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Archive for the ‘Bond Market’ Category

Inveighing against economic vandalism

Bruce Stout, manager of the Murray International investment trust, whose shareholders have tripled their money over the last ten years, inveighs against the “economic vandalism” of QE and unconventional monetary policy in a interview with me in the latest isssue of The Spectator. His doleful conclusion: “Savers will be watching their savings being eaten away for a long time to come”. You can read a fuller version of the interview, which includes his thoughts on where the best future investment returns can be found, on the Independent Investor website.

Written by Jonathan Davis

November 8, 2014 at 8:47 AM

A pause to this market march?

Andrew Smithers, as he notes in his latest World Market Update, has been saying for ages now that the equity markets are overvalued – but probably going up. In other words, while on long term valuation measures equities are priced to deliver below-average returns over the medium term, in the near term with momentum and other factors, principally central bank monetary stimulus, egging them on, they can easily go on rising for quite some time. (For what it is worth, that has been my basic stance for most of this year too: markets are far more volatile than the fundamental value changes). But is that period now due for  pause?

While we are not yet calling an end to this, we see it drawing to a close. The two key supports for the US stock market are corporate buying of equities and quantitative easing (“QE”). The former is threatened by current fiscal plans and the latter by the need to taper QE should unemployment continue to fall. If the Federal budget is finalised as currently indicated then a decline in corporate cash flow seems highly likely and corporate buying, which has fallen recently, is likely to fall further.

If the current budget is not modified, the economy is likely to slow and this would probably cause the Fed to taper its tapering. If the budget is modified, the impact on corporate cash flow would be reduced but the chances of Fed tapering would be increased. Equities have been pushed up by the combination of corporate buying and quantitative easing. It is possible but unlikely that both will remain in place during 2014.

We all know that equity markets rarely move in a straight line. 2013 has been a great year, with the main US indices driving through their pervious all-time highs early in the year and heading for full year gains of 20%-25%, with almost all the gain coming from positive rerating (higher multiples) rather than from earnings growth. The mid-year “tapering” wobble seems to have passed.  Equity fund flows have been running at their strongest since 2004, with bonds on course to produce a negative return for the year as a whole. A correction would be helpful, though I somewhat doubt we will see it before the second quarter of next year.

Written by Jonathan Davis

November 22, 2013 at 1:17 PM

Emerging markets: an accident that’s been waiting to happen

Stern words today about the roots of the current emerging markets crisis from Stephen Roach, the former chief economist at Morgan Stanley now less stressfully ensconced at Yale University, where  he is a senior Fellow. You can read the full broadside here, but this is a short extract, highlighting how the huge destabilising capital flows into – and now out of – emerging markets can be directly traced back to the policy of quantitative easing. The countries now suffering most are those, such as India and Indonesia, which have run large current account deficits and/or have failed to make necessary structural reforms during the good times:

A large current-account deficit is a classic symptom of a pre-crisis economy living beyond its means – in effect, investing more than it is saving. The only way to sustain economic growth in the face of such an imbalance is to borrow surplus savings from abroad. That is where QE came into play.

It provided a surplus of yield-seeking capital from investors in developed countries, thereby allowing emerging economies to remain on high-growth trajectories. IMF research puts emerging markets’ cumulative capital inflows at close to $4 trillion since the onset of QE in 2009. Enticed by the siren song of a shortcut to rapid economic growth, these inflows lulled emerging-market countries into believing that their imbalances were sustainable, enabling them to avoid the discipline needed to put their economies on more stable and viable paths. Read the rest of this entry »

Debt: still very much in favour

Reports by the Wall Street Journal that officials at the Federal Reserve are drawing up plans for starting to rein in the current programme of QE are worth noting. Jon Hilsenrath, the Journal reporter who wrote the story, is widely held to be the Fed’s favourite unofficial channel for making known its future intentions.  Could it be that even the Fed is starting to get concerned about the runaway effect that its monetary stimulus is having on asset prices? Throw in Mr Bernanke’s warnings about excessive risk-taking last week and it is tempting to suppose that even the Fed would be happy to see a pause in the the advance of risk assets, at least for now.

