Where in the world? Hunting for value in the bond market

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Macro Letter – No 99 – 22-06-2018

Where in the world? Hunting for value in the bond market

  • Few government bond markets offer a positive real return
  • Those that do tend to have high associated currency risk
  • Active management of fixed income portfolios is the only real solution
  • Italy is the only G7 country offering a real-yield greater than 1.5%

In my last Macro Letter – Italy and the repricing of European government debt – I said: –

I have never been a great advocate of long-term investment in fixed income securities, not in a world of artificially low official inflation indices and fiat currencies. Given the de minimis real rate of return I regard them as trading assets.

Suffice to say, I received a barrage of advice from some of my good friends who have worked in the fixed income markets for the majority of their careers. I felt I had perhaps been flippant in dismissing an entire asset class without so much as a qualm. In this letter I distil an analysis of more than one hundred markets around the world into a short list of markets which may be worthy of further analysis.

To begin with I organised countries by their most recent inflation rate, then I added their short term interest rate and finally, where I was able to find reliable information, a 10 year yield for the government bond of each country. I then calculated the real interest rate, real yield and shape of the yield curve.

At this point I applied three criteria, firstly that the real yield should be greater than 1.5%, second, that the real interest rate should also exceed that level: and finally, that the yield curve should be more than 2% positive. These measures are not entirely arbitrary. A real return of 1.5% is below the long-run average (1.7%) for fixed income securities in the US since 1900, though not by much. For an analysis of the data, this article from Observations and Notes is informative – U.S. 10-Year Treasury Note Real Return History: –

As you might have expected, the real returns earned were consistently below the initial coupon rate. The only exceptions occur around the time of the Great Depression. During this period, because of deflation, the value of some or all of the yearly interest payments was often higher than the original coupon rate, increasing the yield. (For more on this important period see The 1929 Stock Market Crash Revisited)

While the average coupon rate/nominal return was 4.9%, the average real return was only1.7%. Not surprisingly, the 3.2% difference between the two is the average inflation experienced for the century.

As an investor I require a positive expected real return with the minimum of risk, therefore if short term interest rates offer a real return of more than 1.5% I will incline to favour a floating rate rather than a fixed rate investment. Students of von Mises and Rothbard may beg to differ perhaps; for those of you who are unfamiliar with the Austrian view of the shape of the yield curve in an unhampered market, this article by Frank Shostak – How to Interpret the Shape of the Yield Curve provides an excellent primer. Markets are not unhampered and Central Banks, at the behest of their respective governments, have, since the dawn of the modern state, had an incentive to artificially lower short-term interest rates: and, latterly, rates across the entire maturity spectrum. For more on this subject (6,000 words) I refer you to my essay for the Cobden Centre – A History of Fractional Reserve Banking – the link will take you to part one, click here for part two.

Back to this week’s analysis. I am only interested in buying 10yr government bonds of credit worthy countries, where I can obtain a real yield on 10yr maturity which exceeds 1.5%, but I also require a positive yield curve of 2%. As you may observe in the table below, my original list of 100 countries diminishes rapidly: –

Real Bond yields 1.5 and 2 percent curve

Source: Investing.com, Trading Economics, WorldBondMarkets.com

Five members of this list have negative real interest rates – Italy (the only G7 country) included. Despite the recent prolonged period of negative rates, this situation is not normal. Once rates eventually normalise, either the yield curve will flatten or 10yr yields will rise. Setting aside geopolitical risks, as a non-domicile investor, do I really want to hold the obligations of nations whose short-term real interest rates are less than 1.5%? Probably not.

