There are striking parallels between the dramatic recent sell-off in U.S. Treasuries and the Great Bond Crash of 1994. But the summer of volatility now facing financial markets is no doomsday scenario. Instead, it puts the U.S. Federal Reserve in a bind. Higher interest rates will reduce housing affordability, which is especially troublesome since housing is the primary locomotive of U.S. economic growth. That means the Fed, despite Ben Bernanke’s recently announced timetable, may be forced to expand or extend quantitative easing if the housing market’s response to recent events becomes more acute and starts to negatively affect the job market recovery.
Market bubbles are called bubbles for good reason. They form, they inflate, they grow to an unstably distorted size, and ultimately they undergo the effects of rapid decompression in search of equilibrium. In a word … they pop. And generally speaking, the bigger the bubble the bigger the bang. … Most of us are pretty good by now, we think, at spotting bubbles. After all, we know what they look like; we recognize their characteristics, don’t we? Maybe. Maybe not. Not all bubbles look or act the same. … Is there a bubble inflating again? … people often shrug their shoulders, scratch their heads, and simply accept that there must be good reasons why stocks have been on a roll. The average investor, after all, is at least one step removed from the markets for intangible assets and therefore has comparatively little experience to help avoid becoming their occasional Venus flytrap dinner. … When it comes to assessing the state of the real economy, on the other hand, most people are more circumspect and not so easily taken in. … this bubble was born of desperation, first by the misguided monetary policy regime and then by investors who are sure to become its unsuspecting victims as they look for return—any return—in all the wrong places. … Railing against Fed policy, of course, doesn’t change it. … we continue to believe it is possible—and necessary—to see both the forest and the trees in order to fulfill our highest obligation: to continue acting in the best interests of our clients. As noted investment manager Francois Sicart said recently: “The attitude of many professional investors toward the current market makes me think of a crowd enjoying a dance party on top of an active volcano. They know it is going to erupt but, instead of planning an exit, they keep dancing while trying to guess the exact date and time of the eruption.”
It was a typical workday morning at Wanjia Asset Management Co. in Shanghai's downtown financial district, but the firm's star bond trader Zou Yu was not at his desk. … Zou, 31, had mysteriously failed to report for his job as head of Wanjia's fixed-income department. And his whereabouts remained unknown until five days later when the firm, on April 16, announced that the police had taken Zou into custody for alleged, unspecified financial crimes. … Zou thus joined a growing list of allegedly unsavory bond traders, securities brokers, bankers and fund managers nabbed by authorities this year in their effort to stop illegal deal-making on the nation's interbank bond market.
The asset management industry is about to experience another shake-up, as the investment universe expands to include new asset classes that involve direct loans to the economy rather than financial securities. … This report provides an insight into a new world of unlisted assets. Just as there is a market for private equity (unlisted shares), a market for private bonds and loans is developing as a result of the current large-scale disintermediation process. The report is intended to be instructive and seeks to explain this market using simple language. The editorial covers issues arising from macroeconomic disintermediation in the US and Europe, but also takes a microeconomic view by looking at the asset management industry in Europe, the US and Japan.