That would certainly seem to sit quite well with the normal midyear seasonal pullback that we have seen for each of the last three years. The worry with QE has always been that it is easy to get started on it, but very difficult to stop. Now that the Japanese have joined the QE party in an even more dramatic way, the ripples are being felt in financial markets all round the globe, compounding the scale of the eventual problem. Yields in a number of credit markets (eg junk bonds, leveraged loans) have fallen to what look like dangerously complacent levels. Companies such as Apple are obviously happy to take advantage of the ultra-low rates on corporate debt, but whether that achieves any longer term benefit remains to be seen – not so obvious when the purpose of the debt is committed to share repurchases rather than new capital investment. All the while a return to the levels of economic growth we witnessed before the crisis broke in 2008 remains stubbornly distant. Read the rest of this entry »

The “most dangerous investment environment ever”

These are the latest comments on the implications of the drastic policy measures being adopted by central banks in a so far unsuccessful attempt to stimulate their economies. They come from one of the most successful managers of a “real return” fund in the UK. Iain Stewart has been running the Newton Real Return fund since its launch in 2004, with only one small down year (2011). Anyone interested in capital preservation in the current uncertain climate is likely to find much that resonates here. The full story can be found here (source: FE Trustnet).

“Fixing the price of government bonds is a very risky policy as it can lead to mis-allocated capital. I would say now is the most dangerous environment I have ever seen. It feels nice when stock prices just keep going up, but if anything, those assets are being pushed up by policy. It may be an uncomfortable thought, but we need to keep reminding ourselves that the reason we are all bathing in an ocean of liquidity some five years on from the financial crisis is that we have, to date, failed to lay to rest the legacies of the last cycle. The problem is that forcing mature, ageing economies to grow through monetary easing is recreating the distortions and excesses which caused the crisis in the first place”. Read the rest of this entry »

Written by Jonathan Davis

April 23, 2013 at 3:06 PM

Reality and euphoria in the equity market

In the modern era strong equity market performance in January is not, as used to be believed in days gone by, a reliable forerunner of a good year ahead for the stock market, which is a pity as 2013 has certainly got off to a roaring start, with both the S&P 500 and the world index up by 5.0%, and the main Japanese indices up by nearly twice that amount.  After its lacklustre performance in 2012 the UK equity market produced an impressive 6.4% and China, a dark horse favourite for top performing stock market, a tad more.  However, as this useful corrective note from Soc Gen’s top-rated resident quant Andrew Lapthorne makes clear, there are some curious features of the markets’ generally impressive performance that give cause to doubt quite how enduring this rally will in practice prove to be.

Firstly debt issuance by companies is riding high and a large chunk of this debt is being used to buy back shares. This creates a virtuous circle, where increasing debt issuance supports share prices, pushing down implied leverage and volatility at the same time, which in turn supports ever cheaper credit for the corporate. So, once again, with one of the key marginal buyers of equities the corporate, using capital raised in the debt market means that, as ever, the fate of the corporate bond and equity market are intertwined and as such last week\’s weakness in the high yield bond market is worth keeping tabs on. Read the rest of this entry »

Fools rush in while wise men take their time?

The New Year has started well, with plenty of evidence that professional investors are continuing to rediscover their appetite for risk assets, with the price of equities, corporate bonds and high yield debt all heading higher. The charts for leading equity indices, including the S&P 500 and the FTSE All-Share, have been trending higher ever since Mario Draghi, the head of the European Central Bank, announced last summer his intention to “do whatever it takes” to prevent the eurozone from falling apart. He has every reason to be pleased with the response to his intervention, which to date has been effectively cost-free. Would it were always so easy! European stock markets, having been priced for disaster before, have led the way up as fears of the euro’s fragmentation recede. Volatility, as measured by the VIX, has meanwhile fallen to multi-year low levels. Read the rest of this entry »

An illusion of safety in bonds

Bruce Stout, the manager of Murray International investment trust, is another fund manager whose conservatism and preference for defensive high yielding equities has rewarded his shareholders well over the past few years. Earlier this year I heard him tell an investment trust conference that the most positive thing to be said about financial markets was they were becoming more realistic about the prospects for an early resumption of growth.

He sees little prospect however of any immediate improvement in the macro environment. These are his most recent comments on the markets, as reported by Citywire:

Recent respite in financial markets must be viewed with great scepticism. At the current time, when transparency is low, when harsh deflationary economic conditions are new to policymakers steeped in the past, and when the political establishment is clearly willing to indulge in perpetual bailouts regardless of the consequences, this is no time to let hopeful expectations cloud reality. We remain very cautious, defensively positioned and focused on capital preservation.

