Bonds Hear Bubble Echoes?
The squeeze is on. Persistently low yields on safe-haven government bonds and ultra-loose central-bank policy are pushing money into European credit markets. Portugal is the latest beneficiary, selling its first 10-year bond since its bailout in 2011, but it isn’t alone. Investors are increasingly buying riskier corporate bonds. The problem is that the underlying economic fundamentals look as poor as ever.What is going on? Why are European and US junk bonds rallying so hard? Is this a massive bubble which risks imploding, sending the world into another great depression or is this a sign that the worst is behind us and the global recovery is well underway?
Portugal’s €3 billion ($3.92 billion) bond attracted orders of €10.2 billion, despite offering little premium to the government’s outstanding paper. Yields on 10- year Portuguese bonds are less than 5.5%, down about 6.5 percentage points in the past year or so.
For Portugal, the benefit is clear: It has covered its 2013 funding needs and is regaining market access. For investors, it isn’t so clear-cut. They are betting that if Portugal is to run into trouble, it is a ways off yet. For now, Europe won’t risk a disruptive debt restructuring exercise, even if many worry that Portugal’s poor track record of growth means it is ill- equipped to cope with debt that hit 123.6% of GDP at the end of 2012.
Meanwhile, the European “junk” bond market is seeing bumper issuance even as yields have fallen to record lows, with the Barclays nonfinancial high-yield index now yielding just 5.17%. The cost of insuring blue- chip corporate debt via the Markit iTraxx Europe index has fallen to its lowest since April 2010— before Greece’s first bailout. Investors are snapping up complex hybrid bonds that blend features of debt and equity.
True, corporate balance sheets are in better shape than those of many sovereigns. But the growth outlook for Europe remains poor, and there are continuing worries about the U.S. and China. The banking system in Europe remains a brake on economic growth. Even companies able to borrow cash virtually free aren’t using that to boost investment: Apple’s $ 17 billion record- breaking corporate bond was issued simply to return cash to shareholders.
Many investors acknowledge the dangers here: Too much money chasing too little paper, a throwback to the pre-crisis bubble days, except at far lower yields. But, in another echo of the bubble, they also say they can’t identify a near- term catalyst for the merry-go-round to stop. Without a real recovery or a renewed slump, expect cash to continue to flow into risky bonds.
Niels Jensen of Absolute Return Partners wrote another excellent monthly letter, In the long run we are all in trouble. Jensen begins his comment by recalling the misfortunes of Tony Dye, one of Britain’s best known fund managers in the 1990s:
As equity markets became more and more expensive towards the end of the decade, he became increasingly adamant that markets were overvalued and began to reduce his equity exposure. In 1999 his firm was 66th out of 67 in the UK equity league tables and in February 2000 he was sacked for poor performance. Within a few weeks of his dismissal, the FTSE peaked and one of the largest bear markets of all times began, all of which taught me a very important lesson – poor timing can ruin even the best investment decisions.He goes on to explain why inflation remains subdued, why quantitative easing hasn't spurred bank lending, how the long-run outlook for equities is bleak and how France is the real zombie of Europe. And yet despite this, he ends the May letter by stating:
Now, you may well deduct from all of this that I am as bearish as I have ever been, but nothing could be further from the truth. The issues I have discussed in this month’s letter are clouds on the horizon which are likely to take years to play out and, in the meantime, investors will continue to be preoccupied with far more mundane issues. All I know is that financial markets cannot stay disconnected from economic fundamentals forever so, ultimately, the Tony Dyes of the world will be proven right. Unless they lost their jobs beforehand, that is.In his latest quarterly economic outlook, Lacy Hunt of Hoisington Investment Management echoes similar concerns, discussing the continuing risk of deflation and what this means for asset prices. He ends his comment discussing "irrationality" in markets:
Credible academic research indicates that economic growth deteriorates when debt to GDP reaches critical levels - a condition that has now been met in countries that represent 75% of global GDP. When this reality is coupled with the Fed’s inability to create money growth or inflation, the result will invariably be slow nominal GDP growth.Money manager Dan Arbess, a partner at Perella Weinberg and chief investment officer at PWP Xerion Funds, startled participants at the Milken Institute Global Conference, stating deflation is a 'persistent risk':
The financial and other markets do not seem to reflect this reality of subdued growth. Stock prices are high, or at least back to levels reached more than a decade ago, and bond yields contain a significant inflationary expectations premium. Stock and commodity prices have risen in concert with the announcement of QE1, QE2 and QE3. Theoretically, as well as from a long-term historical perspective, a mechanical link between an expansion of the Fed’s balance sheet and these markets is lacking. It is possible to conclude, therefore, that psychology typical of irrational market behavior is at play. This suggests that when expectations shift from inflation to deflation, irrational behavior might adjust risk asset prices significantly.
Such signs that a shift is beginning can be viewed in the commodity markets. The CRB Commodity Index peaked about two years ago at 691, but now stands at 551, a 20% decline despite massive Fed balance sheet expansion. The ability of the Fed to arrest a downside irrational move in risk assets may be limited. Non-risk assets, such as long dated U.S. treasuries, should benefit from this shift in perception.