In this report, we look at five markets through which investors can lend directly to the economy, each corresponding to a new asset class:
1) Loans guaranteed by export finance agencies
2) Commercial real-estate loans
3) Loans for financing energy-related projects
4) Loans for financing transport-related projects
5) Loans to SMEs and intermediate-sized enterprises (ETIs)
Investors are wary that the tranquility in eurozone bond markets could breed complacency ... Whether this new phase in the eurozone crisis is sustainable or simply the calm before the next storm will help determine the eurozone’s future. The stability reflects market confidence in the eurozone’s prospects – and the fact that fickle international investors fled at an early stage of the crisis. But overreliance on domestic investors has thrown Europe’s economic integration into reverse and may prove dangerous. While the calm may provide breathing space – lower bond yields cut financing costs – it could breed complacency. ... arguably a much bigger reason for the recent stability in eurozone bond markets across much of the rest of the region is that foreign investors have retreated. So far this year, domestic investors have accounted for almost 100 per cent of the net issuance of Italian and Spanish government debt, according to calculations by BNP Paribas. Of outstanding Spanish bonds, almost 70 per cent is currently held domestically. For Italy, the figure is almost 60 per cent. ... Japan has illustrated how a country, with strong domestic ownership, can operate with a level of public sector debt equivalent to more than 200 per cent of national output and still keep official borrowing costs down. Yields on 10-year Japanese government bonds are just 0.6 per cent. ... Yet the stability created by “re-domestication” of eurozone bond markets could prove fragile. A mounting concern of eurozone policy makers is the increased mutual dependence between banks and governments in the eurozone periphery, which could quickly exacerbate financial instability if a fresh crisis erupted somewhere in the financial system. ... The links between banks and sovereigns “basically changes the nature of the eurozone. Banks are acting as the arms of the central bank to help governments avoid default” ... Without outside investment, the struggling periphery economies could find it even harder to escape recession and produce the growth needed to reduce public-sector debt mountains.
From the cyclical monthly high in interest rates in the 1990-91 recession through June of this year, the 30-year Treasury bond yield has dropped from 9% to 3%. This massive decline in long rates was hardly smooth with nine significant backups. In these nine cases yields rose an average of 127 basis points, with the range from about 200 basis points to 60 basis points (Chart 1). The recent move from the monthly low in February has been modest by comparison. Importantly, this powerful 6 percentage point downward move in long-term Treasury rates was nearly identical to the decline in the rate of inflation as measured by the monthly year-over-year change in the Consumer Price Index which moved from just over 6% in 1990 to 0% today. Therefore, it was the backdrop of shifting inflationary circumstances that once again determined the trend in long-term Treasury bond yields. ... In almost all cases, including the most recent rise, the intermittent change in psychology that drove interest rates higher in the short run, occurred despite weakening inflation. There was, however, always a strong sentiment that the rise marked the end of the bull market, and a major trend reversal was taking place. This is also the case today. ... Presently, four misperceptions have pushed Treasury bond yields to levels that represent significant value for long-term investors. These are:
1. The recent downturn in economic activity will give way to improving conditions and even higher bond yields.
2. Intensifying cost pressures will lead to higher inflation/yields.
3. The inevitable normalization of the Federal Funds rate will work its way up along the yield curve causing long rates to rise.
4. The bond market is in a bubble, and like all manias, it will eventually burst.
- Also: Wall Street Journal - Higher Rates Wouldn’t Tame Bubbles Even if Central Banks Tried, IMF Paper Says < 5min
- Also: Financial Times - Technology, inflation and the Federal Reserve < 5min
- Also: CFA Institute - Complexity: The Hidden Cost of Central Bank Actions < 5min
- Also: Financial Times - Shadow banks step into the lending void < 5min
The last decade has seen an extraordinary rise in the importance of a unique class of investor. Generally referred to as “price-insensitive buyers,” these are asset owners for whom the expected returns of the assets they buy are not a primary consideration in their purchase decisions. Such buyers have been the explanation behind a whole series of market price movements that otherwise have not seemed to make sense in a historical context. In today’s world, where prices of all sorts of assets are trading far above historical norms, it is worth recognizing that investors prepared to buy assets without regard to the price of those assets may also find themselves in a position to sell those assets without regard to price as well. This potential is compounded by the reduction in liquidity in markets around the world, which has been driven by tighter regulation of financial institutions, and, paradoxically, a greater desire for liquidity on the part of market participants. Making matters worse, in order to see massive changes in the price of a security, you don’t need the price-insensitive buyer to become a seller. You merely need him to cease being the marginal buyer. If price-insensitive buyers actually become price-insensitive sellers, it becomes possible that price falls could take asset prices significantly below historical norms. This is not to suggest that such an event is inevitable, still less is it an attempt to predict in which assets and when it will occur, but anyone conditioned to think that these investors provide a permanent support for the markets should be aware that the support may at some point be taken away.
