Viewpoint: Chief Economist

Bonds, Baby

  • 26 October 2018
  • 7 min read

Have we just experienced the October curse? Halloween might not be until next week but there have been some horrors in global markets in the last week or so. Equities have already underperformed bonds in Europe, because of growth disappointments and policy uncertainties, and they are on the brink of underperforming bonds in the US. The tensions between a long list of global risks and the ability of investors to keep faith in a US expansion that is closing in on being 10-years in the making have triggered bouts of volatility that have taken in Italian bonds, emerging market currencies and now global equities. Is it the end of the bull market? At the moment, I would say no. But, I would rather focus on capital preservation. Tensions could keep volatility elevated but 2019 should see better return prospects if the worst case outcomes for the trade war, Italy and Brexit are avoided.                        

Bring on the darkness

October can be the cruellest month. This October certainly has been. It has made those early year discussions of synchronised global growth and an overweight allocation to equities seem very distant. We are not quite there yet but a few more down sessions for US equities will put them behind most US bond sectors in terms of year-to-date total returns. It has been the case in Europe for some time that bonds, with their measly and often negative yields, have performed better than European equity markets. We never expected to make money in fixed income this year but the other two key reasons for holding bonds have certainly kicked in – capital preservation and a hedge for risky assets. Take a breath but an index of German government bonds, which had an average yield of 0.06% at the beginning of the year, has delivered a total return of 1.3% as of October 24th. In price terms the key European bourses are down between 6.8% for Paris and 15.4% for Milan.      

Short duration

What is going on? Is it the end of the cycle? Is it that investors are finally taking on board all the risks out there – the threat of an escalating trade war between the US and China, the Italian threat to EU financial stability, and the risk of the UK being jettisoned into a WTO world? Yes, it is all of those things weighing on sentiment. But more than that, we are in a world of quantitative tightening and a world where the best of corporate earnings growth is probably in the past. It doesn’t matter that – in aggregate – global central bank balance sheets are not shrinking but it does matter that they are not growing anymore. Add to that the 200bps tightening of short term US interest rates since the beginning of this current monetary policy cycle. When you consider that it is even more amazing that bonds have proved to be the most resilient asset class. For all the talk about curve flattening, 10-year Treasury yields have risen more or less the same amount as the Fed Funds rate has from their respective lows (December 2015 for Fed Funds, July 2016 for bonds).  So, obviously, longer duration bonds have suffered but a short-duration strategy in US government bonds has seen just a 0.2% drawdown this year, a similar strategy in investment grade has delivered a positive 21 basis points and a 1-5 year high yield index has delivered 4.2%. If the Fed is to tighten more, short-duration is likely to remain the best approach for those investors worried about volatility.

End of QE supports safe assets

I argued some time ago that the process of unwinding quantitative easing (QE) would be long and drawn out but that its effects would most likely be negative for risk assets and positive for safe assets, even though the bulk of central bank buying from 2009 onwards was of government bonds. The portfolio re-balancing effect of QE was to force investors out of low yielding safe assets and into higher yielding risky assets, with the result being a lower cost of capital for the private sector. Now the reverse may be happening. The underperformance of European equities has been a disappointment to those global equity investors that were convinced that Europe would take up the baton of global growth at the beginning of this year. On the bond side in Europe, credit has already started to underperform (very low yielding) government bonds. It has been the same in the sterling markets. In the US, until October, stocks had been performing well on the back of strong economic growth and, in parallel, credit was outperforming government bonds. That remains the case with the rise of Treasury yields above 3.0% in mid-September. However, bonds are now rallying in an impressive risk-off period and credit spreads are poised to jump higher.  The reversal of QE reduces the portfolio balance support for risky assets and allows investors to rebuild their short positions in duration sensitive assets. This week has been an example of how this plays out.