Thus, I arrive at my final cut. Those markets where short-term real interest rates exceed 1.5% and the yield curve is 2% positive. Only nine countries make it onto the table and, perhaps a testament to their governments ability to raise finance, not a single developed economy makes the grade: –

REal Bond yields 1.5 and 2 pecent curve and 1.5 real IR

Source: Investing.com, Trading Economics, WorldBondMarkets.com

There are a couple of caveats. The Ukrainian 10yr yield is derived, I therefore doubt its accuracy. 3yr Ukrainian bonds yield 16.83% and the yield curve is mildly inverted relative to official short-term rates. Brazilian bonds might look tempting, but it is important to remember that its currency, the Real, has declined by 14% against the US$ since January. The Indonesian Rupiah has been more stable, losing less than 3% this year, but, seen in the context of the move since 2012, during which time the currency has lost 35% of its purchasing power, Indonesian bonds cannot but considered ‘risk-free’. I could go on – each of these markets has lesser or greater currency risk.

I recant. For the long term investor there are bond markets which are worth consideration, but, setting aside access, liquidity and the uncertainty of exchange controls, they all require active currency management, which will inevitably reduce the expected return, due to factors such as the negative carry entailed in hedging.

Conclusions and investment opportunities

Investing in bond markets should be approached from a fundamental or technical perspective using strategies such as value or momentum. Since February 2012 Greek 10yr yields have fallen from a high of 41.77% to a low of 3.63%, although from the July 2014 low of 5.47% they rose to 19.44% in July 2015, before falling to recent lows in January of this year. For a trend following strategy, this move has presented abundant opportunity – it increases further if the strategy allows the investor to be short as well as long. Compare Greek bonds with Japanese 10yr JGBs which, over the same period, have fallen in yield from 1.02 in January 2012 to a low of -0.29% in July 2016. That is still a clear trend, although the current BoJ policy of yield curve control have created a roughly 10bp straight-jacket beyond which the central bank is committed to intervene. The value investor can still buy at zero and sell at 10bp – if you trust the resolve of the BoJ – it is likely to be profitable.

The idea of buying bonds and holding them to maturity may be profitable on occasion, but active management is the only logical approach in the current global environment, especially if one hopes to achieve acceptable real returns.

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What to expect from Central Bankers

What to expect from Central Bankers

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Macro Letter – No 94 – 06-04-2018

What to expect from Central Bankers

  • The Federal Reserve continues to tighten and other Central Banks will follow
  • The BIS expects stocks to lose their lustre and bond yields to rise
  • The normalisation process will be protracted, like the QE it replaces
  • Macro prudential policy will have greater emphasis during the next boom

As financial markets adjust to a new, higher, level of volatility, it is worth considering what the Central Banks might be thinking longer term. Many commentators have been blaming geopolitical tensions for the recent fall in stocks, but the Central Banks, led by the Fed, have been signalling clearly for some while. The sudden change in the tempo of the stock market must have another root.

Whenever one considers the collective views of Central Banks it behoves one to consider the opinions of the Central Bankers bank, the BIS. In their Q4 review they discuss the paradox of a tightening Federal Reserve and the continued easing in US national financial conditions. BIS Quarterly Review – December 2017 – A paradoxical tightening?:-

Overall, global financial conditions paradoxically eased despite the persistent, if cautious, Fed tightening. Term spreads flattened in the US Treasury market, while other asset markets in the United States and elsewhere were buoyant…

Chicago Fed’s National Financial Conditions Index (NFCI) trended down to a 24-year trough, in line with several other gauges of financial conditions.

The authors go on to observe that the environment is more reminiscent of the mid-2000’s than the tightening cycle of 1994. Writing in December they attribute the lack of market reaction to the improved communications policies of the Federal Reserve – and, for that matter, other Central Banks. These policies of gradualism and predictability may have contributed to, what the BIS perceive to be, a paradoxical easing of monetary conditions despite the reversals of official accommodation and concomitant rise in interest rates.

This time, however, there appears to be a difference in attitude of market participants, which might pose risks later in this cycle:-

…while investors cut back on the margin debt supporting their equity positions in 1994, and stayed put in 2004, margin debt increased significantly over the last year.

At a global level it is worth remembering that whilst the Federal Reserve has ceased QE and now begun to shrink its balance sheet, elsewhere the expansion of Central Bank balance sheets continues with what might once have passed for gusto.

