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Archive for the ‘Bond yields’ 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

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 »

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

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

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 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

Hoping for the best in 2011

The strategy team at Societe Generale, regularly ranked the best in the City, despite their idiosyncratic ways, chose a useful title for their annual presentation last week on the outlook for markets in the year ahead.  Hoping For The Best, Preparing For The Worst neatly summarises the bipolar nature of where I think we are in the cycle – not much to play for in terms of long term returns, but nevertheless some good reasons to think that the current market recovery can continue into 2011.

Here are a couple of keynote charts from their presentation.  One shows where the US market sits on two well-known long term valuation metrics, a cyclically-adjusted p/e ratio (named after Prof Robert Shiller, the US academic who popularised the methodology) and Tobin’s q, which measures the ratio between the current value of the equity market and the replacement cost of its component companies’ assets.

Read the rest of this entry »

Written by Jonathan Davis

January 24, 2011 at 11:40 AM

Gloom and Opportunity

Back from holiday and the air of gloom that settled over the markets in August, to judge by media headlines, only seems to have deepened. The Fed chairman Ben Bernanke used his speech at the Jackson Hole central banker summit last week to acknowledge that the US economy was slowing and confirmed that the Fed was looking at other ways to add more monetary stimulus if it should become necessary.

However one of the striking features of the current market environment is that many professional investors – the ones whose views I track anyway – are far more optimistic about the outlook for equities than you might think from reading the newspapers – or indeed from looking at bond yields, come to that, which continue to slide to their lowest level for many years. The yield on the 10-year UK gilt, for example, has just dipped to its lowest level for more than 30 years.

UK 10-year Gilt Yield

According to the bond market specialists at M&G, it is notable that Government bonds as a class have pushed through a psychologically important barrier in many countries.  As of yesterday, there was for example no longer a single gilt in the UK that yields more than 4%; no Government bond that yields more than 3% in the United States; and no Government bond that yields more than 2% in Japan.

Read the rest of this entry »

Written by Jonathan Davis

August 31, 2010 at 10:16 PM

The End Of An Era For Bonds?

The toughest questions in investment are not those that challenge specific views, but those that challenge deep-seated assumptions. Markets exist to accommodate a range of participants with divergent views or economic interests, so it is hardly a surprise that almost any position can be justified somehow. Those who judge the position right are rewarded, while those who do not are penalised.

But that is not how the most grievous or most costly mistakes are made. Those arise when it is investors’ entire belief systems that turn out to be misplaced. LTCM is a good case in point. Clever to a man, the principals lost their business because their faith in historical relationships that had worked so well for many years turned out in practice to break down during a period of extreme market stress.

The same, on an even bigger scale, goes for central bankers who bought in, naively, to Alan Greenspan’s convenient view that bubbles in financial markets could not be identified in advance and even if they could, would prove more costly to pre-empt than to clear up after they had burst. As he confessed to Congress in October 2008, bankers’ behaviour during the crisis had revealed “a flaw in the model … that defines how the world works”. The cost to the world of the chairman of the Federal Reserve’s faulty assumption now runs into billions.

Are we now approaching the point with Government bonds where the assumptions that have carried this once derided instrument triumphantly through three decades of consistently good returns need to be discarded? If we are not there already, we are surely not that far away. A recent report by Andrew Smithers posed the question bluntly: “ Bonds – Government and Corporate, Nominal and Real – Why Should Anyone Hold Them?”

His argument is that at current levels Government bonds are “seriously overpriced” and therefore high risk. Returns are likely to be negative in the short term as the twin props of quantitative easing and bank window-dressing are withdrawn. Yields on inflation-linked bonds meanwhile have been driven so low by investors seeking insurance against a resurgence of inflation that, in his view, they are set to do badly whether or not inflation picks up.

Dimson, Marsh and Staunton are just as blunt in their latest Global Investment Returns Yearbook. They note that in defiance of financial theory, over the 40 years to the end of 2008 government bonds outperformed equities. Their world bond index produced an annualised real return of 4.89% between 1969 and 2008, compared with an annualised real return of 4.02% for equities. The long run real historical return from government bonds since 1900, in contrast, a period that incorporates the full gamut of human experience, including two world wars, has been just 1.0% per annum.

