Two weeks ago, the participants at the MoneyWeek Roundtable addressed the issue de jour: the ‘Great Rotation’. This is the name for the anticipated wave of money about to flood out of bonds and into equities. The thinking is that stocks look cheaper compared to bonds than virtually ever before, and that the great start to the year enjoyed by stock markets is the beginning of a mass move out of bonds.
The desperate search for yield
In fact, the truth is that ultra-low government bond yields have been driving investors to search for yield in all sorts of unusual places (including equities) since the rebound from the crisis began in March 2009. The worry is that by the time markets think up a new name for a trend – as they have now – that theme can often be on its last legs already.
But it’s not a Great Rotation out of government bonds and into equities that investors should be focusing on. The big threat facing your savings in 2013 comes from high-yield corporate and emerging-market bond funds.
Despite all the talk of China, commodities, gold and emerging markets in recent years, it’s government bonds (UK gilts, US Treasuries and German bunds) that have led the field. The best-performing asset class worldwide in 2011, beating even gold, was government bonds. That continued for the best part of last year, with ‘govvies’ continuing to outperform as gold and developed-world stockmarkets marked time.
Then, in 2012, money was sucked out of the Bric markets (Brazil, Russia, India and China) as China’s infrastructure programme ran out of steam and Brazil and India both started to founder; only the persistently strong oil price kept Russia in the hunt. With emerging markets losing popularity, it’s small wonder that, as we head into 2013, money has flowed back into major-market equities again.
The concept of a rotation out of bonds and into equities is inspired by three lines of thinking, all of which have their flaws.
An abnormal cycle
First, by the time the economic cycle starts to bottom-out, low interest rates should have stimulated new economic activity, which is good news for company earnings. And as the economy gains traction, the only way for rates is up. So investors move out of bonds and try to capture the coming improvements in earnings. Markets are notoriously early to take advantage of recovery, and he who hesitates is usually lost.
But this cycle is not panning out the way things normally do. The notion of a robust economic recovery has been quashed several times already (there has even been talk of a triple-dip recession). What we know is that quantitative easing (QE), by pumping extra money directly into the system, is sloshing into a wide range of risky assets, inflating prices.
Secondly, ultra-low bond yields are making the yields available on other assets appear, at least relatively speaking, very cheap. It is rare for dividend yields to exceed bond yields as they have done recently, and the yield implied by earnings (this is just the inverse of the price/earnings (p/e) ratio) suggests “equities are stunningly cheap”, as noted by Liontrust’s Jan Luthman at the recent Roundtable.
The idea of comparing earnings yields with bond yields is based on the so-called Fed Model suggested by economist Ed Yardeni. This is believed – though it’s never been verified – to have been the way the US Federal Reserve looked at the relative valuations of US Treasuries and US stocks.
The idea is that if an ex-growth company makes $10 a share, the appropriate p/e ratio for it to trade on depends on how costly debt is. If ten-year yields on Treasuries are 10%, then to give the same investment return, a company should trade on a p/e multiple of ten, give or take some adjustment for risk.
If the outlook for interest rates falls, however, and the yield on ten-year Treasuries falls to 5%, the appropriate stockmarket earnings yield would also fall to 5% (ie, the p/e ratio would rise to 20 times). In this way, a stronger bond market feeds into better stock prices, and vice versa.
But whatever the merits or otherwise of the Fed Model, in a post banking-crisis scenario its most basic assumption proves faulty. As any veteran of Japan will tell you, in the aftermath of a bank crisis, whatever relationship there may be between bonds and equity yields breaks down, and some might argue it even goes into reverse. I’ll explain why.
The Fed Model argument depends on interest rates and government bond yields being fair approximations for the short and long-term costs of debt respectively in the real economy. In normal times, the lower rates go, the easier and cheaper debt becomes for consumers and companies.
But after a crisis, this is no longer the case, because banks are frantically de-risking their balance sheets. The worse things get for banks, the less inclined they are to lend to the likes of you and me, and the more they try to switch their exposure into risk-free cash, or very short-term government bonds.
This ‘rush to safety’ by the banks has driven short-dated yields to extraordinarily low levels – even going negative in some instances – and has dragged the yields on longer-dated government bonds down with it.
So in this environment, lower yields do not mean easier and cheaper credit to the real economy. In fact, they mean quite the opposite. This explains how we can have the lowest UK base rates for 320 years, and yet non-mortgage household borrowing costs are higher than before the crisis, while we have seen a several-hundred-billion-pound drop in the level of bank lending in the economy.
Key engine splutters
Thirdly, despite this abnormal environment, commentators are hopeful that a more normal cyclical rotation is in place because, as stockmarkets have rallied in the New Year, bond markets have coincidentally been selling off. But a far more likely explanation for equities’ strength is QE.
