sense of reality at times and can make it difficult for anyone of us to accept reality and make decisions based on reality.

I’ve had several conversations recently with family, friends and clients about reality and how important it is for us to understand and accept reality. With a proper understanding, we can improve our decision making and ultimately the outcomes in our lives. It’s hard work to train our minds to recognize and accept reality as well as to iterate within our personal decision-making frameworks to the point where we begin to achieve the outcomes we desire for ourselves, our families, our businesses, etc… Patience, perseverance and consistency are essential attributes.

I often find myself forming strong opinions based on by upbringing, my biases or based on what I discover through my own personal research. It’s only after I’m introduced to conflicting information or viewpoints that I begin to earnestly seek to challenge my views in an attempt to discover what reality actually is.

For example, I had a very strong opinion for years that interest rates weren’t going up much, if at all. This was based on several factors including demographics, easy monetary policy and my view that economic growth would be structurally lower for the foreseeable future partially as a result of demographics and partially as a result of lower labor productivity. Well, this view changed to some degree when the Fed announced its intentions to begin shrinking its balance sheet. Since that point, monetary policy has become increasingly restrictive (still not bad though), inflation expectations jumped for a period of time, settled down and may be on the rise again if tariffs actually go into effect and overall projected U.S. debt levels are expected to be higher thanks to spending and tax bills. The demographic situation appears to be the same and while I’m not an expert on labor productivity, automation is becoming increasingly pervasive, which is putting downward pressure on labor productivity.

So with all of that said, are interest rates moving higher from here or are they moving lower or are they standing pat? I can see a reasonable pathway to all outcomes. I believe there are strong forces on both ends that are pulling on rates in their respective directions (up and down). Will these forces cancel each other out? Will one win out over the other?

Nobody really knows the answer to that but most people are fairly bearish on bonds right now. According to the Wall Street Journal, speculative bets against U.S. Treasuries have been increasing, meaning many investors believe rates are going higher from here. I’m guessing rates will probably move higher from here but probably not as quickly or as high as many might expect.

If rates do move higher I wonder if that ends up having a more negative impact on stocks than it does on bonds? Additionally, with so much negative sentiment towards bonds in 2018 I wonder if  investors are currently underallocated to bonds? I realize bonds may be in for a tough stretch but most people don’t own bonds because of their high returns. They own bonds for income and diversification purposes. The counter to the diversification argument by some is that stock and bond correlations may increase in a rising rate environment. That may end up happening, but bond volatility and drawdowns have historically been a lot lower than stock volatility and drawdowns. For most of us, we need that lower volatility and lower drawdown component to help us keep our cool  and sleep at night during a correction or bear market.

Interest rates may be headed higher. Bonds may be in for a rough patch or even a bear market. However, using history as a guide reality would suggest most of us still need to own bonds to maintain our financial sanity and possibly our financial security.