The recent slowdown in China’s growth has caused concern about its long-term growth prospects. Evidence suggests that, before 2008, China’s growth miracle was driven primarily by productivity improvement following economic policy reforms. Since 2008, however, growth has become more dependent on investment and overall growth has slowed. If the recent reform plans can successfully address the country’s structural imbalances, China could maintain a solid growth rate that might help smooth its transition to high-income status. ... Theory suggests that three factors contribute to economic growth: capital accumulation, labor force expansion, and productivity improvement. ... China’s growth miracle since the early 1980s has significantly raised the standards of living in China. It has also made China an increasingly important contributor to world economic growth and a large and growing market for U.S. exports. The rapid growth was driven primarily by productivity gains and capital investment. The recent growth slowdown has raised the concern that China’s growth miracle could be ending.
Something else must be driving the fall in Chinese equities. ... What could that be? Have China’s banks overextended themselves more recently? Central planning or not, as we all learned in 2008, a surge in shadow banking can lead to terrible things. ... I am no expert on China, but it is very tempting to conclude that the Chinese gambling spirit has simply migrated from Macau to Shanghai. ... Relative to 1999, when the euro was first introduced as an accounting currency, Greek workers had at one point (around 2009-10) enjoyed almost twice the wage growth compared to the average German worker. Although much of the advantage has since been given up, Greek workers have still out performed their German colleagues since the introduction of the euro – at least as far as wage growth is concerned ... Ukraine, the Middle East and Puerto Rico are all in the dumps – but for three very different reasons. ... the deflation talk is likely to blossom up again, and several countries on either side of the Atlantic could be flirting with recession later this year or early next. Consequently, yields on long bonds could fall further, and stock markets may be in troubled waters for a while. I don’t expect this to be anywhere nearly as bad as 2008, though. It is a normal cyclical downturn, which may not even be strong enough to be classified as a recession. But a slowdown it is. ... I think the U.S. economy will substantially outperform most other OECD economies over the medium as well as the long term – even if there is a modest cyclical slowdown just around the corner.
So the Fed has chosen to hold off on their goal of normalizing interest rates and the ECB has countered with the threat of extending their scheduled QE with more checks and more negative interest rates and the investment community wonders how long can this keep goin’ on. For a long time I suppose, as evidenced by history at least. ... zero bound interest rates destroy the savings function of capitalism, which is a necessary and in fact synchronous component of investment. Why that is true is not immediately apparent. If companies can borrow close to zero, why wouldn’t they invest the proceeds in the real economy? The evidence of recent years is that they have not. Instead they have plowed trillions into the financial economy as they buy back their own stock with a seemingly safe tax advantaged arbitrage. But more importantly, zero destroys existing business models such as life insurance company balance sheets and pension funds, which in turn are expected to use the proceeds to pay benefits for an aging boomer society. These assumed liabilities were based on the assumption that a balanced portfolio of stocks and bonds would return 7-8% over the long term. Now with corporate bonds at 2-3%, it is obvious that to pay for future health, retirement and insurance related benefits, stocks must appreciate by 10% a year to meet the targeted assumption. That, of course, is a stretch of some accountant’s or actuary’s imagination.
It has always baffled me how the financial industry in general, and financial newspapers in particular, appear to be hell-bent on forecasting this or that in early January. I actually find it outright laughable when someone projects the FTSE100 to be at 7,000 by Christmas time, or for the U.S. 10-year T-bond to hit 2.5% by midsummer. How on earth do they know? The generally poor predictive record proves they don’t, I suppose. On the other hand, that is perhaps what the majority of investors want. If you belong to that majority, there is no need to read any further. You will be wasting your time. ... If you see any forecasts from me (and you do), you will note that (i) they are very long term in nature, and (ii) they are based on structural trends, not tactical (cyclical) trends. Why is that? Partly because I think short-term forecasting is a sucker’s game, and partly because I know for certain that the structural trends that we have identified will happen. It is only a question of when, but more about that later. ... You can hardly open a newspaper these days without some commentator looking to buy fame by attempting to predict the next crisis but, as I just pointed out, the last one isn’t over yet. Therefore a far more relevant question is: What is likely to be the next leg of the GFC? ... I think three topics are particularly likely to steal the limelight in 2016:
- All sanctions against Russia to be lifted and trade relationships to be normalised.