In the UK, this accelerated to three times its previous rate last year (in other words, the Bank of England was snapping up gilts three times as quickly as before). QE naturally feeds into stock prices and has been the key driving force sending the UK stockmarket higher since last March.
We know that QE must be the culprit because it has also been doing all the other things we’d expect: boosting broad money-supply growth to its highest since the crisis began, keeping imported inflation high, and diluting the value of sterling: the pound has slid against even the euro, despite the fact that the euro area has just announced its third successive quarterly drop in GDP.
The trouble is that, if QE is the driving force behind rising stocks, that doesn’t really lend itself to the idea of a ‘Great Rotation’. And, in America especially, QE’s days now look numbered. This is because, as I pointed out here last November, there isn’t really any justification for the latest round of American QE.
The main point of QE is to offset the collapse in the money supply that results when banks get into trouble. When banks make loans and credit their customers’ accounts, money is created. Likewise, on the few occasions where banks need to repair their balance sheets, they destroy money by shrinking lending.
It is this process of money destruction that the US Federal Reserve and the Bank of England have sought to neutralise via QE. The central banks’ bond purchases credit the sellers’ accounts. This makes up for the banks’ shrinking lending, which is debiting their borrowers’ accounts.
QE gets out of control
We know that QE is good for equity prices. So we also know that if QE were to slow down or even stop, that would be bad for equity prices, and would halt any apparent Great Rotation in its tracks. I argued at the end of last year that QE in the UK was going too fast.
The repercussions of that are now becoming clear, in the form of a falling pound and sticky and rising inflation. The big global risk, however, comes not from our small island but from the US, where the whole purpose of further QE is now questionable.
Proportionally speaking, US banks have crystallised far more losses than any others, and are back to lending normally again. That means there is no longer a hole in the US money supply to refill. So any further QE is for the first time coming on top of, and adding to, normal money creation, which in theory should result in outright inflation.
Unfortunately, the Fed stopped publishing its M3 broad money measure back in 2006, just ahead of the financial crisis, so we can only estimate whether or not money is growing out of control. My own estimate suggests that US broad money is growing at an annual rate of 6%-7% and accelerating fast.
That’s already way too much for an underlying rate of real (after-inflation) economic growth that’s probably in the 1%-2% range for 2013 (although actual growth will depend a lot on Congress and what they do about the so-called fiscal cliff).
What is more certain is that investors’ inflation expectations have risen and are now almost as high as they were before the crisis. As a consequence, the US Treasury market has suffered a sharp sell-off, as I warned it might back in November.
If the US’s QE3 continues to cause excessive broad money growth, driving both inflation fears and bond yields higher – as I fear it must – the Fed will be forced to reconsider the employment part of its mandate long before unemployment has dropped to the desired level.
If it waits too long, as central bankers are wont to do, then not only will inflationary pressures have become too entrenched to easily quench, but QE will also be widely seen as a policy initiative that has outlived its usefulness. In fact, I expect to see QE abandoned very publicly by mid-to-late 2013.
The end of QE
This is likely to have at least two profound consequences. First, the end of years of aggressive dilution of the dollar should send the currency on a multi-year recovery trajectory. Second, the rotation out of US Treasuries and into equities is most likely to reverse again, as the inflationary liquidity boost that comes from QE ends.
However, all is not lost for stock bargain-hunters because, just as the QE tap is shut off in the US (and possibly turned down in this country), Europe will most likely need to embark on its own massive QE programme. Since the crisis, Europe’s banks have squandered their time somewhat.
They have only managed to boost their capital back up to the levels US banks could boast of before the crisis hit. For the next phase of their rehabilitation, they will have to follow the US lead and cleanse their balance sheets of all their own toxic loans.
What will this take? Well, the major US banks have realised losses equivalent to over 15% of their peak loan books. So far, major continental European banks have barely established losses of 4%. Of course, it may be that European borrowers are almost entirely good for their debts – but frankly, the economic news out of Europe makes such an idea barely credible.
What’s more likely is that European banks have many hidden losses on their books. Now that their capital ratios aren’t quite as threadbare as they were, Europe’s banks are in a better position to start crystallising these losses and repairing their balance sheets. That will put the banks in a better position – but it implies that they will be shrinking loans on the Continent for several years.
The result could be a deflationary depression. The only way to prevent this – and it seems a likely outcome to me – is for the European Central Bank to succumb and follow the Fed and the Bank of England in adopting QE to offset falling bank lending – and once it begins, money-printing in the eurozone should help boost equities in the region.
What a real bond crash looks like
But what does all this mean for high-yield bond funds? If we were really facing a Great Rotation, the cyclical economic recovery scenario would probably be good for high-yield bonds, at least at first. Economic recovery makes it less likely that companies will default (so investors will pay more for the bonds, as they’re less risky).
