The oft-heralded end of the bond bull market is – apparently – upon us. We will now be transitioning seamlessly from low growth and low inflation to higher growth and controlled inflation. Janus Capital “bond king” Bill Gross has remarked we know we’ll be there when the 10-year Treasury hits 2.6 per cent.
All investors should be diving head first into anything that looks and smells like an equity. Sound advice, I am sure you will agree..?
Rather than argue that the bond bull market is over, let’s think first about the scale of the move we have seen in yields.
In 1981, UK 10-year yields stood at a little over 15 per cent and by last year had fallen below 1 per cent. That represents a huge re-pricing of bonds which began during a highly inflationary period, typified by capital controls, labour unrest and political pyrotechnics.
Today, we have the exact reverse; capital flows freely, as does, within bounds, labour. We also have central banks targeting inflation and there are ready buyers of fixed income assets in the form of pension funds, which are desperate for yield to meet their ever-growing liabilities as the baby boomers move from the accumulation to the retirement phase of their lives.
When it comes to future economic growth, the most enthusiastic members of the “best-is-yet-to-come-club” seem to have conveniently forgotten about the scale of the debt that has been accumulated post-global financial crisis, as well as the complete collapse of labour productivity that is associated with the recovery.
Today, total global debt as a percentage of GDP is approaching 300 per cent (the previous peak was 270 per cent in 2008). Lest we forget, despite record low interest rates and red-hot printing presses, nominal GDP is still muted. Indeed, it is amusing to watch the equity bulls inform us that fiscal policy will now lead the way after the fantastic success achieved by easy monetary policy across the globe over recent years (please excuse our cynicism on this one).
We believe it is highly likely that the new global fiscal regime will create higher inflation but very little additional economic growth in the meantime. Stimulating the economy at a time of fairly high employment has rarely ended well. Bond yields could react negatively in the short term, with government bonds looking particularly vulnerable thanks to the indebted state of sovereign finances.
It is a short hop from creditworthy to credit disaster and here is the biggest risk. By going on a fiscal expansion, the likes of both the US and the UK look like deteriorating credits and hence, yields could rise for all the wrong reasons.
This is a far bigger practical threat than worries about wage growth or input prices, which imply that we are in a normal economic cycle. Clearly we are not. If you think bonds would react badly to deteriorating creditworthiness, imagine what equities would do!
So, has it been a spectacular bond bull market? Absolutely. Is it past its best? Yes, clearly it is. Current yields are best described as dull, but possibly worthy, depending on the role that fixed income is expected to play in a wider portfolio, and fears of a significant rise in bond yields are likely overblown.
In credit land, the spread on corporate bonds is relatively attractive and the asset class remains appealing for investors on the hunt for yield. That said, we must be prepared for a much more modest total return outcome than that to which we have become accustomed.
And just in case the cheerleaders of an economic renaissance are wrong, for most investors, sovereign bonds continue to be the most effective and accessible diversifying and risk-offsetting positions for investment portfolios.
Peter Toogood is investment director at The Adviser centre