- The EM crisis widens as commodity prices continue to fall.
- The credit market is spoiling the party again.
June Gloom, the fog and clouds that often linger here over the Southern California coast this time of year, appears to have spread to the Federal Reserve. ... We agree that QE must end. It has distorted incentives and inflated asset prices to artificial levels. But we think the Fed’s plan may be too hasty. ... Fog may be obscuring the Fed’s view of the economy – in particular, the structural impediments that will inhibit its ability to achieve higher growth and inflation. Mr. Bernanke said the Fed expects the unemployment rate to fall to about 7% by the middle of next year. However, we think this is a long shot. ... Mr. Bernanke’s remarks indicated that the Fed is taking a cyclical view of the economy. ... Our view of the economy places greater emphasis on structural factors. Wages continue to be dampened by globalization. Demographic trends, notably the aging of our society and the retirement of the Baby Boomers, will lead to a lower level of consumer demand. And then there’s the race against the machine; technology continues to eliminate jobs as opposed to provide them. ... It’s reasonable, of course, for Mr. Bernanke to try to prepare markets for the inevitable and necessary wind down of QE. But if he has to wave a white flag three months from now and say, “Sorry, we miscalculated,” the trust of markets and dampened volatility that has driven markets over the past two or three years could probably never be fully regained. It would take even longer for the fog over the economy to lift.
In recent years, a growing number of African governments have issued Eurobonds, diversifying away from traditional sources of finance such as concessional debt and foreign direct investment. Taking the lead in October 2007, when it issued a $750 million Eurobond with an 8.5% coupon rate, Ghana earned the distinction of being the first Sub-Saharan country – other than South Africa – to issue bonds in 30 years. ... This debut Sub-Saharan issue, which was four times oversubscribed, sparked a sovereign borrowing spree in the region. Nine other countries – Gabon, the Democratic Republic of the Congo, Côte d’Ivoire, Senegal, Angola, Nigeria, Namibia, Zambia, and Tanzania – followed suit. By February 2013, these ten African economies had collectively raised $8.1 billion from their maiden sovereign-bond issues, with an average maturity of 11.2 years and an average coupon rate of 6.2%.
At current spreads, high yield seems to be no worse than fair value and probably better than that, even if we assume (as we do) that we are entering a fourth default cycle. In today’s environment, that makes it one of the best available risk assets for investors. But the nature of the high yield market suggests it is a good candidate for overshooting fair value to the downside whenever defaults begin to rise in earnest. Our response for BFAS at current levels is to continue to search for credit securities offering a superior combination of expected returns and downside protection while augmenting this at the margin with more index-like credit exposure. ... It would be lovely to claim we will be able to time the bottom for credit precisely. We will not, and unlike with equities, even if we did know the timing perfectly, getting material exposure to the asset class quickly would be extremely difficult. This leaves us with the hunch we are probably getting in a little early, the fear that we might not get all the exposure we would like before spreads move to less attractive levels, and the sure knowledge we won’t get the bragging rights of having called the turn. In other words, it seems to be an utterly classic value investing opportunity.
