The sharp global bond correction we have been warning about for over a year has suddenly eventuated. But there is now a danger that investors overreact and dump quality, high-yield stocks.
We believe the sharp rise in bond yields, while uncomfortable, is just a much-needed correction, rather than a signal of a fundamental change in the world’s economic outlook.
We therefore don’t think it requires a major shift in strategy; nor should investors dump high-quality equities in response. And we don’t think investors should listen to hedge fund managers who are merely front running asset rotation.
A sharp correction
We have been concerned about the potential for a sharp bond market correction for some time, particularly in the wake of German 10-year bond yields falling close to zero.
The recent correction was certainly sharp but it is not earth shattering. Concurrently, Australian 10-year bond yields, for example, surged to 3 per cent from a record low of about 2.25% in just a few weeks.
Figure 1. 10-year Australian government bond yield
Bonds were ridiculously mispriced with yields belying the risk of inflation, default or currency. The craziness was caused and exacerbated by the European Central Bank, which flagged it was prepared to buy bonds at negative yields.
That was a plainly stupid thing to do and caused the pre-emptive bond buying by hedge funds and traders who were relying on the ECB to follow up on its words.
But the ECB, without saying so, has decided it’s not going to buy bonds at negative yields across the maturity curve.
This highlights that investors need to listen to central banks, but not believe them. Investors need to ask whether what central banks say makes sense or not. And investors should not listen to traders whom claim that bond prices are predicting some cyclical economic change.
Just a correction
Thus we think this is just a correction, rather than the signal of a new global economic environment.
We think that bond markets have moved from completely mispricing risk, to still mispricing risk, but to a significantly lesser extent.
For instance long term investors should not be concerned to see German 10-year bonds move from 0.1 per cent to, say, 1 per cent. Further, the risk of a correction in yields to say 3% in Germany (and that is a historically normal rate) is low given QE.
Meanwhile, the Australian bond market and equity market have logically corrected but arguably they have overreacted. We expect long-term bond yields to gravitate to around 2.75% over the next year; and the US 10-year bonds to sit at around 2.25 per cent
In the scheme of things those are still low yields.
Don’t dump yield stocks
A lot of people – commentators and investment banks – are telling investors to get out of yield stocks and get back into growth.
Their reasoning is that bond yields usually rise following a recession as the market predicts an economic recovery and inflation.
But we don’t think this bond correction is indicative of a surge in inflation around the world, or a growth cycle recovery.
The correction was simply indicative of a mispriced bond market.
So investors should not dump yield stocks and move into cyclical stocks like resources.
The bond correction does, however, show the folly of paying excessive prices for equities.
Indeed, we believe that overvalued parts of the market are very vulnerable and the bigger risk actually lies in those particularly high PE stocks such as Domino’s Pizza, Ramsay Health Care and Medibank Private.