The BIS go on to assess stock market valuations, looking at P/E ratios, CAPE, dividend pay-outs and share buy-backs. By most of these measures stocks look expensive, however, not by all measures:-

Stock market valuations looked far less frothy when compared with bond yields. Over the last 50 years, the real one- and 10-year Treasury yields have fluctuated around the dividend yield. Having fallen close to 1% prior to the dotcom bust, the dividend yield has been steadily increasing since then, currently fluctuating around 2%. Meanwhile, since the GFC, real Treasury yields have fallen to levels much lower than the dividend yield, and indeed have usually been negative. This comparison would suggest that US stock prices were not particularly expensive when compared with Treasuries.

The authors conclude by observing that EM sovereign bonds in local currency are above their long-term average yields. This might support the argument that those stock markets are less vulnerable to a correction – I would be wary of jumping this conclusion, global stocks market correlation may have declined somewhat over the last couple of years but when markets fall hard they fall in tandem: correlations tend towards 100%:-

Credit spreads - BIS

Source: BIS, BOML, EPFR, JP Morgan

The BIS’s final conclusion?-

In spite of these considerations, bond investors remained sanguine. The MOVE* index suggested that US Treasury volatility was expected to be very low, while the flat swaption skew for the 10-year Treasury note denoted a low demand to hedge higher interest rate risks, even on the eve of the inception of the Fed’s balance sheet normalisation. That may leave investors ill-positioned to face unexpected increases in bond yields.

*MOVE = Merrill lynch Option Volatility Estimate

Had you read this on the day of publication you might have exited stocks before the January rally. As markets continue to vacillate wildly, there is still time to consider the implications.

Another BIS publication, from January, also caught my eye, it was the transcript of a speech by Claudio Borio’s – A blind spot in today’s macroeconomics? His opening remarks set the scene:-

We have got so used to it that we hardly notice it. It is the idea that, for all intents and purposes, when making sense of first-order macroeconomic outcomes we can treat the economy as if its output were a single good produced by a single firm. To be sure, economists have worked hard to accommodate variety in goods and services at various levels of aggregation. Moreover, just to mention two, the distinctions between tradeables and non-tradeables or, in some intellectual strands, between consumption and investment goods have a long and distinguished history. But much of the academic and policy debate among macroeconomists hardly goes beyond that, if at all.

The presumption that, as a first approximation, macroeconomics can treat the economy as if it produced a single good through a single firm has important implications. It implies that aggregate demand shortfalls, economic fluctuations and the longer-term evolution of productivity can be properly understood without reference to intersectoral and intrasectoral developments. That is, it implies that whether an economy produces more of one good rather than another or, indeed, whether one firm is more efficient than another in producing the same good are matters that can be safely ignored when examining macroeconomic outcomes. In other words, issues concerned with resource misallocations do not shed much light on the macroeconomy.

Borio goes on to suggest that ignoring the link between resource misallocations and macroeconomic outcomes is a dangerous blind spot in marcoeconomic thinking. Having touched on the problem of zombie firms he talks of a possible link between interest rates, resource misallocations and productivity.

The speaker reveals two key findings from BIS research; firstly that credit booms tend to undermine productivity growth and second, that the subsequent impact of the labour reallocations that occur during a financial boom last for much longer if a banking crisis follows. Productivity stagnates following a credit cycle bust and it can be protracted:-

Taking, say, a (synthetic) five-year credit boom and five postcrisis years together, the cumulative shortfall in productivity growth would amount to some 6 percentage points. Put differently, for the period 2008–13, we are talking about a loss of some 0.6 percentage points per year for the advanced economies that saw booms and crises. This is roughly equal to their actual average productivity growth during the same window.

Productivy stagnates - BIS

Source: Borio et al, BIS

Borio’s conclusion is that different sectors of the economy expand and the contract with greater and lesser momentum, suggesting the need for more research in this area.