As we have observed in the past, financial markets appear to solely focus on one major risk/return catalyst at any given time, before, like a bored teenager, turning attention to the “next new thing.” Over the past year and a half, we have seen primary market focus transition from the dramatic decline in oil prices, to economic stresses in China, and most recently to the forthcoming referendum in the United Kingdom and the possibility of “Brexit.” We are not for a moment suggesting that these factors are unimportant, as indeed they are all critical parts to a broader puzzle, but we would suggest that stepping back to apprehend the full image on the puzzle is vital when too many market participants are overly focused on one part of it. In fact, we think that such an overly limited focus in a world of complex market crosscurrents may be part of what leads many to underperform. To that end, we seek to take a broader view with our market outlook. ... In this edition of the outlook we begin by sorting through and evaluating some partial market myths that have recently been promulgated to explain market volatility. These include exaggerated concerns that the volatility is due to bond market illiquidity, or overdone assertions that markets are being driven higher and lower primarily on the back of oil price movements. Rather, we think that secular structural changes involving demographic trends and profound technological innovations are much more important considerations when judging those forces that are truly impacting economic and asset valuation dispersions. Further, we believe these secular challenges should also be the focus of the risk factors that represent the major fault lines in markets today, or the locations of potentially serious left tail risks.
- Also: Project Syndicate - The Fear Factor in Global Markets < 5min
- Also: Financial Times - Central banks prove Einstein’s theory < 5min
- Also: Wall Street Journal - The High Consequences of Low Interest Rates < 5min
- Also: CFA Institute - Policy Divergence and Investor Implications 5-15min
- Also: Bloomberg - Japan Negative Rates Alchemy Beats Australia's Highest AAA Yield < 5min
Most significant for future growth, however, is that the additional layer of debt in 2015 is a liability going forward since debt is always a shift from future spending to the present. The negative impact, historically, has occurred more swiftly and more seriously as economies became extremely over-indebted. Thus, while the debt helped to prop up economic growth in 2015, this small plus will be turned into a longer lasting negative that will diminish any benefit from last year’s debt bulge. ... Our economic view for 2016 remains unchanged. The composition of last year’s debt gain indicates that velocity will decline more sharply in 2016 than 2015. The modest Fed tightening is a slight negative for both M2 growth and velocity. Additionally, velocity appears to have dropped even faster in the first quarter of 2016 than in the fourth quarter of 2015. Thus, nominal GDP growth should slow to a 2.3% - 2.8% range for the year. The slower pace in nominal GDP would continue the 2014-15 pattern, when the rate of rise in nominal GDP decelerated from 3.9% to 3.1%. Such slow top line growth suggests that spurts in inflation will simply reduce real GDP growth and thus be transitory in nature.
The past five years have been challenging for long-term value-based asset allocation. We do not believe this constitutes a paradigm shift, dooming such strategies in the future. The basic driver for long-term value working historically has been the excessive volatility of asset prices relative to their underlying fundamental cash flows, and recent history does not show any evidence of that changing. Outperforming the markets given that pattern requires either betting that the excessive swings will reverse over time or accurately predicting what those excessive swings will be. The former strategy amounts to long-term value-based investing, while the latter requires outpredicting others as to both what surprises will hit the markets and how the markets will react to them. Our strong preference is to focus on long-term value, despite the inevitable periods of tough performance that strategy will entail. ... The volatility of U.S. stocks since 1881 has been a little over 17% per year. The volatility of the underlying fair value of the market has been a little over 1% per year. Well over 90% of the volatility of the stock market cannot be explained as a rational response to the changing value of the stream of dividends it embodies. This means that the volatility is due to some combination of changing discount rates applied to those cash flows, and changes to expectations of future dividends that turned out to be incorrect. It is difficult to determine exactly which has been the driver at any given time, but there doesn’t seem to be a lot of evidence for changing discount rates having been a major force. Even in the most extreme overvaluation in U.S. stock market history, the 1999-2000 internet bubble, none of the investors we heard explaining why the stock market was rational to have risen to such giddy heights explained it on the basis that future returns should be lower than history.