It is true that the anomaly of bonds outperforming equities over long periods has reversed after last year’s equity market revival, but it remains the case, the professors note, that “in an apparent violation of the law of risk and return” (than which nothing of course is more offensive to the academic mind), bonds have “produced equity-like performance, with annualised returns just a little below those on stocks, yet at much lower volatility”. Extrapolating these high returns in the future would, they conclude, “be fantasy”.

They are right about that. With 10-year yields at 3.8% in the United States and 4.0% in the UK, to project a 4.0% annualised real rate of return from Government bonds at these levels only makes sense if the world is heading for outright deflation, a fast receding possibility. Even if that were to happen, the boost to bond returns would at best be a transitory one.

In fact, from a valuation perspective it is hard to construct a plausible world economic scenario which would validate buying Government bonds today other than as a short term tactic. It is true that bonds were one of the few asset classes to display diversification value during the global financial crisis. Diversification remains the other prop, besides disinflation, on which investors’ faith in Government bonds rests.

But even this, an article of faith for entire generations of investors, is open to challenge. For Mr Smithers, the argument cuts little ice. As an instrument of diversification, cash shapes up at least as well as bonds, notwithstanding the current miserly returns on short term deposits. The huge supply overhang that is implicit in the ballooning fiscal deficits in the US, Europe and the UK meanwhile seems sure to drive yields higher. When is a only matter of time and degree.

It is not that investors who buy bonds today cannot experience one last hurrah before the 30-year cycle turns for good. There will always be opportunities to play the yield curve (now much steeper than its historical average) for profit. The message is rather that the returns of the last 30 years on which many market participants’ investment philosophy is based cannot and will not be repeated over the next 30, with all the implications that must flow from that statement.

Written by Jonathan Davis

March 8, 2010 at 4:26 PM

The Argument For Long Bonds

One phrase of Professor Paul Samuleson’s that has stuck in my mind for 20 years was his exhortation that investors should always “work the other side of the street”, the idea being that you are more likely to find value in testing non-consensual views as in accepting conventional thinking at its face value. Given that the remarkable feature of financial markets at present is how quickly consensus thinking seems to switch from one extreme view to another, the mental gymnastics required to do as he suggests have become increasingly demanding.

But the need for such challenge remains, with the inflation-deflation debate the most important current issue. In little more than a year, market prices suggest that we have moved from fear of inflation to fear of savage deflation – and now back again. True, it is not easy to gauge where consensus thinking genuinely now lies on this subject, as short covering by frustrated bears surely accounts for a good deal of the force behind the equity market’s recent strength.

My impression is that the majority of market participants remain unconvinced by the argument that inflation is once again the main enemy. There is no denying however that sentiment to that effect is gaining momentum. Most of the professional investors whose judgement I rate highly are now acting in the belief that the inflation, not deflation, camp is the right place to belong. The belief that deflation has been licked is one of the factors that has been driving equity markets higher.

In such circumstances, the need to stand back and look at the other side of the argument is greater than ever. The bond market is one obvious place to look. Peter Geikie Cobb, who co-manages Thames River Capital’s Global Bond fund (up a handsome 36% last year), gave me a powerful corrective opinion last week. His view is that there is simply no convincing evidence that inflation is rearing its head, or will do so any time soon. So firm is this conviction that his fund’s largest position by far is now in the longest duration UK gilt you can find, namely the 4.25% 2055 issue, currently yielding 4.5%. He and Paul Thursby, his co-manager, have never, it seems, owned such a long duration government bond portfolio as they do today.

The argument for such an apparently high risk stance, in essence, is that even if renewed inflation is eventually on its way, to bet on such an outcome today is distinctly premature. The only way that the US and UK economies can redeem their spiralling debt burden in the short term is through a rapid increase in the savings rate. That is already happening, but many investors may be underestimating how far and fast that process needs to unfold. Past experience suggests it will be dramatic.

In Thames River Capital’s view, with prices still falling, it is likely to be several years before we see reported inflation rising above 0%, which is why they see real yields of 4% or more at the long end of the curve as attractive. While it is evident that quantitative easing will hold down shorter dated yields in the government bond market, there is no doubt that the prices of longer dated issues do look, in general, more appealing. Although TIPs appear better value, real yields on index-linked gilts are too low to generate much current interest.

