James Bevan: The bond market ‘supernova’
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James Bevan
Central bankers have been fighting price deflation even though this is quite a normal force in periods of peace with technological change and free trade. During wartime, inflation prevails because there is much less competition and resources are depleted.
In the current chapter, central bankers also face adverse demographics, with populations around the world aging rapidly with lower fertility rates and greater longevity, and older consumers typically spend less than younger ones.
With central bankers seemingly unable to deliver stronger growth, there’s increasing talk of protectionism which would damage not support growth, and market participants have increasingly sought to position for disaster.
Gross warning
Bill Gross has recently warned that central bank policies that pushed trillions of dollars into bonds with negative interest rates will eventually backfire violently.
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8th Local Authority Treasurers Investment Forum
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Thus, last Thursday, Gross tweeted, “Global yields lowest in 500 years of recorded history”. He added, “$10 trillion of neg. rate bonds. This is a supernova that will explode one day.”
Gross has argued for some time that the economy is at the end of a decades-long cycle of expanding credit that has culminated in negative interest rates, which he sees as unsustainable. Rather than spurring economic growth, low rates are promoting asset bubbles as investors reach for higher yields while punishing individual savers and industries that rely on interest rates, such as bank and insurance companies.
George Soros. Photo: Noccolo Carranti, Flickr
Meanwhile the 9th June WSJ reported: “After a long hiatus, George Soros has returned to trading, lured by opportunities to profit from what he sees as coming economic troubles. Worried about the outlook for the global economy and concerned that large market shifts may be at hand, the billionaire hedge-fund founder and philanthropist recently directed a series of big, bearish investments, according to people close to the matter.”
Soros is bearish on China and told the WSJ in an email: “China continues to suffer from capital flight and has been depleting its foreign currency reserves while other Asian countries have been accumulating foreign currency. China is facing internal conflict within its political leadership, and over the coming year this will complicate its ability to deal with financial issues.”
Soros is also bearish on the European Union. He argues that there’s a good chance the EU will collapse under the weight of the migration crisis, continuing challenges in Greece, and a potential exit by the United Kingdom from the EU.
“If Britain leaves, it could unleash a general exodus, and the disintegration of the European Union will become practically unavoidable,” he says.
Central bank tidal wave
Then there are those who have been constructive but who have lost patience. Thus in a spech on 4th May at the Sohn Investment Conference, Stanley Druckenmiller stated: “Three years ago on this stage I criticized the rationale of Fed policy but drew a bullish intermediate conclusion as the weight of the evidence suggested the tidal wave of central bank money worldwide would still propel financial assets higher.
“I now feel the weight of the evidence has shifted the other way; higher valuations, three more years of unproductive corporate behavior, limits to further easing and excessive borrowing from the future suggest that the bull market is exhausting itself.” He warned: “While policymakers have no end game, markets do.”
Nervous investors are buying high-quality bonds and gold, and shorting stocks. The price of gold has risen 21.5% since its most recent low on 17th December.
Even more startling (though not surprising to us) is the drop in the 10-year Treasury yield down to 1.64% on Friday. The proliferation of near-zero and negative interest rates in Euroland and Japan has significantly reduced the cost of financing gold positions and it has also increased the gravitational pull on US bond yields.
So far, global stock prices have yet to confirm the dire outlook, but that’s mostly because of the strength of the US MSCI stock price index, which is only 2.3% below its record high on 21st May 2015. Excluding the US, the World MSCI (in local currencies) is down 20.2% from its record high on 11th October 2007.
Also belying the imminent endgame scenario is the narrowing yield spread between high-yield corporate bonds and the US 10-year Treasury.
Recession fears earlier this year have abated, increasing the attractiveness of high-yield securities to all those investors who continue to reach for yield in a world with more and more bonds providing negative returns.
TINA
Stepping back to see the big picture, central bankers have been hoping that by providing ultra-easy monetary policy, their economies can achieve “escape velocity” so that they can begin to normalize their monetary policies. That hasn’t been working well, so they’ve provided additional easing, and notwithstanding the bearishness, there are grounds for expecting the S&P500 to make new record highs over the next 12 months.
In his speech cited above, Druckenmiller bemoaned: “Not a week goes by without someone extolling the virtues of the equity market because ‘there is no alternative’ with rates at zero. The view has become so widely held it has its own acronym, ‘TINA.’”
Furthermore, he predicted this will all end badly: “The Fed’s objective seems to be getting by another six months without a 20% decline in the S&P and avoiding a recession over the near term.
“In doing so, they are enabling the opposite of needed reform and increasing, not lowering, the odds of the economic tail risk they are trying to avoid. At the government level, the impeding of market signals has allowed politicians to continue to ignore badly needed entitlement and tax reform.”
But as I recently discussed with Nick Cavalla, CIO of the Cambridge Endowment, although this may seem logical and scary, long-term investors with real liabilities won’t want to speculate on gold (and we agreed that it was a speculation as it produces no cash flow for investors) and a portfolio manager would have to be very bearish and very confidant of that bearishness, to raise lots of cash, particularly with interest rates so low.
Our shared view is that stocks, particularly dividend-yielding ones, remain attractive, even with valuations relatively high and renewed anxiety about an imminent endgame, especially if the UK votes Brexit.
In any event, the big buyers of stocks during the current bull market haven’t been individual or institutional buyers.
They’ve been corporations buying back their own shares or the shares of other corporations through M&A deals.
Very low interest rates continue to favour those types of corporate finance activities, and over the past four quarters, net equity issuance in the US was -$374bn, with non-financial corporations accounting for $591bn of this total.
Still reporting net positive equity issuance at $165bn were financial corporations, but that was all attributable to new ETFs.
Net equity issuance in the US by the rest of the world fell from a four-quarter record high of $549bn during
Photo (cropped): Curtis Garbutt, Flickr
Q2 2015 to $52bn over the past year through Q1 2016. While S&P500 buybacks remained high during Q1 and over the past four quarters, gross stock issuance, which the Fed compiles monthly, fell sharply over the past year through April.
Meanwhile, monthly data compiled by Investment Company Institute show that equity mutual funds have had a $29bn net monthly outflow over the past year through April, while equity ETFs have attracted $140bn, and over the past four quarters, institutional and foreign investors have been net sellers of equity, totalling $193bn and $206bn, respectively.
Endgame
As for central banks, I doubt that the Fed will ever purchase US equities, but we can’t rule out that scenario. The BOJ has been buying equity ETFs for some time now. The ECB started buying corporate bonds last week.
Betting on the endgame scenario is the same as betting against the central banks. That’s been a bad bet so far. One day it might work, but don’t forget that Yellen/Draghi/Kuroda have an unlimited supply of dollars/euros/yen, and are willing to spend them.
Betting with the central bankers might continue to make more sense than betting against them with Gross/Soros/Druckenmiller. The one requirement for sane investing in this environment is to stick to quality growth, where free cash flow is a heady multiple of cash rates and bond yields, and where companies can deliver growth even in an environment of low real growth and ongoing deflationary pressures.
James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla
*CCLA is a supporter of Room151
Photo: Niccolò Carranti, Flickr.