Over the last six or seven years, most financial assets have done very well. The performance divide has not been between low-risk assets and high-risk assets or between liquid assets and illiquid assets, but between long-duration assets and short-duration assets. Long-duration assets such as stocks, bonds, real estate, and private equity have benefitted from a large fall in the discount rate associated with their cash flows, while short-duration assets have been hurt by the same fall. Investors tend to tilt their portfolios in favor of those assets that have done well, and today that pushes them to be increasing effective duration in their portfolios, just when the potential returns to those assets have dropped. What we believe would be most helpful to investors are short-duration risk assets, as they offer the potential of decent returns over time with less vulnerability to rising discount rates. These assets, generally lumped together under the “alternatives” title, are generally out of favor today given their disappointing performance since the financial crisis, but the characteristics that made them disappoint may well prove a blessing if discount rates start to rise.
Following 17 months of mostly negative equity returns in Europe, very recently, I have noticed an inclination amongst European investors to increase the risk profile in their portfolios. They may not exactly be going for broke (yet), but the willingness to take more risk is clearly on the rise. The rising appetite for risk could be driven by one of two factors. Investors could either be turning more optimistic, or it could be the result of less benign factors, such as a need to generate higher returns, whether they really believe in such an outcome or not. ... In short, I suspect investors are chasing returns that (I think) are unrealistic, and it is not the first time that happens. When investors are under extreme pressure, as I think many are now, they sometimes behave quite irrationally. They do things they would have sworn only a short while earlier they would never do. ... Is there anything else investors could do to raise the overall return level and, in particular, to generate more income without necessarily taking more risk?
Given today’s low yields and high valuations across almost all asset classes, there are no particularly good outcomes available for investors. We believe that either valuations will revert to historically normal levels and near-term returns will be very bad, or valuations will remain elevated relative to history. If valuations remain elevated indefinitely, near-term returns will be less bad but still insufficient for investors to achieve their goals. Furthermore, given elevated valuations in the long term, long-term returns will also be insufficient for investors to achieve their goals. It would be very handy to know which scenario will play out, as the reversion versus no reversion scenarios have important implications both for the appropriate portfolio to run today and critical institution-level decisions that investors will be forced to make in the future. Unfortunately, we believe there is no certainty as to which scenario will play out. As a result, we believe it is prudent for investors to try to build portfolios that are robust to either outcome and start contingency planning for the possibility that long-term returns will be meaningfully lower than what is necessary for their current saving/ contribution and spending plans to be sustainable. ... By now some of our clients are probably thoroughly sick of hearing about the topic, but this piece is going to delve into it yet again, because the question of whether we are in Purgatory or Hell is a crucial one, not only for its implications for what portfolio is the right one for an investor to hold at the moment, but also for the institutional choices investors have to make that go well beyond simple asset allocation. ... In the long run, we can hope that valuations fall to historically normal levels, because only if that happens will the institutional business models and savings and investing heuristics that institutions and savers have built still be valid.
Two groups of true believers are driving changes in the developed world. The first: single-minded central bankers who spent trillions of dollars pushing government bond yields close to zero (and below). While this unprecedented monetary experiment helped owners of stocks and real estate, its regressive nature did little to satisfy the second group: voters who are disenfranchised by globalization and automation, and who are on the march. What next? The fiscal experiments now begin (again). ... why do we see 2017 as another year of modest portfolio gains despite the length of the current global expansion, one of the longest in history? As 2016 came to a close, global business surveys improved to levels consistent with 3% global GDP growth, suggesting that corporate profits will start growing at around 10% again after a weak 2016. More positive news: a rise in industrial metals prices, which is helpful in spotting turns in the business cycle ... Furthermore (and I understand that there’s plenty of disagreement on the benefits of this), many developed countries are transitioning from “monetary stimulus only” to expansionary fiscal policy as well. Political establishments are aware of mortal threats to their existence, and are looking to fiscal stimulus (or at least, less austerity) as a means of getting people back to work. The problem: given low productivity growth and low growth in labor supply, many countries are closer to full capacity than you might think. If so, too much fiscal stimulus could result in wage inflation and higher interest rates faster than you might think as well. That is certainly one of the bigger risks for the US.