Stock markets are known for often going too far.
So can bond markets, although they tend to go mad a little less often, and to do so in a way that is less visible. However, one thing is clear from looking at the behaviour of global bond markets and that is that we have seen a classic bond MELT-UP in August 2019.
Bond markets are generally slow movers. Trends tend to be well-established and turning points well-defined. Bond yields are usually a function of inflation expectations and these are also slow movers.
As early as 2016, we have warned about the end of the dis-inflationary phase of US Kondratieff, a 34-year period between 1982 and 2016 during which inflation has been falling across the board and across the globe after 33 years of inflationary pressures between 1949 and 1982
Indeed, using US Core inflation as the inflation benchmark, Inflation has been falling from the 13.6 % high reached in June 1982 to a low of 0.6 % reached on the 31st October 2010.
Since then, inflation has been stabilising and in fact started rising – higher lows- from 2016 onwards.
In fact, interestingly enough, the latest reading in Aug. 2019 was 2.4 %, the highest inflation reading since 2010.
When looking at bond yields, the picture is the same, save for a very unusual divergence in 2019
The peak in 30 year US Government bond yields took place in May 1984, two years after the peak in inflation, the downtrend has been perfectly established for 30 years between 1984 and 2014, a double bottom was made in 2015 and 2016 and then yields broke out of the downtrend in 2017.
Until a highly unusual fall in bond yields happened in 2019, with 30 year Government bond yields falling from 3.4 % to 2 % in the matter of a few months.
More intriguing is the fact that the latest move in yields does not correspond to any move in the underlying inflation as the preceding chart establishes.
The extraordinary rally in recent weeks has been taken as a sign that a recession is at hand.
That, after all, is what $15 trillion in negative-yielding bonds around the world, and an all-time low in the 30-year U.S. Treasury bond, imply.
The disconnection from inflation means that the coming recession has nothing to do with a traditional economic slowdown – which in turn would take inflation gauges lower – but with a sharp economic contraction probably due to an external shock – the uncertainty caused by the US – China Trade War and its impact on investments and manufacturing.
The disconnection between bonds and inflation also means that there has been a massive flight to quality and the safety of Government bonds after maybe a highly volatile year in equities in 2018.
But it is also highly likely that this is the moment when the three-decade-long bull market in bonds has reached an untenable extreme and is ready to snap back.
In other words, the melt-up we have just experimented in the past few weeks may well be the bond market equivalent of end of the dot-com bubble in the stock market in 2000.
One month later, the bond market’s odds on a recession look overdone and the markets are starting to look at positive economic surprises. Expectations for rate cuts have been toned down and the yield curve reverted to a positive – even if very mildly – slope.
Once again, the world we live in is not a calm flowing river and there are very realistic scenarios that suggest the current trade impasse between the U.S. and China could lead to something terrible, particularly if Donald Trump makes good his threat to block Chinese corporations from accessing the US capital markets or banning US corporations from investing in China.
The famous economist Thomas Friedman has repeatedly warned about “a digital Berlin Wall and a two-internet, two-technology world: one dominated by China and the other by the United States” as already an economic catastrophe, but just imagine a world where two financial worlds. do not talk to each other on top. Who will finance the US budget deficit then ???
But besides the doomsday scenario above, the behaviour of inflation and the behaviour of bond yields point to an episode of stagflation of even recession with inflation.
And as every bond manager knows, a recession with inflation is actually the worst possible scenario for bonds.
As an illustration of what is in store for the future, the Institute for Supply Management’s US factory index slipped to 47.8 in September, the lowest reading since June 2009, according to data released today. The figure missed all estimates in a Bloomberg survey that had called for an increase from August’s 49.1.
Manufacturing and production are collapsing everywhere, including in the Us without any impact on inflation.
Behavioral economists explain the melt-up in bond yields by the fact that the mood of investors has reached an extreme of catharsis or revulsion. Financial journalists have become obsessed with a world with no yields or even negative interest rates and project the current situation well into the future.
The Japanese are familiar with the problem and Europe is now grappling with this unhappy reality.
Another indicator of extreme sentiment are the flurry of angry presidential tweets directed at the FED – a premiere in the history of the United States of America – urging it to lower rates even further and even to stop quantitative tightening — apparently ignoring the fact that it did just that back in June.
Finally, the chart of the 100 year Austria Government bond says it all :
Not only the price of the bond went ballistic in 2019 rising form 110 to 210, a chart more usual for stocks like Netflix or Amazon, but it has marked a major top after a clear vertical acceleration. The second lower top has just been recorded two weeks ago, and the next move is clearly down.
Lots of money is currently riding on the notion that central banks will keep cutting interest rates and that we will settle into a deflationary, Japanified environment. ( this is what the journalists love to tell at the moment )
But the reality is that we are in a structural environment of returning to inflation, and that is what the market is NOT prepared for.
A return to inflation. Could this really happen? It could and it will because the main cause of inflation is wages and that we are hitting a wall in manufacturing and investments because of the Trade War but at a time where labor markets are tight and are actually getting even tighter.
One of the greatest structural cause of the big disinflationary trend of the past there decades was globalisation and the need for China to create hundreds of millions of jobs to shift its population from the rural sector to cities and the service and industrial sectors.
As China celebrates today the 70th anniversary of the founding of the People’s Republic of China, XI Jing Ping can proudly say that this need is over and that China is now seeing full employment and rising wages.
Its labor is no longer competing with the rest of the world’s labor and – guess what – we are now moving from globalisation to isolation.
