“The most common of all fallacies is to believe passionately in the palpably not true. It is the chief occupation of mankind.” - H.L. Mencken.
Five years ago, we wrote a book about the apparent absurdities and illogicalities then suffusing the financial markets. The book was called Investing Through The Looking Glass and its introduction contained the following text:
After four decades of ever-larger crises and bailouts, and lower interest rates (the 1987 mini-Crash; the 1998 collapse of Long-Term Capital Management; the dotcom bust of the early 2000s), we now seem to have reached the endgame. US interest rates, and indeed rates throughout the Western economies, can’t realistically go much lower. (Admittedly, at the time of writing, some 30% of all sovereign bond yields, along with several euro zone countries’ bank deposit rates, had turned negative. Like the White Queen in Alice through the Looking Glass, we must now all believe as many as six impossible things before breakfast.) Meanwhile the mountain of debt – borrowings by governments, corporations and households – has just kept on getting bigger. McKinsey estimate that since 2007, far from deleveraging, the world’s major economies have added $57 trillion to their combined debt loads – raising their debt to GDP ratios by some 17% in the process.
It was Herbert Stein that coined the appropriate adage for our current debt predicament: “If something cannot go on forever, it will stop.” The debt pyramid cannot keep growing forever. At some point, bond investors will cry “Stop.”
In January 2010, for example, the global bond fund manager Bill Gross, then in charge of $270 billion at the Pacific Investment Management Company (Pimco), warned that the UK government bond market was “a must to avoid” and “resting on a bed of nitroglycerine”. In January 2010, the UK national debt stood at just under £1 trillion. 10-year Gilts at the time yielded 4%
They now yield less than 1%. The price of those government bonds, which moves inversely to their yield, has risen sharply higher. Yet our national debt now stands at over £1.6 trillion. While the number of Gilts outstanding has grown by 60%, the price of those Gilts has continued to shoot up. If Gilts were resting on nitroglycerine six years ago, they are now bouncing up and down on a bed of picric acid, firing napalm arrows at a dartboard made of pure antimatter.
Bond investors have not yet cried “Stop.” But each day that passes brings us closer to everyone in the bond market hearing that deafening cri de coeur. An iron law in finance is that if interest rates go up, bond prices go down. This is simple mathematics. Bond interest payments are invariably fixed, hence the designation ‘fixed income’ to describe bonds. When interest rates rise, they make those fixed income payments comparatively less attractive. To compensate bond investors, when interest rates rise, bond prices fall.
The global bond market is currently worth well over $70 trillion. The chances are you have some exposure to that $70+ trillion of debt. If you don’t, your pension fund probably does. Now ask yourself a question. After an explicit policy of suppressing bond yields, and now that global interest rates are down to their lowest levels for 5000 years, do we think bonds are outrageously expensive, or merely hilariously mispriced? A follow-on question: given that the size of the world’s bond markets dwarfs that of the world’s stock markets, what do we think happens to stock prices if and when $70 trillion worth of bond investors decide to head for the exits at once? We are in the process of finding out.
That was then. Five years, a “pandemic”, a bucketload of stimulus and intervention and furlough payments and an enforced economic lockdown of most of the Anglosphere later, this is now. From The Financial Times, 24th February 2021 (‘Investors spooked by worst start to year for bonds since 2015’):
“The bond vigilantes seem to be saddling up and getting ready to ambush the policymakers on the road to reflation,” [Ed Yardeni] wrote in a note to clients on Tuesday. “It could be a heck of a shootout..”
Gregory Peters, a senior fund manager at PGIM Fixed Income, said the moves were reminiscent of a “mini taper tantrum 2.0”, a reference to when the Fed’s announcement in 2013 that it would curtail its bond-buying programme rattled global financial markets.
“The move higher is starting to spook other markets,” Peters said. “Stocks are squishy, and corporate bonds are squishy . . . It’s causing people to freak out a little.” He suspects that the severity of the bond market sell-off may be getting overdone, but is — for now — wary of betting on the rout fizzling out. “When you’re staring down the barrel of double-digit GDP growth data, stimulus as far as the eye can see, and central banks on hold, you’d have to be brave to step in front of this,” he said..
The challenge is that central banks have committed to keeping monetary policy exceptionally easy even if inflation does accelerate — a commitment that some traders are now beginning to test..
If inflation, allied to some form of post-vaccine deployment global economic recovery, really is a live and pressing concern (and we believe that it is), it may be worth thinking about whether those sectors that have reached extraordinary highs relative to their equity market peers might now be somewhat vulnerable to a correction. Not to put too fine a point on it, Big Tech looks expensive (no change there, admittedly) whereas value looks extremely, not to say compellingly, attractive by comparison.
Or consider commodities versus financial assets (e.g. the S&P 500 stock index). On a comparative basis, commodities haven’t been this attractive for 60 years.
Being mindful of the history of money printing, we don’t own bonds in any meaningful way. We do own:
What colour is YOUR parachute ?
Tim Price is co-manager of the VT Price Value Portfolio and author of ‘Investing through the Looking Glass: a rational guide to irrational financial markets’. You can access a full archive of these weekly investment commentaries here. You can listen to our regular ‘State of the Markets’ podcasts, with Paul Rodriguez of ThinkTrading.com, here. Email us: firstname.lastname@example.org.
Price Value Partners manage investment portfolios for private clients. We also manage the VT Price Value Portfolio, an unconstrained global fund investing in Benjamin Graham-style value stocks and specialist managed funds.
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