There wasn’t much to ‘Like’ in the financial markets last
week as stocks took a hit on another round of global worries. High on the list
of concerns were:
·
Continuing anxiety over Greece’s
ability to avoid default and remain in the euro.
·
Rising borrowing costs for Italy and
Spain.
·
Ongoing fears of an economic
slowdown in China.
·
Loss of faith in the banking system
due to JPMorgan’s $2 billion (and growing) bad bet.
·
A very tepid response to the highly
anticipated stock market debut of Facebook.
Source: CNNMoney
Investors are particularly frustrated that the European debt
situation keeps popping up like dandelions. After two years and 17 euro zone summits,
the issue is still not resolved. In fact, it might be worse than ever as Europe
is quickly running out of road to kick the can down, according to BusinessWeek.
Greece is at the epicenter of this worldwide concern despite
the fact that its population is less than the state of Ohio. Like the subprime
crisis before it, investors are concerned that Greece may be the falling domino
that kicks off a series of undesirable effects. If Greece has a disorderly
collapse, it could spread to other weak European countries and then ripple out
to the rest of the world.
Unfortunately, the time for easy solutions has long passed.
Central banks and governments around the world have already added trillions of
dollars to their balance sheets so they don’t have much room to maneuver. And,
here in the U.S., we have a potentially bruising election and looming tax and fiscal
matters to deal with by the end of the year.
When you add it up, 2012 is on track to be another dramatic
year in world affairs.
WOULD YOU GIVE YOUR MONEY
TO THE U.S. GOVERNMENT for 10 years and lock in a negative
yield? Well, that’s exactly what happened last week as investors handed over
$13 billion to the government and, in return, received 10-year Treasury
Inflation Protected Securities (TIPS). These securities were sold at a record
low negative
yield of 0.39 percent, according to The
Wall Street Journal.
TIPS are a bit different from traditional government
securities because, “The principal of a TIPS increases with inflation and
decreases with deflation, as measured by the Consumer Price Index. When a TIPS
matures, you are paid the adjusted principal or original principal, whichever
is greater,” according to the Treasury Department.
Now, why would anybody buy a TIPS with a negative yield when
they could buy a traditional 10-year government security with a yield of about
1.7 percent last week? The answer lies in the difference between the two
yields.
As reported by Bloomberg, the yield difference between a
10-year TIPS and a comparable 10-year Treasury security was 2.04 percentage
points on May 17. Analysts call this the “break even inflation rate.” It means
investors were expecting inflation to average 2.04 percent over the next 10
years. When you add the 2.04 percent expected inflation rate to the negative
0.39 percent yield of a TIPS, you get close to the yield of a traditional
10-year government security.
From an investment standpoint, if inflation averages more
than 2.04 percent over the next 10 years, then owning TIPS might be a better
deal than owning the traditional 10-year government security. Likewise, if
inflation averages less than 2.04 percent over the next 10 years, then owning
the traditional 10-year security might be better, according to The Vanguard
Group.
With its built-in inflation protection component, TIPS are
traditionally viewed as a hedge against inflation rather than a play on
interest income.
As an advisor, it’s important for us to know the break even
inflation rate that is embedded in TIPS. Knowing the market’s best estimate of
inflation provides data we can use to help us value and analyze other
investments that may be affected by changes in investors’ inflation
expectations.
Weekly Focus – Did You Know…
There is only one word in the English language with all five
vowels in reverse order. Try to guess what it is before reading below for the
answer.
The answer is “subcontinental.”
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