But not all bad news

Having said all that, I don’t believe the cycle is over yet. I don’t necessarily believe that we have seen the peak in bond yields in the US either. The Federal Reserve (Fed) is expected to hike again in December (perhaps in spite of President Trump’s attacks on the central bank) and there remains a core scenario that has the Fed hiking by another 100bps in 2019. While the equity world might be having a hissy fit that earnings growth has perhaps not continued to live up to analysts’ over-blown expectations, the Q3 earning season has still seen reported EPS above consensus estimates with many more positive surprises from companies that have reported already than negative surprises. The dynamics of the economy are still positive as well. There continues to be strong growth in employment and a shortage of labour that is pushing up the risk of wage increases. Job openings are at a record high. Consumption has been boosted by tax cuts and government spending is likely to remain a positive feature for a few more quarters. Companies are upping their capital spending plans. Yes, the trade issue is a major dark cloud and an escalation of tariffs to all Chinese imports will change the outlook completely, but we still have some time for that to be avoided.   

Sentiment is poor

There is no question, however, that there is much less confidence in the global outlook than there was at the beginning of the year. Emerging markets have been hit by the tightening of dollar liquidity and the threat of disruptions to global supply chains. Within that, Chinese growth has slowed in response to global concerns and the on-going rebalancing of the domestic economy away from state -owned enterprise led investment and the fact that the reduction in investment has hit the economy hard this year. European growth has disappointed and there is a no real confidence in the policy outlook given the political challenges of dealing with Brexit and Italy and whether or not to loosen the fiscal purse strings (which, actually, seems to be happening and may, for one, be fortuitously counter-cyclical). But does any of this mean a serious profits slump or an increase in default risks? Not yet, I don’t think.

Stay cautious

However, my preference in the short term remains with government bonds over spread in bond markets. Not that I think government bonds will deliver positive returns but they could be a good source of capital preservation and diversification while spread products might continue to adjust in this post-QE world, where the fundamentals are likely to deteriorate somewhat. Eventually there will be a renewed buying opportunity in credit and equities but it is going to be choppy because the Fed hasn’t finished and the ECB hasn’t started. If one believes that the monetary policy cycle gets short-circuited so that the Fed won’t get to where it thinks it should be and the ECB won’t even be able to start raising rates at all, then that is a world which is altogether worse than the one we face today and even more reason to be out of risky assets. The core scenario is not that one. The core scenario is a US slowdown from some point in 2019, the modest beginning of an adjustment to policy setting in Europe helped by an easier fiscal stance, and a recovery in emerging markets helped by an easing of trade tensions and appropriate policy adjustments in those economies that had the worst imbalances in 2018.

Optimism in the back pocket

If 2018 turns out to be as it is today then returns from both stocks and bonds will have been very low. What will 2019 look like? It could be better. The US bond market could generate total returns of between 3% and 5% depending on where yields peak. Even hedged into other currencies this will look better than what is likely in European fixed income markets. Stocks would benefit from an easing of risks and a prolongation of the economic cycle if further fiscal stimulus is achieved in the developed world. China’s growth prospects are sensitive to the success of domestic economic policy and recent initiatives to ease liquidity have already boosted the stock market. There is likely to be some sort of Brexit deal and Italian tensions will ease because even a populist government will not want to send Italy into a scenario where its membership of the euro is seriously questioned. If you believe that these optimistic events can happen you probably still need to park the optimism for a while. Markets can still adjust lower in the short term because there are a lot of stale long-risk positions out there. October has a habit of shaking markets up. Usually there is a relief rally between Thanksgiving and Christmas. The mid-term elections on November 6 might help set market sentiment as they could result in a break on President Trump’s agenda of further tax cuts and trade spats. The bottom line is, keep you capital safe for the rest of the year.

Out of Europe 

I won’t dwell on another shocking display at Old Trafford by Manchester United against Juventus. The opposition didn’t even need Ronaldo to perform but still outclassed United. Things don’t appear to be getting any better and relying on comebacks from going behind in every game is not a satisfactory strategy. Jose Mourinho’s position is rather like that of Theresa May’s. Things are not going well, there is an argument for replacing the incumbent, but the problems go way deeper than the abilities of the person at the top. After the performance on Tuesday, both United and the UK are heading out of Europe with little hope of anyone seeing things getting better. 

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