We have covered this issue extensively (some might argue exhaustively), in recent times, but in the light of the move above the psychologically important (to some), 3% level in US 10-year bond yields it might be worth looking at the issue afresh, this time from a slightly broader perspective.
The Fed continues to look to raise interest rates, reaching 1.75% last March, with no signs of them deviating from this path, as new Chairman Jerome Powell aims to “normalise” monetary policy from the crisis era nadir of 0.25%.
Meanwhile, Governments, Corporates and Individuals are still amassing record levels of debt, totalling c.$217 trillion as of the end of 2016, (according to the IIF), which represents 327% of Global GDP (and up over $50 trillion in the last 10 years). This, despite repeated warnings from the Institute of International Finance, the IMF about the risks being run by Corporations, Individuals as well as States over their debt levels.
Investors have noticed and have been selling bonds across the Globe; the Barclays Global Aggregate bond Index has fallen 7.8% in Sterling terms since October 2016 and has risen a scant 0.62% in Dollars. (Coupon rates are around 2% per annum, implying a capital loss over this period).
The pro-growth spending plans of Trump (and the consequent rise in government deficits that this implies) are known (and thus should be already in prices); are bond naysayers missing the big picture?
Several high-profile investors such as Bill Gross and Hedge fund manager Jeffrey Gundlach (of Doubleline Capital) have recently backed away from their previously bearish views on bonds, whilst Lacy Hunt has gone one stage further, arguing that the extremely high debt levels have created a law of diminishing returns – as the costs of servicing the debt rises, it restricts cash flows, slowing growth and thus leading to lower interest rates once again. The debt is far too large to allow a write-off, (a so-called debt re-set, favoured by many on the Left of the political spectrum) as it would bankrupt the financial system (which would of course be hyper-deflationary). His solution? “an extended period of living within our means” (which is another way of saying “I wouldn’t start from here”), and is a political non-starter, as recent events in Italy are demonstrating. Whether we like it or not, electors do not have any desire to take meaningfully action.
Central Banks have “bought time” via their almost unlimited QE programmes of the last decade, but little reform, (and thus no real benefit), has been garnered by their policies and we appear to have reached the limits of money-printing; if they were to withdraw almost any of their stimulus, the “house of cards” could collapse. Will they allow a correction in what appear to be over-valued asset markets? If they do, the deflationary effects would be exacerbated, leaving investors with few (non-bond) alternatives. If they do not, (the more likely scenario involves yet more money printing and even Central Bank outright buying of equities as in Japan), the possibility is that Mr Hunt’s thesis will be played out on a slightly longer timescale.
3-month US bills currently yield 1.86% (even after a strong surge this week), compared to 1.84% for the S&P 500, marking the first period for a decade where investors can (with virtually no risk) achieve a better yield in short-term bonds than in stocks; furthermore, the 2-year US bond is at 2.43% announcing the end of the TINA (There is No Alternative) era for stock investors. This situation is not yet present in Europe, the UK or Japan (courtesy of Draghi et al), but once investors sense a change on the mood music for equities, the “flight to safety” will begin in earnest.
The much-vaunted “death” of the bond market may therefore be somewhat of an exaggeration (to paraphrase Mark Twain. Other factors, primarily the aging populations of the Western world but also the seemingly intractable decline in productivity growth argue not for an inflationary spiral, but a more prolonged economic stagnation, leaving bonds once more as the “cleanest dirty shirt in the laundry basket”.
Whether this leads to falls in equities is an open question, (recent price action is inconclusive for now), but NOT owning bonds may be a bigger risk than being long shares at present. We believe that bonds are the investment equivalent of water (to equity market whisky); they dilute portfolio risk caused by being invested in equity assets. We do not claim to know which asset class will do best, so we aim to own as many as is practically possible; provided they have a low correlation between them, risk is thereby reduced without meaningfully impacting expected returns. That way, both we and our clients can sleep at night.
About the Author
Alistair Meadows is a veteran of stock markets having started his career in the City of London during the heady days of the mid 1980s. After 10 years he moved into (active) fund management in 2000. He repented of his ways and joined EBI in 2014 and is now responsible for helping advisers and investors get the same flow of timely information and quality analysis that is available to professional investors. He qualified as a Chartered Financial Analyst in 2005 and refreshed his skills in 2015 by gaining the Investment Management Certificate. He can be contacted at firstname.lastname@example.org.
The views expressed in this article are the author’s own and not necessarily those of EBI Portfolios Ltd.
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