Markets enjoyed a great end to the week last week. The US dollar eased off as the Federal Reserve came out with a “dovish” interest rate rise – a weaker US dollar puts most asset classes in a good mood, as it basically equates to looser monetary policy for the world.
Meanwhile, the pound managed to hang on in there through the ups and downs of Brexit, Scoxit, and Budget U-turns, mainly because one voter on the Monetary Policy Committee thought that raising interest rates might be a good idea
And even the euro picked up as Dutch voters decided largely not to vote for populist Geert Wilders (although whether you can really read much into this about other European elections this year is debatable).
The sun is shining, and everything is hunky-dory. So where are the clouds on the horizon?
As we’ve been discussing a lot recently, I think that the biggest threat lies with the bond market.
Central banks own a lot of bonds. They’re now trying to retreat from years of pumping money into the economy in favour of “normalising” monetary policy. It’s a tricky balancing act for Janet Yellen and she ducked the question of what to do about all those bonds at this month’s post-Fed meeting press conference.
But given how pricey bonds are, and how warped the market currently is, you can see that it wouldn’t take much to trigger something potentially quite nasty. Bill Gross, the man once known as the bond king, told his clients earlier this month that “our highly levered financial system is like a truck load of nitroglycerin in a bump road”.
What might that mean in practical terms? How far could US bond yields rise (ie, how far could prices fall)?
A painful collapse for a risk-free investment
Conveniently enough, I read an interesting piece from research group Cross Border Capital earlier this week on this very topic.
It starts by making the point that a lot of money has fled both China and the eurozone over the last few years – it reckons it amounts to about $3trn altogether.
Where did that money go? It reckons it flowed into US Treasuries. So that kept bond prices high (and yields low) and also drove up the price of the US dollar. However, that capital flight is now reversing in China, and slowing down in the eurozone.
What’s the upshot? Well, Cross Border Capital reckons that both US bonds and the US dollar are overvalued. With capital flows reversing, it reckons that “traditional ‘safe’ assets look vulnerable”. In fact, it thinks that over the next year, the ten-year Treasury yield “could test 4%”.
For the typical bond investor, that could mean an 11%-12% drop in price. Throw in 5%-10% US dollar depreciation, and foreign investors in Treasuries could end up with a 15%-20% loss on their holdings.
That is quite a drop for a “risk-free” asset.
What concerns me is what happens when this becomes a self-sustaining cycle. In other words, bonds sell off, investors suddenly wake up to how much they could lose, and then they panic and bail out.
Don’t get me wrong – a US Treasury yielding 4% sounds attractive at this point, and clearly there’s a floor to how far bonds can fall. At a certain level of yield, people will pile in, pretty much regardless of any losses others have sustained.
But how much damage could that do in the meantime? I suppose that’s why Gross is still advising his clients: “Be more concerned about the return of your money than the return on your money in 2017 and beyond.”
From one over-priced market to another
The other glaringly overpriced market out there is – of course – the US stockmarket.
I could list any number of metrics to show that stocks are expensive. There’s the classic Shiller price/earnings ratio. That takes average earnings over ten years, and divides the share price by the figure. According to this figure, the US market is now more expensive than at any other point in history, bar the tech bubble.
Or there’s Warren Buffett’s favourite valuation measure – the market capitalisation of the US stockmarket (as measured by the Wilshire 5000 index) divided by US GDP. That’s currently up at around 130% – higher than at any point apart from – you guessed it – during the tech bubble.
Or there’s Tobin’s ‘Q’ – which basically looks at the book value of the stockmarket (how much would it cost to break up all the companies and build them again from scratch). It’s at 1 just now, which sounds OK, until you hear that the historic average is more like 0.65.
You get the picture. The US stockmarket is as overvalued as it’s ever been, with the possible exception of right before the tech bubble blew up.
So what should we be investing in instead?
Albert Edwards, the Société Générale strategist, has a suggestion. He takes a look at profits for the entire US economy as judged by corporate tax returns. This is a more reliable measure of company earnings at this stage in the cycle, he says, because as markets get more expensive and companies come under ever increasing pressure to make their earnings look good, they’re tempted to make their figures look better than they are.
Looking at figures for the fourth quarter, profitability is starting to feel the squeeze from rising wage costs. If that’s the case, then it means that the stockmarket is even more expensive than it looks, because the earnings aren’t as good as companies say they are.
However, this isn’t the case for all markets. Edwards looks in particular at MoneyWeek favourite, Japan. Japanese stocks have had a reasonable few years, but price/earnings figures have been pretty much static for the past six years or so, whereas both US and eurozone p/e ratios have risen quite strongly. In other words, the US and to an extent, Europe, have “re-rated” – but that hasn’t happened in Japan yet.
Given the choice, I know where I’d rather invest my money right now.