He then moves to investigate the interest rate productivity nexus, believing the theory that, over long enough periods, the real economy evolves independently of monetary policy and therefore that market interest rates converge to an equilibrium real interest rates, may be overly simplistic. Instead, Borio suggests that causality runs from interest rates to productivity; in other words, that interest rates during a cyclical boom may have pro-cyclical consequences for certain sectors, property in particular:-

During the expansion phase, low interest rates, especially if persistent, are likely to increase the cycle’s amplitude and length. After all, one way in which monetary policy operates is precisely by boosting credit, asset prices and risk-taking. Indeed, there is plenty of evidence to this effect. Moreover, the impact of low interest rates is unlikely to be uniform across the economy. Sectors naturally differ in their interest rate sensitivity. And so do firms within a given sector, depending on their need for external funds and ability to tap markets. For instance, the firms’ age, size and collateral availability matter. To the extent that low interest rates boost financial booms and induce resource shifts into sectors such as construction or finance, they will also influence the evolution of productivity, especially if a banking crisis follows. Since financial cycles can be quite long – up to 16 to 20 years – and their impact on productivity growth quite persistent, thinking of changes in interest rates (monetary policy) as “neutral” is not helpful over relevant policy horizons.

During the financial contraction, persistently low interest rates can contribute to this outcome (Borio (2014)). To be absolutely clear: low rates following a financial bust are welcome and necessary to stabilise the economy and prevent a downward spiral between the financial system and output. This is what the crisis management phase is all about. The question concerns the possible collateral damage of persistently and unusually low rates thereafter, when the priority is to repair balance sheets in the crisis resolution phase. Granted, low rates lighten borrowers’ heavy debt burden, especially when that debt is at variable rates or can be refinanced at no cost. But they may also slow down the necessary balance sheet repair.

Finally, Borio returns to the impact on zombie companies, whose number has risen as interest rates have fallen. Not only are these companies reducing productivity and economic growth in their own right, they are draining resources from the more productive new economy. If interest rates were set by market forces, zombies would fail and investment would flow to those companies that were inherently more profitable. Inevitably the author qualifies this observation:-

Now, the relationship could be purely coincidental. Possible factors, unrelated to interest rates as such, might help explain the observed relationship. One other possibility is reverse causality: weaker profitability, as productivity and economic activity decline in the aggregate, would tend to induce central banks to ease policy and reduce interest rates.

Zombies - BIS

Source: Banerjee and Hoffmann, BIS

Among the conclusions reached by the Central Bankers bank, is that the full impact and repercussions of persistently low rates may not have been entirely anticipated. An admission that QE has been an experiment, the outcome of which remains unclear.

Conclusions and Investment Opportunities

These two articles give some indication of the thinking of Central Bankers globally. They suggest that the rise in bond yields and subsequent fall in equity markets was anticipated and will be tolerated, perhaps for longer than the market anticipate. It also suggests that Central Banks will attempt to use macro-prudential policies more extensively in future, to insure that speculative investment in the less productive areas of the economy do not crowd out investment in the more productive and productivity enhancing sectors. I see this policy shift taking the shape of credit controls and increases in capital requirements for certain forms of collateralised lending.

Whether notionally independent Central Banks will be able to achieve these aims in the face of pro-cyclical political pressure remains to be seen. A protracted period of readjustment is likely. A stock market crash will be met with liquidity and short term respite but the world’s leading Central Banks need to shrink their balance sheets and normalise interest rates. We have a long way to go. Well managed profitable companies, especially if they are not saddled with debt, will still provide opportunities, but stock indices may be on a sideways trajectory for several years while bond yields follow the direction of their respective Central Banks official rates.