Given the unprecedented reflationary efforts now under way, some will argue that the 20-year bull market in government bonds must already be approaching its end. The charts still tell a somewhat different story. Measured against their 20-year history, yields for 10-year benchmark gilts, at 3.5%, are still firmly in the middle of the down-trending channel they have followed over the whole of those two decades. If the tipping point is coming, in other words, it has certainly not yet arrived, let alone confirmed.

So while government bonds as a class seem distinctly unattractive to those of us who expect higher inflation, the more you look at it, the case for the long bond play, whether you regard it as a hedge or as a trade, looks not unreasonable. To put it another way, even if you are concerned about inflation, it may be the least worst option available in Government bonds.

Notable too is another of the Thames River Capital team’s current convictions, which is that sterling’s renewed has further to run. Their argument is that the eurozone has still to take the punishment that sterling has had over the past few months and that the pound could well go to $1.65/$1.70 to the dollar and 1.25/$1.30 to the euro before its current bout of strength is done. Even if sterling loses its AAA status, as is certainly possible, most other currencies will be suffering just as much, if not more.

Written by Jonathan Davis

June 1, 2009 at 9:27 AM

An Anomaly In The Long Bond Market?

Long term government bond yields look very attractive, according to the managers of the Thames River Capital Global Bond Fund, Paul Thursby and Peter Geikie-Cobb. The biggest positions in their popular fund, up 34% in last year’s exceptional conditions, are in the longest dated UK gilts and US Treasuries, the former currently yielding 4.5%. This looks very tempting, given that, even if (like me) you are a believer that inflation will eventually return as a result of unprecedented Government and central bank activity, published inflation figures are not going to be positive for a long time yet. The real yield on long-dated government bonds looks a bargain therefore, though nobody in their right minds would voluntarily think of lending money to the UK government at shorter-dated rates.

I find this argument convincing, and have added some of these gilts to my own portfolio. Whether it turns out to be a hedge or a trade remains to be seen. (I will not be around to hold these instruments to maturity, alas). Sterling will also continue to strengthen, the Thames River Capital team thinks, and could well reach $1.70 and 1.30 to the euro before it is done. The euro looks most at risk. The two Thames River bond managers have never held such a long duration government bond portfolio as they do today, despite nearly 20 years investing in the field. They are also fully hedged back into sterling.

Written by Jonathan Davis

May 21, 2009 at 4:50 PM

The Message from Corporate Bond Yields

Peter Bernstein, the New York economist, puts his finger on a challenge facing all investors today: what to make of the choice between corporate bonds and Government bonds? The difference in yields between the two clases of bonds is wider than at any time in our lifetimes. The spread between the two is several standard deviations above historical experience. What is more, the yields on corporates and Treasuries are moving in opposite directions, something which has rarely if ever happened before.

Peter thinks that this relationship is “fundamentally unstable” and must change, as do I. Of the two types of bond, it seems fairly obvious which looks the better bet. If you believe that we heading for a sustained period of debt deflation, you can just about make a case for owning Government bonds even at today’s extremely low yields. The 10-year US Treasury bond at 2.69%, notes Peter, is the lowest it has been since 1956. It does not look an attractive long term rate at which to lend money to a massively indebted Government.

But here is the sting in the tail. If we get an outcome as bad as sustained debt deflation, it would not take long for the perceived security of Government bonds to vanish. As Peter explains: “Ultimately the national debt depends upon the economy of the nation itself, which produces the tax revenues necessary to service the debt. The nation’s economy is what keeps Treasury debt from turning into a Ponzi scheme. In short government debt is riskless only when the nation’s economy is prosperous”. (Source: Economics and Portfolio Strategy; a subscriber publication).

Meanwhile the case for corporate bonds rests on the fact that a catastrophically bad economy and unprecedented default rates are already priced in at today’s yields. Of course investors will need to pick their corporate bonds with care to reduce the risk of default. As a class however, corporate bonds clearly have the edge over Government bonds. The only question now is how long it will take the investment community, prodded by the Federal Reserve’s zero interest rate policy, to realise the same thing.

Not long, I suspect.

Written by Jonathan Davis

December 26, 2008 at 12:19 PM

Posted in Bond yields, Treasuries