Government bonds in the firing line

It is always important to put aside preconceptions and let all the data speak – and not just that which confirms prior beliefs. At present, the data which best models the long-term outlook (valuations) are suggestive of relatively weak returns in global equities and this has informed our cautious positioning. Furthermore, bond yields and interest rates remain unusually low on a historical basis. Yet for the short-term, economic surprises are currently positive, business sentiment strong and profits growth relatively robust. It is this short-term data which also needs to be heard.

The short-term long (momentum) /long-term short (value) dilemma in equities is something we have discussed previously. A sharp fall in equity markets is less likely when profits growth remains robust. For the medium-term, a cautious view remains appropriate in our view and equity portfolios should be skewed towards specific company or event-driven situations.

However, if the current economic momentum continues ultra-low government bond yields look increasingly out of line. We accept that shorting government bonds is a trade which has systematically punished investors during the long period of unconventional monetary policy over the past decade. As a result, the fear factor is very strong, even as economic fundamentals start to point towards significantly higher bond yields.

On a global basis world GDP growth for 2017 is forecast to be 3.5%, the strongest performance for the past 5 years. Inflation may still be a little below target in the US and eurozone but with the exception of Japan and Switzerland is now well above zero, highlighting the diminishing risk of the deflationary outcome which was feared as recently as 2015 in the eurozone.

Exhibit 1: Global inflation rates now much closer to 2%

Output gaps across the developed world have closed steadily since 2012 and while investors still seem reluctant to take the Fed’s guidance for 3 rate increases next year at face value, a progressive tightening of monetary policy in the US and eurozone is backed by the numbers. In the eurozone, the ECB’s policy appears to be to stay behind the curve in order provide as much stimulus as possible, increasing the risk that policy will have to tighten faster later. Should this environment of improving economic activity persist, the long period of financial repression (aka ultra-loose monetary policy) may be closer to an end than markets currently assume.

Exhibit 2: Global output gaps have steadily closed

In the US, the prospect of higher interest rates and a wind-down of the Fed’s balance sheet has pushed 10y yields only a little higher, leading to a notable flattening of the yield curve. This has caught the eye of commentators but the slope of the yield curve is not a perfect predictor of a recession, nor is it yet inverted, with a positive slope of 0.8% at present. Should the US economy continue to expand, this flattening of the yield curve is likely to be reversed in our view as longer-term bond yields rise.

The relevant parallel may therefore not be 2007 but possibly 1994. An increase in US policy rates following the US recovery of the early 1990s led to long-term yields increasing from 5.3% to 8% with significant capital losses for bondholders. Although this was an enormous move in bond yields, US equities traded sideways throughout the period.

Exhibit 3: US 1994 experience- rising rates, bond yields, flat equity markets, but no recession

Nevertheless, equity valuations did decline with the non-financial price/book ratio falling by approximately 10% during this period and the market p/e ratio falling by 20% to 17x. There was no recession following the 1994 tightening of financial conditions; the US economy continued to grow even as policy rates were maintained at a higher level for the rest of the decade.

It may be perhaps too much to expect long-term government bond yields to trade close to trend nominal GDP growth (3 and 4% in the eurozone and US respectively), given the very high debt burdens in most developed nations. However, current yields appear too low in our view given the improving economic momentum. This is particularly notable within the eurozone with German 10y Bunds yielding only 0.36%. The pricing of Bunds has more to do with eurozone dynamics than the German economy. German inflation is close to 15 year highs, growth strong and unemployment low.

In this cycle, US equity valuations are markedly higher compared to 1994 and we cannot exclude the possibility of a period of sub-par returns during 2018 as global monetary policy tightens. Provided economic and profits growth remains robust, this may occur through a de-rating of equity markets which as a result trade sideways for a period of time.

We acknowledge that as a diversifying risk-free asset it might be expected that government bond yields are somewhat depressed, given the still strong bid for (economic) disaster insurance due to extraordinarily high levels of debt/GDP worldwide. However, we believe investors have become shy of being underweight duration exposure due to the exceptionally strong performance of this asset class in recent years and the risk to yields is still to the upside.

It should also be noted that in the period 2007-2008 bond yields rose with tightening US monetary policy, at least until the evidence of a credit crisis became widely known. In addition to the positive economic data, the effect of the return of interest rate risk and the withdrawal of US QE should act to push yields higher over coming quarters. We believe investors should increase cash allocations to take advantage of higher short-term interest rates and carry lower than benchmark duration exposure.