Finally, after years of near-zero interest rates and tons of printed money, bond yields are on the turn. How should investors respond? John Stepek reports.
Ask an investor today to name the safest asset in the world and the chances are they will point to US Treasuries. After all, the US is the world’s most powerful nation, has never defaulted on its debt, and runs the world’s reserve currency. Yet US government bonds weren’t always viewed as the ultimate in portfolio safety. Indeed, in the early 1980s, US Treasuries were nicknamed “certificates of confiscation”. On 26 October 1981 – the climax of a 35-year bear market in bonds, during which time yields had soared (and prices had slid) – the 30-year US Treasury yielded 15.21%. From today’s perspective, that sounds like a fantastic bargain. It was. Yet, at the time, it looked like anything but. One experienced bond trader interviewed by The New York Times at the time spoke to the conventional wisdom when he said, “Anyone who buys a bond today to hold for more than five years is out of his mind.”
A peculiar symmetry
With hindsight, that was the point when fear of inflation, and of the “bond vigilantes” (an imaginary collective of investors who would drive up interest rates for countries that borrowed too much money), hit a peak. The bond market turned, and a great bull market ensued. All through the booming Eighties, the globalising Nineties and the disruptive Noughties, with their myriad financial and political crises, the one common denominator in financial markets – notwithstanding the odd blip higher – was falling bond yields. The inflation of the 1980s gradually gave way to the disinflation of the 1990s, and then the deflation of the late 2000s. Global central banks cut interest rates steadily – led by the Federal Reserve – and after the financial crisis of 2008, resorted to printing money (quantitative easing, or QE) to buy their own nation’s bonds.
Then, with remarkable symmetry, almost exactly 35 years on from the 1981 peak in yields, July 2016 found investors struggling to price in the implications of Britain’s vote to leave the European Union. The Bank of England had, in a panic, restarted QE, and was buying more bonds. In the US, the 30-year Treasury yield hit a near-record low of 2.1% (it had only been lower once before, dipping to 2.03% in 1946). The ten-year hit a new all-time low of 1.4%. Meanwhile, the Swiss government found itself able to sell 50-year bonds at a negative interest rate – investors were willing to pay the Swiss government (and many others, over shorter periods) to look after their money. With hindsight, it now looks as though that was the point where fear of deflation, and the mania for “safe assets”, finally peaked. With investors now increasingly focused on economic growth and the return of inflation, and central banks stepping back from their money-printing activities, we could be seeing another turn for bonds. A fresh bear market may already have begun. So what does that epochal shift in interest rates and inflation mean for your money?
Inflation and the bursting bond bubble
The first component of any potential bond bear market is the return of inflation. The 1990s and early 2000s saw extremely disinflationary forces unleashed on the world. The expansion of the global workforce, introduced by the opening up of China in particular, helped to keep wages down. The dawn of the internet increased competition and cut costs in industries from publishing to high-street retail. Capital did well at the expense of labour. But this is all reversing now. In the political sphere, “populism” is largely anti-globalisation, which implies rising protectionism and more trade barriers, which increases costs. Meanwhile, many of the cost advantages accruing to outsourcing have shrunk as wages in emerging markets have risen. The internet continues to disrupt industries across the world, but new business models are becoming established and the dominant players are very apparent.
More importantly, governments are increasingly joining forces with workers to call for higher wages, and to challenge monopolistic behaviour, low pay and tax avoidance. They are also – as Donald Trump’s recent tax reforms highlight – less inclined to worry about deficits and the public finances, and more keen to win votes by cutting taxes or boosting public spending. Put very simply, we are moving from a world which has been flooded with excess capacity, to one where resources – from workers to finance – are going to be harder to come by.
None of this has to be bad for growth. Indeed, it should lead to more efficient resource allocation and higher wages (as companies have to compete for workers and capital), which in turn should be a boon for growth. Higher wages mean more demand and, collectively, near-record corporate profit margins mean companies are well able to afford to invest and spend more on their workforces. However, it’s a major change, and one that many financial assets – which have been buoyed by a pool of money that has essentially had nowhere else to go – may struggle to cope with.