Stocks for the Long Run but not the short

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Macro Letter – No 93 – 23-03-2018

Stocks for the Long Run but not the short

  • In the long run stocks outperform bonds
  • For a decade stocks, bonds and real estate have risen in tandem
  • The risk of a substantial correction is high
  • Value-based equity investment is unfashionably enticing

The first part of the title of this Macro Letter is borrowed from an excellent book originally written in 1994. Among several observations made by the author, Jeremy Siegel, was the idea that stocks would at least keep pace with GDP growth or even exceed it at the national level. The data, which went back to the 19th Century, showed that stocks also outperformed bonds in the long-run. The price one has to pay for that outperformance is higher volatility than for bonds and occasional, possibly protracted, periods of under-performance or, if your portfolio is concentrated, the risk of default. This is not to say that bonds are exempt from default risk, notwithstanding the term ‘risk free rate’ which we associate with many government obligations. A diversified portfolio of stocks (and bonds) has been seen as the ideal investment approach ever since Markowitz promulgated the concept of modern portfolio theory.

Today, passive index tracking funds have swallowed a massive percentage of all the investment which flows into the stock market. Why? Because robust empirical data shows that it is almost impossible for active portfolio managers to consistently outperform their benchmark index in the long run once their higher fees have been factored in.

An interesting way of showing how indexation has propelled the stock market higher recently, regardless of valuation, is shown in this chart from Ben Hunt at Epsilon Theory – Three Body Problem. He uses it to show how the factor which is QE has trumped everything in its wake. I’ll allow Ben to explain:-

Here’s the impact of all that gravity on the Quality-of-Companies derivative investment strategy.

The green line below is the S&P 500 index. The white line below is a Quality Index sponsored by Deutsche Bank. They look at 1,000 global large cap companies and evaluate them for return on equity, return on invested capital, and accounting accruals … quantifiable proxies for the most common ways that investors think about quality. Because the goal is to isolate the Quality factor, the index is long in equal amounts the top 20% of measured  companies and short the bottom 20% (so market neutral), and has equal amounts invested long and short in the component sectors of the market (so sector neutral). The chart begins on March 9, 2009, when the Fed launched its first QE program.

epsilon-theory-the-three-body-problem-december-21-2017-quality-index-graph

Source: Bloomberg, Deutsche Bank

Over the past eight and a half years, Quality has been absolutely useless as an investment derivative. You’ve made a grand total of not quite 3% on your investment, while the S&P 500 is up almost 300%.

Long term there are two strategies which have been shown to consistently improve risk adjusted return from the stock market, momentum (by which I mean trend following) and value (I refer you to Graham and Dodd). Last month the Managed Futures community, consisting primarily of momentum based strategies, had its worst month for 17 years. Value, as the chart above declares, has been out of favour since the great recession at the very least. Indiscriminate Momentum has been the star performer over the same period. The chart below uses a log scale and is adjusted for inflation:-

S&P 1870 to 2018

Source: Advisor Perspectives

At the current level we are certainly sucking on ether in terms of the variance from trend. If the driver has been QE and QQE then the experiment have been unprecedented; a policy mistake is almost inevitable, as Central Banks endeavour to unwind their egregious largesse.

My good friend, and a former head of bond trading at Bankers Trust, wrote a recent essay on the subject of Federal Reserve policy in the new monetary era. He has kindly consented to allow me to quote some of his poignant observations, he starts by zooming out – the emphasis is mine:-

Recent debates regarding future monetary policy seem to focus on a degree of micro-economic precision no longer reliably available from the monthly data.  Arguments about minor changes in the yield curve or how many tightening moves will occur this year risk ignoring the dramatic adjustments in all major economic policies of the United States, not to mention the plausible array of international responses…

for the first time since the demise of Bear Stearns, et al; global sovereign bond markets will have to seek out a new assemblage of price-sensitive buyers…

Given that QE was a systematic purchase programme devoid of any judgement about relative or absolute value, the return of the price-sensitive buyer, is an important distinction. The author goes on to question how one can hope to model the current policy mix.

 …There is no confident means of modeling the interaction of residual QE, tax reform, fiscal pump-priming, and now aggressive tariffs. This Mnuchin concoction is designed to generate growth exceeding 3%.  If successful, the Fed’s inflation goal will finally be breached in a meaningful way…

…Classical economists will argue that higher global tariffs are contractionary; threatening the recession that boosts adrenaline levels among the passionate yield curve flattening crowd.  But they are also inflationary as they reduce global productivity and bolster input prices…

Contractionary and inflationary, in other words stagflationary. I wonder whether the current bevvy of dovish central bankers will ever switch their focus to price stability at the risk of destroying growth – and the inevitable collapsed in employment that would signify?

