Figure 1. Investors running between the stock and bond markets
Source: CNN Money
Whether occurring at birth or some other subsequent stage in life, there is often a fundamentally opposed viewpoint between equity and bond investors. Much like the proverbial ‘glass half full’ phase, equity investors will tend to focus on the business positives (the business’ strategy for growth) while bond investors will tend to be most concerned with potential business risks (the business’ capability to pay me back my money). A simplified view no doubt, but one that illuminates the contrasting perspectives of the two groups of investors. What both equity and bond investors do (or at least should) have in common is the same evaluation framework of:
- Capital deployed
- At what risk?
- For what likely outcome?
This article reviews what appears to be an inflection point in longer-term bond yields and the implications for the apparent ‘glass half empty’ view of bond investors.
Bottoming of long-end of the interest rate curve
The long end of the global interest rate curve very likely bottomed around the end July / early August 2016 and this has resulted in a sharp turnaround in interest rates since. For example, the yield on US 10-year treasuries hit a low of around 1.4% and is now around 2.5%, while the Australian 10-year bond came from 1.8% to 2.8%, currently. These marked movements in the bond market have resulted in corresponding declines in the capital price of these instruments (Fig. 2).
Figure 2. US and Australian 10-year government bond yields
Source: IRESS and Clime Asset management
This sharp reversal in the long-end of the curve has generated a stream of warnings from market commentators on the impending crash in the bond market. To paraphrase Mark Twain, we believe ‘the reports of the bond market crashing are greatly exaggerated’ and further these viewpoints are not overly useful. We believe it is the following two questions that have more relevance:
- Has the interest rate cycle bottomed?
- Will interest rates move back to pre-GFC levels in a hurry?
In our view, the short answer to these questions are yes and no respectively, which we will elucidate below.
Has the interest rate cycle bottomed?
We believe long-term rates have bottomed in what has been a multi-decade downward trend because:
- There is a lot of criticism of the low, no and negative interest rate policy settings that have been adopted since the GFC as they have not proved to be effective after years of implementation.
- We remain optimistic of what seems to be a slight change in Central bank thinking about ultra-accommodative interest rate settings, particularly against a backdrop of what seems to be emerging inflation.
- The US Fed has commenced its interest rate rising program and in the absence of a crisis resurfacing in the near to medium-term, it is likely they will continue to hike, albeit in a measured way.
- While still on the low side, there are signs that inflation is starting to come through the economies of major developed markets. Expectations of inflation in 5 years from now is (at least on a relative basis) considerably higher.
Importantly, whilst we believe the long-term interest rate cycle has bottomed, this does not mean that there will not be oscillation around current levels.
Will interest rates move back to pre-GFC levels in a hurry?
Whilst it is possible that the Australian 10-year bond yield can move beyond 3.0%, we believe it is more likely to consolidate at or around current levels. This is because:
- The world simply cannot afford to have high interest rates. Based on the latest IMF update, the global debt level reached US$152 trillion in 2015. This represents 225% of global GDP. Of that, $100 trillion (around two thirds), is held by the private sector, and is primarily concentrated in the world’s advanced economies. While history is more likely to rhyme than repeat, the primary outcome from various episodes of high leverage from different regions in the past are similar, and they aren’t good. These outcomes include:
- The sheer size of the debt is hazardous, and has the potential to inhibit economic growth. It constitutes one of the most important headwinds to growth in the global economy. Hence, with lower growth it is likely that the world will have lower inflationary pressure.
- Financial and economic stability are at risk. A number of studies have demonstrated that when there is a build-up of abnormally high debt, particularly high privately held debt, the likelihood of a financial crisis is considerably higher and financial recessions are more severe and prolonged. This will lead to more extended uncertain (and volatile) financial market conditions.
- The world currently faces significant strains from an aging population. Their demand for yield is understandably an important influence across financial markets. Hence, we believe higher yielding assets will still be highly sought after over the medium-term and this will subsequently limit dramatic increases in long-term rates.
- The spending patterns of this aging population is another point of consideration. They are living longer and need retirement savings to last. The older population is typically in less of a hurry to spend, resulting in a more ‘slow and steady’ (and more segmented) influence on growth in the overall economy.
- Technological advancement, particularly in areas such as the energy sector (think solar cells and batteries), over recent years has (or at least should) also reduced the input cost of most goods and services. As more companies embrace the digital revolution and adopt newer technologies to compete, these more advance technologies (increased automation) – when coupled with lower energy costs – bring downward pressure on prices of goods and services. Something that has occurred since the early 2000s. With increasing automation in every sector of the economy, there are less jobs and/or differing types of jobs. Starting at the repetitive lower skill end initially and moving into more highly skilled worker’s roles that may have previously been outsourced to workers overseas, many roles are increasingly being automated by machine. The implication is that wages growth and wage-driven inflation has and will likely continue to be relatively muted.
Given this backdrop, we don’t see a marked increase in inflation or inflation expectation, and as a result we do not believe long-term bond yields will move back to pre-GFC levels in a hurry.
We encourage investors, whether from an equity and bond investor perspective to share a common evaluation framework of
- Capital deployed
- At what risk
- For what likely outcome
In contrast to what is typically an equity investor’s perspective, we hope that you’ve found these insights useful. As always, we would love to hear any comments or thoughts that you have on the subject.