The flight to safety reverses
Of course, inflation has so far been hard to come by, despite central banks’ best efforts. It has certainly reared its head in the UK, aided by the weak pound (and the Bank of England appears to be finally taking notice). But in the US, its appearance has still been on the tentative side. However, this is not just about the return of inflation. It’s about the end of financial suppression, too.
Central banks have been deliberately keeping interest rates low for roughly the past decade. With a combination of interest-rate cuts and ever-increasing bond purchases, both short-term and long-term interest rates have been sat on. But now, that suppression is ending. The US ended its QE programme in 2014. However, both the Bank of Japan and the European Central Bank (ECB) picked up the baton, continuing to pump more money into the global financial system. Meanwhile, according to capital-flow specialists CrossBorder Capital, US assets also benefited from safe-haven flows from China, “much of which poured into Treasuries following President Xi Jinping’s anti-corruption drive. We estimate these flows totalled a whopping $1.5trn, paced by similar-sized outflows from the eurozone as the ECB’s exceptionally loose monetary stance spilled out. Together, this $3trn of ‘flight’ capital fuelled the recent blow-off in bond returns.” So, in effect, the repression of US bond yields continued, even though – to all intents and purposes – the US economy had recovered from the financial crisis.
Now, however, this money is starting to leave the US again (as evidenced by the falling US dollar in recent months). Today, says CrossBorder, it “is starting to shuffle back, first to China as recent data appear to confirm the better-than-expected economic performance, and next to the eurozone, as investors begin to anticipate the upcoming monetary tightening by the ECB.”
More Treasuries, fewer buyers
So falling demand for safe-haven assets and a drop-off in global QE means there will automatically be less demand for US Treasuries and other safe-haven assets, suggesting that yields should go higher on that basis alone. Indeed, CrossBorder reckons US ten-year Treasury yields are set to touch 3.5% this year, even if inflation and interest-rate expectations remain pretty tame. This is particularly significant because, alongside demand for Treasuries falling, supply looks set to rocket. With the Trump tax cuts, the US Congressional Budget Office reckons the amount the US government needs to borrow from the markets is set to rise from roughly $500bn in recent years to more than $1trn this year, and more than $1.5trn next year.
Meanwhile, if the global economy is growing, then private-sector companies will be looking to borrow money to expand, too, argues Richard Bove of the Vertical Group on CNBC. That is going to be a shock to the system. The concept of “crowding out” – where deficit-running governments compete with private-sector borrowers in the markets, driving up the cost of money – could well make a comeback. “For a decade there has been a great deal of money around at real prices below zero. This era is over. Anyone who does not understand that this is a significant fundamental change needs to take a thoughtful look at these numbers and think about what they mean.”
What history tells us
So what might happen next? At the start of the last epic bond bear market in 1946, memories of the Depression were still very fresh, and economists also cited the short but brutal deflationary collapse that happened just after World War I (the brief depression of 1920-21). So although inflation took off as war-time price controls were lifted, investors spent most of the late 1940s worrying more about a return of deflation. In fact, 30-year US Treasury yields (which had also been suppressed by the Fed, this time because of the need to finance the war) were trading at a similar level to 2016, at around 2%-2.3%. They didn’t really start to rise until 1949, and even then it took another ten years before the 30-year was much above 4%.
The comforting news for equity investors is that the start of this particular bond bear market was a great period for investors. Indeed, 1949 marked one of the four best times to buy US stocks during the 20th century, according to Russell Napier’s Anatomy of the Bear. However, before you rush out to buy, there’s just one problem – equities were also dirt cheap in 1949, which we certainly can’t say today.