If America closes its borders to Chinese products and prevents US corporation form sourcing their products above, then labor costs in the US are bound to rise, and inflation with it.
We have pointed out several times that the US tariffs will ultimately raise the costs of goods and are therefore inflationary.
- Trade wars and currency volatility increase the demand for safe haven assets
- Trade wars and disruptions to global supply chains make economies less efficient and hamper the international flow of savings.
- Tariffs are, by definition, inflationary. The latest round of tariffs targets final consumer goods and will have a more direct impact on the CPI: the great moderation of inflation in the past two decades was primarily caused by a decline in the prices of tradable consumer goods, which will be subject to tariffs of 10% after September 1st.
By the same token, if the market has focused on a need to find havens, it must eventually yield to the fact that protectionism is eventually bullish for inflation and bearish for Treasuries — both because it sparks inflation and because it reduces the American ability to finance itself with the excess savings of trade partners.
One parallel, raised by many, is 1981, which saw cathartic lows for the stock market and highs for bond yields, based on the assumption that inflation would continue forever.
What we are now experiencing is the exact mirror image as bond investors expect that deflation will continue forever, as testified by 100 year bonds trading at less than 1 % yields.
What all this is telling us is that the next significant move in bond yields is UP and NOT DOWN.
Bond investors should be ready, but equity investors should be ready as well.
As we have argued many times in our various publications, U.S. stocks are extremely expensive by
historical standards. We recently reproduced this interesting chart that plots both the CAPE ratio and the Tobin Q ratio for the US stock market since 1900.
Valuations are at extremes that have ALWAYS preceded MAJOR corrections in stocks.
The cyclically-adjusted price-to-earnings, or CAPE, ratio is extremely high at 30.3x, or 44% above its long-term average of 16.9.
This P/E is calculated using real corporate earnings over the past 10 years to iron out short-term fluctuations. Except for 2008, that P/E has been above the long-run average since the early 1990s, so if the long-term number is still valid, the CAPE will be below 16.9 for a number of years in the future just to return to trend.
Equity bulls, including US banks, try to justify current valuations by pointing to extremely low levels of interest rates.
The current argument favoring higher P/E ratios is low interest rates and TINA, the fact that There Is no Alternative
Low bond yields mean there is less competition between interest coupons and appreciating stocks. This assumes, however, that investors buy stocks mainly for price gains but buy bonds for yield.
In fact, most bond investors do not buy bonds for their yield, but for their capital appreciation.
Otherwise, none would ever buy German 30 Year Government bonds with Negative Yields.
On a total return basis, investing in 30 year US Government bonds in 1981 – 1982 and holding them till today would have yielded 5.5 times more than investing in the SP 500 Index.
On a yield basis, 2% returns on the US 30 year Government bond is equal to the dividend yield on the S&P 500. Equity bull then say that equities can support valuations because they provide potential appreciation on. top of their dividend yield that bonds do not offer.
However, the dividend yield on stocks should be much higher than the one on bonds to account for the higher volatility and higher risk of equities when compared to risk-free Treasury bonds.
Of course, if investors neglect the likelihood that low bond yields foretell a recession, something that is highly detrimental to stocks, they can rightly believe that low rates and high P/Es go hand in hand.
And if investors believe that there will be no recession, then there should be inflation considering the tightness of the labor market, then bond yields are bound to rise from here.
Whichever one looks at the equation, the rationale of low bonds yields to justify high equity valuations does not hold water.
Moreover, there are numerous reasons why low rates are not a valid reason to pay sky-high equity prices relative to profits.
With companies preparing to start reporting results for the third quarter, the S&P 500 Index is trading at 19.1 times earnings over the last 12 months, compared with the average of 16.9 over the long term.
But investors should take notice of the fact that earnings per share in the past year have been supported by substantial and unsustainable stock buybacks.
CEO’s and Board Members tend to have a buy high, sell low mentality.
They tend to be overly enthusiastic at business cycle peaks when corporate cash is plentiful and they tend to purchase purchase their shares at high prices. The phenomenon has been amplified in the past couple of years by extremely low nominal yields that have enticed CEOs to issue bonds and use the proceeds to buy back their shares.
In August/September alone, and maybe as another sign that bond markets were overly expensive, cash rich companies such as Warren Buffett’s Berkshire Hathaway and Tim Cook’s Apple Inc rushed to the market to borrow money that have strictly nu use neither justification for.
In addition, corporate earnings in 2018 – 2019 have been boosted by the 2017 corporate tax cut that reduced the top tax rate from 35% to 21% and boosted earnings and cash flows.
All this to say that paying extremes of valuations on artificially boosted earnings when interest rates are more likely to rise than fall is probably an extremely dangerous exercise.
Inflation is by far the key determiner of Treasury yields, with a 60% correlation.
Inflation is usually very detrimental to stocks as was the case in the late 1960s and 1970s when double-digit annual price increases disrupted business and transferred profits to the government via taxes.
As we have argued all along, we are NOT in a deflation environment, regardless of what the bond market says, but in an inflationary environment and the Trade war will just amplify that inflationary effect.
Believing that low interest rates make stocks cheap is a major mistake.
Quite the contrary, low yields are probably foretelling an abrupt economic weakness that will dramatically slash corporate earnings and P/Es.
The Melt-up in Bonds is probably the signal that equities are about to roll-over significantly.
Some say that this time is different !
and by looking at the extraordinary monetary policies that have been implemented in the past ten years it is clearly different… But this should be more a cause for concern than a re-assurance !
Recent Comments