We've been wrong to assume that the economic crisis is over, Arbess said. We stopped the crisis from reaching Great Depression levels through drastic fiscal actions such as TARP and the Obama administration's fiscal stimulus. But almost as suddenly as we started, we stopped these efforts, which Arbess says has resulted in us being "mired down" for the past four years.If deflation is a persistent risk, it suggests risk assets are grossly overvalued and that a rude awakening is on the horizon. It also suggests that investors are better off buying bonds, even at these record low yields and the facade of strength in the stock market is a chimera.
What's kept us afloat has been monetary policy, but that's now reaching its limits, according to Arbess. The threat of deflation is once again rearing its head.
"The persistent risk in our economy is deflation not inflation," Arbess said.
His proposed solution is that we start directly funding government expenditures through the central bank. That is, we should stop relying on taxes or further debt issuances to finance government—or at least reduce our reliance on taxes and bonds. Just let the Federal Reserve pay the government's bills by exercising its money creation powers.
Another possible catalyst for global deflation is the seismic shift going on in Japan. Michael Casey, managing editor for the Americas at DJ FX Trader, wrote an interesting comment for MarketWatch on how deflation risks being Japan's biggest export, noting the following:
For now, investors in foreign markets are celebrating. With the dollar higher across the board and gold and other commodities lower, the disinflationary forces unleashed by Japan are giving other central banks room to follow its lead, exemplified by the European Central Bank’s and the Reserve Bank of Australia’s rate cuts this past week. In response, the Dow Jones Industrial Average has punctured 15,000 and the once alarmingly high bond yields of peripheral euro-zone countries are down at levels not seen since the pre-crisis bubble years.As I've stated before, talk of a global currency war is way overblown but there is no doubt that the weaker yen is raising hope and fear. So far, the G7 indicated they will tolerate a sliding yen for now as they intensify their focus on Japan's recovery strategy. Still, Soros is reportedly shorting the Aussie dollar and others are worried that Canada is heading for a fall.
But this virtuous circle can yet turn vicious. Together, the U.S. Federal Reserve and the Bank of Japan will print the equivalent of $155 billion every month for an indefinite period. With yield opportunities getting ever slimmer in the developed world, that flood of money will inevitably slosh into whatever currencies still offer a modicum of interest rate “spread.” (Even at a record low 2.75%, benchmark Aussie rates pay markedly more than the near-zero returns on the dollar or yen.) And this week, governments and central banks in various countries have taken action against currency appreciation. The term “currency war” has fallen out of vogue, but the forces that stirred those fighting words two years ago are alive and well.
Global asset allocators have to understand the macro environment and how central banks are influencing asset prices across the world. For example, Japanese pension funds and insurance companies shifting out of JGBs into global bonds will drive down yields of Treasuries, European sovereign debt and high-yield bonds in the US and Europe even lower. This will propel global equity markets even higher.
Is this a time to be taking on more or less risk? It's a tough environment from a valuation standpoint but if you look at the return of private equity giants, you would conclude they are not too worried of a global collapse anytime soon. Quite the opposite, they see opportunities across the world and are feverishly competing for allocations to capitalize on these opportunities.
Similarly, hedge funds' bullish bets on commodities is at a 6-week high, signalling a global recovery may be in the offing. Another story that caught my attention is how top hedge funds like Farallon Capital, York Capital Management, QVT Financial, CQS and Third Point are set to participate in the recapitalization of Greek banks.
Why are these hedge funds willing to take on such huge risk? The biggest reason is that they have been lured to participate because of the potential returns they can make through special warrants attached, for free, to the new issue of bank shares. As one money manager said: “It is free leverage with limited downside. A 50 per cent move in the share price would result in a 400 per cent increase in the warrant value.”
But another reason is that the word's best and brightest hedge fund managers are not buying the gloom and doom in Europe and elsewhere. They're clearly taking intelligent risks with asymmetric payoffs but the point I'm making is that they are taking risk, not focusing on all the noise in the markets.
Let me end this comment by plugging an excellent fund here in Montreal, Hexavest, an investment firm that specializes in equities and tactical asset allocation for institutional clients. I recently met Vital Proulx, their president and chief investment officer, and came away thoroughly impressed with their process and their values. Vital is extremely nice and very sharp, explaining to me their process, performance and risk management.
Hexavest recently announced a strategic partnership with Eaton Vance to help them with distribution around the world. Vital told me they are very happy because it allows them to focus on performance and Eaton Vance is an excellent partner with global reach. If you're looking for a top long-only global equities fund that understands the macro environment, I highly suggest you take a close look at Hexavest, one of the best funds in Canada and one of the few Montreal success stories (sad how the city's financial industry is shrinking).
Below, Gary Shilling, Bloomberg View Columnist, discusses inflation, deflation, and central bank actions. He spoke on Bloomberg Television's "Bloomberg Surveillance," explaining why inflation alarmists are wrong and why deflation and deleveraging will depress asset prices.
On the other side of the trade, Jeremy Siegel, professor of finance at the University of Pennsylvania's Wharton School, talks about the U.S. economy and stock and bond markets. He speaks with Trish Regan and Adam Johnson on Bloomberg Television's "Street Smart." Steve Forbes, chief executive officer of Forbes Inc., also speaks.