Read the rest of this entry »

Written by Jonathan Davis

August 27, 2012 at 5:20 PM

The truth about future economic growth

Rob Arnott, the chairman of Research Affiliates, is one of the most articulate and interesting market analysts in the States, and someone whose ideas and research I have followed for a number of years. In my latest 30-minute podcast, I discuss with him the outlook for investment returns – and how they will be dramatically influenced by what he calls the three Ds now hanging over the world – debt, deficits and demographics. All three are conspiring to drag down likely future rates of economic growth in the developed world. Investors need not despair however, Rob argues: better returns are available if investors switch their focus from conventional benchmarks to a multi-asset strategy based on broad economic, rather than purely financial, criteria. Before listening in, click the link below to download a copy of the slides he used to develop his arguments at a recent presentation to a London Stock Exchange seminar. The podcast can be downloaded from here. Recommended.

Arnott LSE Presentation July 2012

Written by Jonathan Davis

July 29, 2012 at 5:30 PM

Looking beyond Greece

We don’t know whether the Eurozone agreement on Greece will hold – let alone for how long. My guess is not for long. In any case, for investors this long-awaited deal looks like a classic case of buy on the story, sell on the news. Financial markets have run up so strongly in anticipation of such an outcome that equities now look massively overbought, implying that the short-term reaction is more likely to be negative than positive. Longer term it is still impoosible to know for certain how this great drama reaches its endgame.

My view remains, as it has done for some time, that the best outcome now, as Bill Emmott was saying in The Times yesterday, is for a managed default (and probable exit) by Greece at some point in the course of this year, as it becomes apparent that the country cannot meet the demands which have now been placed on it. I suspect that this is the outcome which the Germans have been after for quite a while now, without of course being able to say so in so many words. It is also in the best interests of the Greeks themselves over time.

Read the rest of this entry »

Written by Jonathan Davis

February 21, 2012 at 9:45 AM

New Year hopes

My suspicions back in the autumn that a market rally was on the way have, I am happy to say, been borne our by events. Not for the first time, the peak of rhetorical despair – this time about the dire outlook for the world economy should the Eurozone crisis not be resolved – has turned out to be the moment to turn bullish. The rally since the failure of the Cannes summit has been impressive.

The MSCI world index is up by more than 20 per cent since its October low and has risen for seven straight weeks in a row, something that has not happened since the spring of 2009, according to the equity strategists at Societe Generale. Equity markets have made an even stronger start in 2012, with January producing one of its best monthly returns for many years. Contrarian sentiment indicators, such as the venerable Investors Intelligence survey of investment advisors in the United States, once again proved invaluable in identifying a turning point back in the autumn.

Read the rest of this entry »

Nose out of book

After several weeks immersed in completing the book I have been writing on the investment methods of Sir John Templeton, to be pubished in the spring next year, this week sees the return of this blog to active duty. The past three months in the financial markets have been amongst the strangest and most volatile I can remember for some while - certainly since the great crisis of 2008. Two main things (the Eurozone crisis/horror movie and an apparent slowdown in the recovery of the US economy) have dominated market sentiment throughout these months, leading to a huge amount of displacement activity by anxious investors, and a good deal of hyperbole amongst the commentariat.

Suffice it to say that the news on both counts appears to have improved in the last few days. Although the Eurozone crisis is clearly still a long way from being resolved, the US data does appear to point to things picking up on the other side of the Atlantic, which should silence the most extreme prophets of doom for a while, at least.  Having broken out of their trading range, it will be surprising if equity markets do not finish the year on a relatively strong note, perhaps even crawling their way back to the level at which they started the year. The prospect of new bouts of quantitative easing by the Federal Reserve and Bank of England have dampened yields on long term Government bond, but the sovereign debt of overborrowed developed countries continues to look a/the most vulnerable asset class on any but the shortest of time horizons. Read the rest of this entry »

Written by Jonathan Davis

October 31, 2011 at 4:04 PM

Economists and banks

Some observations on economists from veteran US investor Laslzo Birinyi, writing in the Financial Times.

In my experience, economists are not equipped by training or discipline to provide insight and guidance on stocks. As manifest by an number of cliches, the bond market is about here and now, while stocks are always looking ahead. Hence economists, almost by definition, “lead from the rear”.