Also, in the early stages of such a recovery, with output still some way below capacity, inflationary pressures should be muted, which means that government bond yields shouldn’t rise too fast.
But this cyclical norm is not the scenario we face here. If the Fed stays too long at the QE party, as seems likely (judging by central bankers’ past poor judgement on such matters), inflationary expectations could rocket, potentially trashing government bond yields in the process.
And due to a quirk in the maths of compounding interest, this would be much more dangerous, now that yields are nominally so low, than in previous bond market sell-offs.
The worst is yet to come
It gets worse. In the last bond market ‘crash’ of 1994, UK ten-year yields rose by three percentage points, enough to knock 17% off the cash price of a gilt trading at par. However, bond investors aren’t traditionally overly concerned about falls in the cash price of a gilt, because the government will pay them the face value when the bond matures anyway and, in the meantime, they can keep collecting their coupons.
The coupon on the benchmark bond in 1994 was 8%. So over the course of the couple of years of the crash, the total return for gilt investors (a 17% drop in cash price, offset against 16% of coupon income) was about flat.
There have been three other gilt market sell-offs over the last 30 years and they’ve all seen similar mark-downs on the cash price, though some have enjoyed even higher compensating coupon income and even faster returns to nominal profit than 1994. Bond investors have naturally become rather used to the idea that, even in the worst-case scenario, you’re still unlikely to actually lose money.
However, if the same three percentage-point increase in yields happened today, due to the much lower coupon on the benchmark ten-year gilt, the cash price fall would be a rather more hefty 22%. That miserly 1.75% coupon would also mean that a gilt holder would only receive only 3.5% of compensating income over the ensuing two years; meaning the total return would be a loss, not of 1%, but of more than 18%. That’d be far, far more shocking than any of the last four so-called bond ‘crashes’.
The thing to be aware of is that you are taking the appropriate risks. For most people, the stockmarket is where their risky investments are. The bond market, whether they’re aware of it or not, is where their savings are kept. Investors are used to taking the rough with the smooth in the stockmarket.
But wiping a fifth off people’s savings in the supposedly much safer bond market is another matter – especially since such wobbles seem to hit the bond market every seven years or so.
Yet no bond traders I’ve spoken to are conscious of the much more extreme risk our current ultra-low-rate environment poses. Indeed, the assumption that fixed income, rather than say portfolio diversity, is intrinsically safe, now pervades the financial sector.
Pension fund exposure to equities is close to a five-decade low as more and more funds follow actuarial advice and match long-term liabilities to long-dated bond assets. The insurance sector is almost entirely invested in fixed income. Since the bond market has been essentially a bull market for a generation, there has been no test of the assumptions behind the assumptions.
And this is just the scenario facing investors in the world’s most liquid government bond markets. For those who have strayed into the illiquid world of junk bonds, or emerging-market debt, there are two other risks that would compound any inflation scare: default risk (the threat of an issuer going bust) and illiquidity risk (the danger that you can’t get out when you want to sell).
It’s the latter that I’m particularly concerned about. One of the market’s most outstanding analysts is Russell Napier (who’ll be attending the MoneyWeek conference in May, as will I), who points out that emerging-market bond funds have grown in size from $34bn in 2003 to $306bn today.
Open-ended bond funds have seen a surge in demand from investors asking few questions as they desperately seek yield. Such funds run the risk of massive redemptions – everyone selling – all at once if government bond yields rise above a tipping point.
This is exactly the sort of thing that happens when investors buy into the idea of a ‘Great Rotation’. The danger is that, although such funds find supply almost unlimited on the way in, history shows that few of the bonds these funds invest in have an active after-market. Liquidity that seems no problem on the way in, can disappear almost completely when the tide goes out.
The reason for this is that when emerging markets are exporting a lot of goods, they run trade and current-account surpluses. This pushes their currencies up and attracts investment. As we discovered during our own credit bubble, if you offer people unlimited, cheap credit, they tend to take it.
But over time, they use it for increasingly unproductive projects. Emerging markets become capital importers, and the danger point comes when their current-account surpluses turn around and start heading towards deficit.
A dangerous tipping point
With external debt-to-GDP ratios in many emerging markets now above the red light level of 30-35%, a tipping point could be very dangerous. Most worryingly of all, almost all emerging markets’ foreign-reserve accumulation is now reversing.
If this triggers a net outflow of capital, everyone could be running for the exit at once. Open-ended bond funds won’t be able to find sufficient buyers for their holdings without taking a steep discount – in other words, they’ll have to sell at a loss.
The history of emerging-market capital flows is littered with such dramatic turnarounds, the most recent being the Asian crisis of the late 1990s. In short, we have the makings here of the perfect bond-market storm – and its epicentre could well be emerging markets. If you have any money invested in such funds, the risks may be significantly higher than your understanding. I’d strongly consider reducing your exposure now.