James Bevan: Is 12 July a special day?

Another Sunday with Greece in focus, and there’s that sense that we’ve been here many times before – just as we have on other topical issues such as the debates on Britain/Brexit/Scotland, and the people vs their states in Europe, and the ultimate risks that flow from political re-organisations and complacency.

Thus looking back to 12^th Julys in years gone by, we can see that in 927, Æthelstan, then king of England secured a pledge from Constantine II of Scotland that the latter wouldn’t ally with the Vikings, and thus began process of unifying Great Britain.

More recently, in 1789, French revolutionary and radical journalist Camille Desmoulins gave a speech in response to the dismissal of Jacques Necker, France’s finance minister, the day before. The speech called the citizens to arms and led to the storming of the Bastille two days later. Just twelve months after that on 12^th July 1790, France passed its Civil Constitution. There followed years of change and turmoil that stretched way beyond Europe – for example on 12^th July 1812, the US invaded Canada.

So, when we look at the current turbulence, imbalances and fault lines in global economies and markets, although in many ways they are unprecedented in scale and complexity, we do have some evidence as to what to expect – and most of our ‘building block’ models and frameworks say it is too soon to abandon a preference for equities on a 12-month view.

Thus, QE has kept the Equity Risk Premium (ERP) high – leaving plenty of room for it to fall. In theory this could come more via a jump in bond yields rather than strong equity returns, but a low nominal growth world is not conducive to a big rise in bond yields. Current ERP levels are consistent with equities’ outperformance versus bonds, especially in Japan, where bonds now look vulnerable and are held up only by the Bank of Japan.

A 10%+ correction in global equities over the summer is on the cards but any further pullback should be short in duration based on bond markets conditions, the current gap between OECD real M1 money supply growth and industrial output growth is also a positive signal for equities over the next year.

Again looking back through history, the 1950s may provide a possible roadmap for what could happen when policy rates are first raised, and then normalized, after a long period of “financial repression”: with rates rising slowly in nominal terms (and not at all in real terms), bondholders did not lose out in absolute terms, but suffered relative to equities.

The “mid-cycle” stage of the business cycle – where most of the major developed regions have been residing – is one in which equities tend to outperform bonds – but were the US to move clearly into “late-cycle”, the attraction of equities versus bonds would diminish based on historical comparisons. However, this time round, “mid-cycle” has been different in many respects (economic variables, policy, relative asset performance) from previous “mid-cycle” phases so historical “late-cycle” comparisons will not apply directly and we will need to keep an eye on a broad range of developments that will effect economies, companies and equity pricing.

Turning to bonds, against a backdrop of QE, a lack of new supply has been helping to depress major government yields. But the lack of a term premium in the curve means the risk/reward trade-off is poor and we will stay underweight government bonds in balanced mandates with strategic focus. Bonds still look risky and during the “Bund shock” of April/May,  long German bonds (10+ years) lost more in a three-week period than any G3 market since at least 1992. This may have a lasting impact on how longer-term investors view bonds, providing gradual upward pressure on term premia.

One of the issues is that with bonds, this time it really is different and with bond yields so low, for multi-asset portfolios, not only are potential returns dire, but the role of bonds as a risk diversifier is suspect. Thus, when coupons are near zero, there is little buffer to offset price risk.

Secondly, the recent rise in bond volatility relative to equity volatility looks to be part of a longer-running trend. Putting a five-year moving average through the ratio of the 60-day realized volatility of the German 10+ year index relative to that of the Dax, it bottomed as long ago as 2005. In the US, long bond (returns) vol has been trending up relative to equities for even longer.

Thirdly, the negative correlation between bonds and equities may have passed its peak. Fourthly, even where bonds/equities remain negatively correlated, risk and portfolio managers need to watch for signs that the beta of bond returns to equity declines is weakening as has been the case in Japan in recent years after yields dropped near to zero.

A connected issue is that in a financially-repressed world, investors will continue to search for yield. Bond investors will reasonably focus on where the curve is steep, credit risk low or improving, and real yields high (or where inflation or nominal GDP growth should trend lower without harming credit risk). Bond investors may therefore look at Indian bonds – but actually good quality equities have these desirable qualities and a lot more besides.