Their recent concern regarding the banks and the implication for the financial system may indeed be correct, but I would note that the recent weakness of the traditional banks is actually the norm. In the nine bull markets back to 1962, 48 per cent of banks’s ultimate gains was made in the first two months of the rally. In the last two bull markets, after the first two months, banks not only underperformed, they were actually down the rest of the rally.

US bank shares certainly have been going nowhere for some time.

Meanwhile, as the market has been indicating since the weekend, the narrow Greek vote in favour of the austerity programme – although it does nothing but defer the country’s inevitable sovereign debt default  - looks likely to be the trigger for a reversal of the straight line fall in equities and bond yields which has been such a striking feature of the last two months in the markets.

Written by Jonathan Davis

June 30, 2011 at 6:41 AM

The conundrum of cash

The current phase of “financial repression” (negative real interest rates that penalise the virtuous while inflation erodes the liabilities of imprudent borrowers)  is creating difficult issues for financial advisers and wealth management firms, many of whom have no experience of living through such an unusual environment. Central to that is the issue of what to do with cash at a time of market uncertainty, when conventional valuation measures are being distorted by the impact which quantitative easing and other monetary policy measures are having on government and corporate bond yields.

Look for example at this interesting report on Trustnet about the way that one of Cazenove Capital’s fund managers is preserving cash in his cautious managed fund, which has a benchmark of beating the CPE by 4% per annum.

Marcus Brookes has defended his 20 per cent cash position in the £707m Cazenove Multi Manager Diversity fund, even though he acknowledges that the UK’s high inflationary environment is set to endure. With the consumer price index (CPI) at 4.5 per cent and base rates at a historic low, cash is losing a substantial percentage of its real value by sitting in the bank. However, Brookes says he has no plans to cut his exposure to money markets any time soon. “Although there is a lot of talk about inflation at the moment, we are even more worried about the government bond market, particularly as a long-term bet,” he explained.

“The fund maintains a third of its assets in equities, a third in either fixed interest or cash, and a third in alternatives, no matter the market environment. We think the potential capital losses in government debt are so high that we’d rather hold cash for the time being.” Although Brookes could invest this 20 per cent in corporate debt, he says this would go against the fund’s risk profile. According to Financial Express data, Cazenove Multi Manager Diversity is one of the least-volatile funds in the IMA Cautious Managed sector over a five-year period.

“We could move into investment grade and high yield corporate debt, but at this point of the economic cycle we think this would increase the risk of the fund,” he said. “A lot of people are saying that the end of QE2 has been priced into the market but we are not so sure. The data coming out of the US has been poor and we anticipate another soft patch. The cash position also keeps our options open when certain areas of the market get cheaper,” he added.

Being prepared to sit on holdings of cash when the market appears to be offering few opportunities  is, as I argued in my most recent FT column, one of the hallmarks of the most successful money managers. The two advantages are: (1) avoiding drawdown during market falls and (2) having the firepower to take advantage of the valuation anomalies that always appear when the market slumps.

To do so requires good judgement and a lot of courage however, since such a stance is easy to criticise if markets remain buoyant.  To do so in an environment where cash is providing negative real returns - and the opportunity cost is therefore higher than normal – makes it an even braver thing for a fund manager or financial adviser to do. However that does not mean it is wrong.

Written by Jonathan Davis

June 15, 2011 at 2:02 PM

The best shorting opportunity for 20 years

According to Doug Casey, the well known American investor and commodities analyst, interviewed by the Sunday Times in London, the bonds issued by developed market governments are “the best short sale since Japan twenty years ago”.  US Treasuries, he says,  are “a triple threat to your wealth. Interest rates are going to go up, the currency is going down and there is the default risk”.

He has been buying more hard assets and topping up his holdings in gold and silver, “mainly as a store value”. He doesn’t believe the Federal Reserve when it says it will not restart quantitative easing.

Most US government debt is short term – either of one or two years duration – and is paying less than 1%. Its deficits, on the other hand, are more than a trillion dollars a year for as far as the eye can see. Who’s going to be stupid enough to lend money to a bankrupt entity at less than 1% a year? Only the Federal Reserve is going to buy the debt, hence more QE”.

Asked about the best value commodities, he says only two are currently cheap – natural gas and cattle. He owns cattle directly these days, on his farm in Argentina, though he used to own an ETF, and natural gas exposure through exploration companies in North America.

