Given the panic in financial markets at present, it is amazing that Government bonds across the developed world are rallying to unprecedented levels. Was it not Government debt that set off spasmodic crises in markets over the last five years? Seemingly today more Government debt across Europe and Japan is good news. Suddenly it is claimed that the Japanese Yen has taken on the status of a “safe haven currency” in spite of a massive QE program and negative interest rates. Have we all gone mad?
What has become less clear and subject to much conjecture are the reasons for and the consequences of this historic bond rally.
The following points is a snapshot of bond markets (5 and 10 years) taken this week. The yields on bonds have declined to extraordinary levels. Indeed, it is estimated that over 15% of all bonds on issue across the developed world have negative yields.

  • Japanese 10 year bond yield negative 0.1%
  • German 5 year bond yield negative 0.35%
  • French 5 year bond yield negative 0.1%
  • US 10 year bond yield 1.6%
  • Italian 5 year bond yield 0.5%
  • United Kingdom 5 year bond yield 0.75%
  • Australian 10 year bond yield 2.4%

Why?

There are two main chains of thought to explain today’s bond market prices and the recent rally.
First, there is the view that bond prices are the legacy of quantitative easing programs across the world.
The second and alternative view suggests that bond prices reflect the risk of deflation, recession or financial institution problems in Europe and the US – following the Japanese experience of the last decade. The financial institution problem directly flows from the collapse in energy prices and the credit exposure of banks.
Whatever may be the reason for the current price of bonds, we can draw the conclusion that the likely returns from bonds will be very poor over the next five to ten years. Indeed, it is likely that the returns from higher risk assets – notably equities – will far exceed the returns from bonds and reverse the trend of the last ten years.
The trick is not to think or invest for the short term. Following a 20% correction, today’s equity market presents as an attractive proposition, and it should outperform bonds over the medium and longer term from this point. However, there is no need for a headlong rush to invest in equities. Rather, one should be diligent and patient. Most of all, there is a requirement to stay unemotional in the face of panic. History suggests that the best long term returns are set for investors when panic grips markets.
So let’s think logically about asset markets. Today in Australia the purchaser of a ten year Commonwealth bond that is held to maturity will receive a 28% total return (2.5% compounded annually). That return is low by historical standards, and it is actually 20% below the return of the Australian equity market over the last ten years. Remember that is the period which includes the massive drawdown of the GFC.
Our point is this. During times of panic, there will occur a dislocation of price from value caused by fear. While we do not dispute that fear is likely to drive equity prices lower from this point, we suggest that there is a tactical and logical response: long term investors should be accumulating equities during weakness.
In the past, we have cautioned against investment in bubbles; and today, we advise that investment strategies must not be overwhelmed by fear. Over the next five to ten years, careful analysis and historical precedent suggests that the Australian equity market will generate a “far superior return” than that of the Australian bond market. From a risk adjusted stance, that is all one needs to know. Low returns will flow to those that panic, while higher returns will be gifted to those that don’t.
While the prices of Australian bonds do not actually reflect fear in Australia, they do represent the fear present in offshore markets. That creates the opportunity, but it likewise suggests that equities in Australia, like overseas, could decline further over the next 3 to 6 months. However, it is during this period of heightened fear and uncertainty that investors should be tactically considering a higher allocation to equities.
Remember that while the equity market is predictive, it is also driven by fear and greed. Despite these influences, the market will adjust well before both economic downturns and upturns. Often the adjustment is rapid and excessive.
We do not expect a quick recovery in share prices anytime soon – there is simply too much global uncertainty and domestic weakness for that to be the most likely scenario. However, periods of weakness create opportunities. An averaging-down accumulation strategy should be considered, and more so if panic grips overseas markets.
Australian asset markets will not be immune from overseas events. However, we must carefully consider whether the declining share prices truly reflect the problems of our economy as opposed to overseas economies. Further, we should reflect on the last ten years of sub-optimal equity returns and remember that equities have always recovered strongly after periods of disappointing returns.