September 2019
Many readers remember the 1960s TV show The Beverly Hillbillies. Although silly and hilarious, a puzzling and often repeated theme was “Mr. Drysdale’s Nightmare.” With this Newsletter, we revive an analogy originally penned by Andrew Burns 17 years ago to discuss today’s bond market and the prevalence of negative interest rates.
In the show, bumpkins Jed Clampett and his mother-in-law Daisy May Moses (Granny) became sudden millionaires and moved from the Ozarks to Beverly Hills where they deposited their fortune in the local Commerce Bank—Milburn Drysdale’s bank. From time to time, and unannounced, Jed and Granny would show up at the bank asking to see their money … they wanted to count it. Mr. Drysdale would fluster and panic. A ten-year-old watching the show may have sided with Jed and Granny, believing that Mr. Drysdale should have showed them their cash.
What financially aware adults understood then was that banks lend or invest most deposits, keeping just a portion in cash on hand for routine daily withdrawals. In effect, if numerous depositors had shown up to do what the Clampetts were doing, they would have caused a “run” on Mr. Drysdale’s bank.
How Low Can You Go?
In our opinion, the peculiarities of Mr. Drysdale’s deposit woes are analogous to why portions of the global bond markets are so screwy right now with interest rates at rock-bottom levels or, shockingly for trillions of dollars worth of global bonds and deposits, in negative territory. That’s right; in Europe depositors increasingly have to pay their banks to hold deposits. In fact, right now there are $16 trillion in global bonds with negative yields.1 Although not a direct analogy, negative interest rates are on par with paying someone to rent your car.
In trying to determine why this is occurring, it is helpful to consider Germany’s Deutsche Bank, one of the most leveraged dark holes of incalculable risk in modern history. With its name all over the 2008 mortgage crisis, the LIBOR scandal of 2015 and numerous other questionable associations, the bank is slowly unwinding. Close to 18,000 employees are being laid off and the stock has traded off some 92% from its high in 2007. Its 1.4€ trillion in assets are backed by a scant market value of its common equity of roughly 14.2€ billion or a cushion of just 1%.2 Rather than face another 2008 meltdown, Germany and the European Central Bank are thus far handling the Deutsche Bank contraction with guarantees and care—helped by super low interest rates. Let’s hope the proverbial Jed and Granny don’t darken Deutsche Bank’s door because one-quarter of the bank’s liabilities are deposits that can be demanded at any time—which in a panic could be problematic.
Get to Work
Beyond Deutsche Bank, Europe worries because they are, generally, not “out of the woods” yet with relation to the 2008 financial crisis. The European Central Bank is trying to promote economic growth with monetary policy while member countries resist sufficient structural economic reforms. An example where labor markets need reconstituting is France where youth unemployment is 20% while the overall rate is 8.7%. Things are worse in Italy, Spain and Greece. By comparison, American labor markets are far more open so our youth unemployment is 8.3% versus our overall 3.7% rate.3
The strong arm in Europe is Germany who has its house mostly in order but struggles to get its neighbors to behave. Instead, they promote low and negative interest rates to encourage banks and investors to make riskier investments to promote growth. Meanwhile, the mess perpetuates as the question is begged—how do you say “push on a string” in German?
Historically, investors could count on signals from the bond market to help guide allocation decisions. Sadly, the degree of central bank meddling among all major economies including China, USA, Europe and Japan have created monetary distortions that make no sense unless you are a politician looking for economic growth (and votes) at any cost. The European Central bank holds 2.9€ trillion of bonds on its balance sheet4 while the U.S. Federal Reserve has $3.6 trillion.5 Prior to the 2008 financial crisis, these two central banks held 271.2€ million and $500 billion respectively. Just these two central banks alone have “gobbled up” trillions of supply and promise to add more, if needed in their judgement. While economists can surely debate the policy merits good and bad, it would be difficult to argue this isn’t creating a market distortion that has consequences across the globe.
For the time being, we believe a wise investment strategy now might be to seek quality and avoid debt-laden countries and companies. Market distortions can persist for years, but we believe they all eventually unwind, often resulting in temporary “crises.” Those “responsible parties” that remain prudent throughout often end up with the best opportunities to both weather and capitalize on such events.
Let’s Move to the City
The parallel reality is that there remains much to be optimistic about as technology and connectivity spread across the globe, bringing prosperity and “middle-class” conveniences (like brushing your teeth, wearing contact lenses and owning a cell phone) to consumers in developing countries. Identifying companies that can take advantage of that growth, we believe, is well worth our individual stock research efforts as opposed to index strategies that cannot be selective.
As for Mr. Drysdale, Granny once said of him “…he won’t give me my money! He’s been slippery footin’ around here like a hog on ice. If you ask me, he ain’t got it.” We would argue that is a sage observation from Granny and she may have been a good stock-picker herself. These are unusual times, and we will continue to apply Granny’s healthy skepticism as we look for investment opportunities in the coming years.
1) https://www.bloomberg.com/news/articles/2019-08-15/negative-yielding-debt-hits-record-16-trillion-on-curve-fright
2) Factset data as of August 6, 2019
3) Factset data as of August 6, 2019
4) European Central Bank
5) U.S. Federal Reserve