Hot on the heels of Wednesday’s rate hike, the author (who wrote the essay last week) goes on to discuss the market fixation with 25bp rate increases – an adage from my early days in the market was, ‘Rates go up by the lift and down by the stairs,’ there is no reason why the Fed shouldn’t be more pre-emptive, except for the damage it might do to their reputation if catastrophe (read recession) ensues. A glance at the 30yr T-Bond chart shows 3.25% as a level of critical support. Pointing to the dwindling of foreign currency reserves of other central banks as the effect of tariffs reduces their trade surplus with the US, not to mention the deficit funding needs of the current administration, Allan concludes:-

…Powell will hopefully resort to his own roots as a pragmatic investment banker rather than try to retool Yellenism.  He will have to be very creative to avoid abrupt shifts in liquidity preference.  I strongly advise a very open mind on Powell monetary policy.  From current levels, a substantial steepening of the yield curve is far more likely than material flattening, as all fiscal indicators point toward market-led higher bond yields.

What we witnessed in the stock market during February was a wake-up call. QE is being reversed in the US and what went up – stocks, bonds and real estate – is bound to come back down. Over the next decade it is unlikely that stocks can deliver the capital appreciation we have witnessed during the previous 10 years.

Whilst global stock market correlations have declined of late they remain high (see the chart below) the value based approach – which, as the Deutsche Bank index shows, has underwhelmed consistently for the past decade – may now offer a defensive alternative to exiting the stock market completely. This does not have to be Long/Short or Equity Market Neutral. One can still find good stocks even when overall market sentiment is dire.

Stock Mkt correlations July 2017

Source: Charles Schwab, Factset

For momentum investors the first problem with stocks is their relatively high correlation. A momentum based strategy may help if there is a dramatic sell-off, but if the markets move sideways, these strategies are liable to haemorrhage via a steady sequence of false signals, selling at the nadir of the trading range and buying at the zenith, as the overall market moves listlessly sideways. Value strategies generally fare better in this environment by purchasing the undervalued and selling the overvalued.

The table below from Star Capital assesses stock indices using a range of metrics, it is sorted by the 10yr CAPE ratio:-

CAPE etc Star Capital 28-2-2018

Source: Star Capital

Of course there are weaknesses in using these methodologies even at the index level. The valuation methods applied by Obermatt in the table below may be of greater benefit to the value oriented investor. These are there Top 10 stocks from the S&P500 index by value, they also assess each stock on the basis of growth and safety, creating a composite ‘combined’ evaluation:-

TOP 10 VALUE SandP500 - Obermatt

Source: Obermatt

Conclusion

I was asked this week, why I am still not bearish on the stock market? The simple answer is because the market has yet to turn. ‘The market can remain irrational longer than I can remain solvent,’ is one of Keynes more enduring observations. Fundamental valuations suggest that stocks will underperform over the next decade because they are expensive today. This implies that a bear market may be nigh, but it does not guarantee it. Using a very long-term moving average one might not have exited the stock market since the 1980’s, every bear-market since then has been a mere corrective wave.

The amount of political capital tied up in the stock market is unparalleled. In a world or QE, fiat currencies, budget deficits and big government, it seems foolhardy to bite the hand which feeds. Stocks may well suffer from a sharp and substantial correction. Even if they don’t plummet like a stone they are likely to deliver underwhelming returns over the next decade, but I still believe they offer the best value in the long run. A tactical reduction in exposure may be warranted but be prepared to wait for a protracted period gaining little or nothing from your cash. Diversify into other asset classes but remember the degree to which the level of interest rates and liquidity may influence their prices. Unfashionable value investing remains a tempting alternative.