Perhaps a better comparison lies further into the last bond bear market – in the late 1960s. The early 1960s saw unusually low inflation. Between January 1959 and May 1965, US inflation (as measured by the CPI – consumer prices index) had ranged between as low as 0.3% for much of 1959 to highs of 1.7%. But, fuelled by government spending – both on the Vietnam War and Lyndon B Johnson’s Great Society reforms – and strong growth (unemployment fell below 4% in 1966), inflation started to rise. In 1966 it reached 3.8% and by 1970 it was regularly above 6%. It was 1986 before it was ever below 2% again. As a result, as Paul Schmelzing of Harvard University noted in a study for the Bank of England last year, US ten-year Treasuries lost 36% in real terms between 1965 and 1970. And that was just a warm-up for the real disaster of the highly inflationary 1970s.
Of course, the return of inflation doesn’t mean we need to end up with the double-digit inflation of the 1970s. The return of big-spending governments and angry voters doesn’t necessarily bode well – throw an energy crisis into the mix and maybe we will get the Seventies again – but there are other outcomes. As Jim Grant of Grant’s Interest Rate Observer puts it: “Let’s say that the indestructible US economy, for whatever reason, got back its mojo, and the Fed seemed to be way behind the curve. Interest rates would go up for the wholesome reason that things were looking better. At that point, you could make a very good case for common stocks.” We look at what this could mean for your portfolio below.
What to buy now to profit from “the great rotation”
Let’s assume the bond bear market really has arrived (2012 looked like a sure thing for a while, too, but didn’t quite pan out). The first point is that it’s probably best to reduce your asset allocation to bonds, excluding very short-term cash substitutes. For example, the iShares 20+ Year Treasury Bond exchange-traded fund (Nasdaq: TLT) has already lost 7% so far this year. Secondly, holding some gold makes sense. The recent rise in government bond yields hasn’t had much impact on gold, but if investors start to worry about inflation genuinely taking off (rather than rising bond yields being a function of capital flows or rising supply), then gold should do well.
So what about equities? If US Treasuries sell off hard, then it’s hard not to see stockmarkets taking a hit, too. Rising bond yields means rising interest rates, and that will unnerve markets, given that they’ve been cosseted by central banks for so long. We have already seen an abrupt sell-off earlier this year, which has left markets nervous, even though they’ve mostly recovered the lost ground. Most pundits have been focusing on the ten-year Treasury and the 3% yield level, but Bloomberg’s Marcus Ashworth suggests watching the 30-year. It’s “now within touching distance of highs reached in 2015, 2016 and 2017. This 3.24% level is the dividing line between a fairly orderly bond sell-off and a proper rout – the latter has the capacity to spill over into stocks and even potentially signal a credit crunch.” So that’s something to watch.
However, beyond a short-term interest-rate panic, the key theme in equities is “the great rotation”. Certain types of companies do well when economic growth is scarce and inflation is weak. Growth stocks, such as the big tech companies, for example, can command a premium because they are rarities in an otherwise moribund economy. (This is another key similarity between now and the 1960s – back then, it was the “Nifty Fifty” stocks that did well until inflation took off.) “Bond-like” stocks – big consumer staples companies, or utilities paying solid dividends – are other types of defensive stock that tend to do well in weak economies.
But as inflation returns, it should be the turn – in theory – of value stocks, which have been underperforming for a long time, to shine. So what should do well? Among sectors that have performed poorly in relative terms, commodities stands out, despite rallying in 2016. One easy way to play the resources sector is via the BlackRock World Mining Trust (LSE: BRWM), currently trading at a discount of around 11%.
On specific markets, Japan is worth getting exposure to. It has one of the cheapest banking sectors in the world and, as a result, should do particularly well from any pick-up in inflation (rising interest rates are good for banks’ profits). There are several good Japan investment trusts that we’ve tipped in the very recent past (see issue 881), but one wider-ranging trust that holds several Japanese banks and is also well positioned both for the return of inflation and for any resulting volatility is the Ruffer Investment Company (LSE: RICA).