Written by Jonathan Davis

June 12, 2011 at 8:36 AM

Anything but gilts

My latest piece in The Spectator discusses what might make a future trade of the decade to match that which was the standout (and therefore widely ignored) long term trade at the time of the Prince Charles- Princess Diana wedding in 1981. Then the trade was to buy UK Government bonds; now, I argue, it would be to buy anything but gilts, and concentrate on assets which can withstand the inevitable arrival of inflation.   Note that I am discussing here the best long term buys and sells facing investors today, not which asset class might do best in the next few months (when I fear that a new deflation scare, which would be positive for gilts, remains a distinct possibility).

Written by Jonathan Davis

May 22, 2011 at 9:07 PM

Crunch time for America and Japan

The US is likely to lose its AAA credit rating in 2013, and that will also be the last year in which both Japan and the States will be able to carry on borrowing at risk-free rates without sorting out their unsustainable fiscal deficits. That was the blunt warning today from Willem Buiter, former member of the Bank of England Monetary Policy Committee, now Chief Economist at Citigroup.

Speaking at the CFA Institute conference in Edinburgh, Mr Buiter added that the bond market might well force the inevitable 3% rise in US Treasury bond yields even earlier than that date, for example if Chicago was about to go bust. The best chance of the US finally getting to grips with its huge debt burden would be immediately after the 2012 elections, but as yet there are absolutely no signs of a bipartisan approach to a solution.

Written by Jonathan Davis

May 10, 2011 at 3:27 PM

Storm clouds ahead?

Several more interesting speeches at the CFA Institute conference in Edinburgh, where I am. Notable was a warning by Russell Napier, the independent market strategist, that the growing inflationary crisis in Asia and emerging markets will be the trigger that finally forces the Federal Reserve into raising rates.  Investors worried about the “big reset” (rising bond yields) may be looking in the wrong direction for the trigger.  He expects one more big deflationary scare and that the subsequent bear market in US Treasuries will last “for decades”.

Written by Jonathan Davis

May 10, 2011 at 11:13 AM

The word from Warren Buffett

I don’t know how many of you had time to catch up with Warren Buffett’s annual appearance on the TV channel CNBC last week, timed to coincide with the appearance of his widely followed Letter to Shareholders, but I thought it might be useful to note the most important things that struck me from the transcript of his three-hour appearance. (Listening to the video of the show means having to sit through a lot of banter from the presenters, not to mention regular commercial breaks, making it a far too time-consuming way for most people to keep track of what he had to say).

This is my quick and dirty summary of the main things he had to say:

He thinks that the Federal Reserve has done enough monetary stimulus with the QE2 programme of quantitative easing.  US monetary and fiscal stimulus combined will be equal to 10% of GDP this year, a massive amount. Stimulus was important in fending off the banking crisis, but now it is time to trust in the “natural regenerative capacity of capitalism”. Again, in his words: “There is a resiliency to the American system. It does work”.

Read the rest of this entry »

Written by Jonathan Davis

March 9, 2011 at 3:20 PM

The truth about bonds

There was more interesting research out today from Dimson, Marsh and Staunton, the three London Business School academics who produce the annual Global Investment Returns Yearbook in conjunction with the Credit Suisse Research Institute. This has become established as the world’s most comprehensive database of asset class returns, covering as it does equities, bonds, cash, inflation and currencies for 19 countries from 1900 to the present day.

I will be publishing a more detailed review of this interesting study on the Independent Investor website shortly, but five points are worth highlighting here today. The main focus of the research this year is on Government bonds and the related issue of investors’ search for yield:

  • While investors look to fixed income as protection against the kind of severe losses (drawdown) which we all know characterise the equity market, history provides no assurance that this is a safe assumption. In fact, the LBS professors say, “historically bond market drawdowns have been larger and/or longer than for equities” (as anyone who remembers the period before 1980 will know from experience). US investors who bought bonds in December 1940 experienced a 67% loss in real terms on their investment over the next forty years and it was not until September 1991 – more than half a century later – that they finally became better off in real terms than they were at the outset. For UK investors who bought bonds at the peak in October 1946 their investment remained underwater for 47 years, thanks to the devestating losses produced by inflation. Read the rest of this entry »

Written by Jonathan Davis

February 28, 2011 at 5:11 PM