The death of government bonds has been long in investors’ minds. Fixed income sages were forewarning a bear market well before US Treasuries “peaked” in summer 2012 (when the 10-year note yield fell to 1.5 per cent).
Arguments were reasonable. Valuation was amplified by low interest rate policy. Record purchases by central banks and increased regulatory efforts amplified demand. The 2008 financial crisis reduced appetite structurally for riskier alternatives. Private sector deleveraging and a huge capacity overhang from the commodity boom years and subsequent global economic slump drove inflation lower. The list goes on. Bond bears bet these factors would prove temporary and the market would retrace to “pre-crisis” levels. They never did.
Today’s environment is best described by serial disappointment. Economic growth, despite glimmers of acceleration, continues to miss expectations year-after-year.
In our view two (simple) factors are at play. First, deep financial crises take decades to recover from. Second, we are mere passengers on a powerful and secular demographic trend. UN data shows the global annual growth rate of working-age people declining from 1.8 per cent in 2010 to below 1 per cent through the next decade. It may not sound much but it represents the sharpest deceleration over any decade.
The elixir of long-term economic growth relies on this population growth rate alongside productive investment and technological improvements. This is critical, because bond investors ultimately concern themselves with the interplay between growth, inflation and [central banks’] monetary policy response.
Investment in the post-crisis landscape has been weak at best. To boot, zero interest rate policy facilitated a misallocation of capital. Under ‘normal’ circumstances, companies and projects that would be accounting failures are instead kept alive, starving potentially superior investments of capital.
Technology meanwhile has been remarkable. Creative responses to regulatory efforts have vastly improved efficiencies. For example between 2011 and 2016 the average US vehicle fuel economy standard has increased from 30.2mpg to a planned 35.5mpg (an 18 per cent improvement). Through to 2025 it is planned to rise to 54.5mpg – an astonishing 54 per cent further efficiency gain.
Such a framework provides insight and conclusions for investment strategies. Foremost, government bonds are far from dead. For the remainder of this decade we should expect lower growth and inflation rates than previously seen. Consequently bond yields, while at the low-end historically, are fundamentally justified.
While the macro setting promotes a pro-bond environment over the medium term, we think there are reasons to be cautious – ignore bond sages at your peril. Equally though, in somewhat unloved places, attractive opportunities do exist.
It’s been a very good ride for government bonds. The return from investment in so-calle risk-free US Treasuries since 2000 has far outstripped ‘risky’ equities – and without the drawdowns. But the proverbial elephant in the room, the US Federal Reserve, looms.
Its inclination to begin increasing policy rates after a record period of cheap money sets a bearish tone for US government bonds. At current yields, it could potentially take years to collect enough coupon income to offset capital losses. My personal bond guru described this as being akin to picking pennies from a motorway.
It’s a similar story for UK Gilts too. However, long-term growth and inflation dynamics tell us that any sell-off is likely to be capped beyond any historical precedent. A school of thought also exists that longer-dated bonds could rally as market participants become nervous of a policy error by central banks; i.e. tightening too soon could stall any nascent recovery.
Emerging markets, both economically and financial asset-wise, have suffered since the Federal Reserve mentioned removing the QE punchbowl in the summer of 2013. Central banks responded by trimming rates – many with multiple cuts.
Our models show Asia, Latin America and emerging Europe and Africa will decelerate further below trends, suggesting more policy action in the future. If true, there is a large yield differential to arbitrage. It may seem strange to suggest allocating to emerging markets at this juncture but yields in many countries are significantly positive in real terms. When emerging countries’ growth is weak and decelerating this just doesn’t make sense – policymakers will eventually need to cut rates to stimulate their economies.
In our view we are at an inflection point where so much bad sentiment is priced into areas of emerging markets fixed income that downside, barring catastrophe, is limited. In selected places you are being handsomely compensated for the implied risks. Even the most resolute bond sage will struggle to argue with that.
Hinesh Patel is co-manager on the Old Mutual Global Bond Fund at Old Mutual Global Investors.
The Fed and Bank of England moving rates provides an opportunity in the bond sector, but investors have to be aware of the secular super-macro outlook of structurally lower yields. Allocating to unloved emerging markets where real yields are positive is one option, but investors must remeber where they are in the risk-reward spectrum.