Are investors doomed?
Bearish sentiment is rife in the equity markets. And there are plenty of good reasons for that. But the biggest risk of all may be of a bond market crash. Max King explains why.
A recent headline in The Telegraph which read “the market crash is coming” encapsulated the prevailing view of the commentariat about the investment outlook.
Of course, gloom is far from an unusual stance for market watchers, who recognise that bad news catches the eye of readers more easily than good news and that pessimism is widely regarded as the hallmark of a higher intellect, even though it is usually wrong.
The current bearish argument is, however, cogent.
The bears have many good points, but will they prove right?
The bearish argument goes roughly along these lines: equities, especially those in the growth sectors, are highly rated, propped up by government bonds on historically low yields.
Yet inflation will persist even if the current spike proves transitory. This makes higher interest rates and bond yields inevitable; the former will be damaging for economic growth, the latter will result in equities being de-rated.
Faced with much higher borrowing costs, governments will either have to pursue austerity, thus worsening the economic outlook, or continue to print money, leading to escalating inflation. This will exacerbate the downturn, potentially leading to stagflation and compounding the bad news for equity investors.
But is it right?
Charles Gave of Gavekal Research believes that US equity valuations are at or close to bubble levels, implying that the bubble will soon pop. He bases this on three calculations; the high cyclically-adjusted price/earnings ratio of the market, taking into account low US Treasury yields; the high valuation of the S&P 500 relative to the price of energy; and the excessive momentum of the market in the last five years, indicating investor complacency.
The US market is expensively valued relative to others and accounts for a disproportionate share (60%) of the MSCI All Countries World Index, so Gave’s arguments do not necessarily apply to non-US markets. “The US is in a period of accelerating inflation,” he says, “but every peak in inflation since 1885 has either occurred in a recession or as a result of a deflationary shock.”
He believes that the “euthanasia of the rentier” is the policy of the US and European administrations, who will keep interest rates and bond yields below the rate of inflation to finance political and misguided economic objectives. The US bond market, he argues, is positioned for falling GDP; the yield on 30-year Treasuries should be 3.65% based on the structural rate of growth in the US, not 2.1%. “Equities are the only thing to own” – but are too highly valued at present.
His colleague Anatole Kaletssky takes a different view: “Moderating growth will keep interest rates very low and the bond bubble will deflate only slowly. Equities are reasonably valued while non-US equities are cheap. Though a 1970 upward spiral in inflation is possible, more likely is a period of creeping inflation as in the 1950s.”
The current spike in inflation will pass and a temporary period, perhaps lasting several years, of apparent policy success will follow. “This scenario is much more consistent with current market pricing than a stagflation disaster.” He believes that the market is wrongly priced much less often than the market sages like to think.
In support of this thesis, economic data is showing inflationary pressures starting to ease. Pandemic spending is coming to an end and higher prices, notably for energy, are eating into disposable income, so growth is set to slow. US president Joe Biden’s grossly extravagant spending programme is likely to be severely curtailed by Congress, while in the UK Boris Johnson’s colleagues are running scared of his tax-and-spend strategy.
The factors pushing up energy prices are varied and likely to be resolved. The oil price could spike higher but all previous spikes have resulted in increased output, more efficient usage and the encouragement of innovation.
As Verdad Advisers points out: “the view that increasing oil prices are bad for stock returns has long been a popular one but our research shows that both are primarily influenced by the business cycle. Equity investors only need to worry if the price increases are driven by shrinking supply.” This means that investors have more to fear from falling prices.
If the various bottlenecks currently pushing up prices ease, inflation will fade, but there is a risk that the shortage of labour leads to a wage-price spiral comparable to the 1970s. That risk is accentuated by the increasing role of the productivity-sapping public sector in crowding out private sector employment.
There is also a risk that the squeeze on consumers from higher taxes and prices – exacerbated by higher interest rates – causes a recession which hits corporate profits and hence the stock market.
The biggest risk of all – a bond market crash
But the biggest risk may be of a bond market crash, as feared by James Ferguson of Macro Strategy Research. It may seem that currently low government bond yields are looking through the current spike in inflation to lower numbers thereafter but Ferguson shows that “bond markets have no predictive power over inflation.”
Throughout the 1960s and 1970s, bond investors were complacent about the rising trend of inflation, with yields persistently too low. In the 1980s and 1990s, bond yields were slow to follow inflation down and ten-year US Treasury yields remained over three percentage points above the core rate of inflation. This was the era of what Ed Yardeni called “the bond vigilantes” who intimidated the US government and Federal Reserve into fiscal and monetary rectitude by making government borrowing and inflationary monetary policy very expensive.
Real Treasury yields started to fall in 2000 and by 2012, yields were less than one percentage point above core inflation. They are now 2.5 percentage points below, which is on a par with 1974. Even if inflation comes back down to 2% and stays there, investors might again demand an inflation risk-premium, pushing ten-year yields up to 5%. “The scope for a disaster in the bond market is very real,” says Ferguson.
This would undoubtedly spill over internationally and into equity markets. It would also cause severe problems for governments in financing their deficits and debts, as well as push up shorter-term interest rates, to the cost of all borrowers. Gave would argue that though this would be painful in the short term, the consequent return of financial discipline would be wholly beneficial for the global economy in the longer term.
This bond market crunch may not be imminent. But Ferguson and Gave are surely right to say that negative real bond yields are as unsustainable now as they were in 1974. Kaletsky may well be right to argue that investors are overly anxious in the shorter term – but the sword of Damocles will hang over markets until borrowers, especially governments, are dissuaded and savers rewarded.