Finally, long-term government bond yields are starting to realise that global growth is robust. Inflationary pressure is building, and central bank balance sheets have peaked. US 10-year bonds broke trading resistance at 2.40% and the US 30-year bond broke the 200-day moving average at 2.91%.
I remain firmly of the view that world government bond markets offer “return-free capital risk.” The much greater risk from here is capital losses for bond investors; there could well be substantial capital losses over the next few years. This also has ramifications for stock and sector weightings in global and domestic equities.
We have entered the most sustained period of synchronised global growth since the Global Financial Crisis. All major developed and developing economies are advancing, with China and the Eurozone leading the growth engine. Every economic indicator we look at confirms this view, and it seems the bond market is finally working this out with bond yields rising and bond prices falling.
Basic economic theory suggests a long bond yield should be roughly GDP growth rate plus inflation. However, as we sit here today due to the previous actions of central banks with their unprecedented bond buying QE programmes, most of the world’s developed bond markets still have negative real yields. For example, in Germany the GDP growth rate is 3%, and the inflation rate is +1.8%. In theory, the German 10-year Bund yield should be, all things being equal, 4.8%. Today it is 0.48%. Unbelievably the 5-year German Bund yield is still negative at -0.27%, meaning anyone who buys a 5-year German Bund actually pays the German Government interest!! That is utter madness and won’t end well for bondholders.
German 10–year Bund Yield
Bubbles always have an easy to understand narrative. In the case of long bonds, we have entered a period of “structural deflation” driven by advances in technology and an “ageing” global population creating demand for income products. There’s also a belief that interest rates will remain “lower for longer” because households are so indebted that central banks can’t risk raising rates quickly.
I believe the long bond market is the greatest bubble I have seen in markets. To me, it’s just a matter of whether this bubble deflates in an orderly or disorderly way.
Currently, even bond bears believe it will be orderly because central banks won’t let it get disorderly, but that is a very glass half full approach; bubbles tend to burst, not deflate.
I’m starting to believe that all the variables are in place for this bond market bubble to “burst.” We have strong, synchronised global growth, full employment, rising wage pressure, high consumer and business confidence and cyclical equities upgrading earnings. We have equity markets at all-time highs, potential tax cuts in the USA, strong industrial commodity prices, strong agricultural commodity prices and rising inflation data. And most importantly of all, we have central banks reducing their bond-buying programmes.
With the marginal buyer of bonds, central banks, pulling back and eventually letting their bond holdings mature (not reinvesting), there is every chance the bond market hits an air pocket and has to move to a to yield where a “sane” investor would buy that yield. Remember, central banks aren’t investors: they are market manipulators for economic reasons. They have no benchmark and limitless timeframes. When they withdraw from a market, that market needs genuine investors to stand in. The prices that a central bank and a genuine investor would pay are vastly different.
Central bank balance sheets have peaked, and cash rates have bottomed globally. It’s time to be very, very careful in long bonds and anything “masquerading” as a long bond in equity markets. Remember a considerable amount of money has been pushed out of bonds into equities that have bond-like characteristics. As bond yields rise, you will see capital losses in bond-like equities all around the world.
The peak of the so-called yield trade is now behind us. The only two sectors that benefit from rising bond yields and steepening yield curves are the banking & insurance sectors. Banks borrow short (deposits) and lend long which means net interest margins will increase as bond yield curves steepen. Insurers benefit from better returns on their portfolios. My fund is heavily invested in banks and insurance stocks around the world in anticipation of steepening yield curves and higher profits from these sectors. In fact, financials will lead all equity indices globally as bond yields rise.
In terms of what gets sold or de-rated, it is long duration defensive assets that have been priced inverse to bond yields. I’d be cautious in utilities, telecommunications, healthcare, supermarkets, infrastructure and real estate investment trusts. It is most likely, in my view, time to take multi-year profits in those sectors and move to the sidelines or rotate to banks and financials if you want to maintain dividend yield in your portfolio with less risk of capital losses.
Just to remind you of the capital gains that are there to be taken in bond-like equities, below is a long-term chart of Transurban (TCL) vs. the US 10-year bond yield. As US 10-year bonds fell from 6.00% to around 2.00%, TCL rallied from $2.00 to $12.00. Of course, TCL grew its business, etc. during this period, and it’s not an entirely fair comparison, however, to put this in context TCL is now trading on a P/E of 65x consensus FY18 earnings. My view is under a rising bond yield scenario TCL shares could easily fall -20% and still be expensive.
My key message today is being in a “defensive” sector doesn’t make your share price “defensive.” In fact, there are no “defensive” characteristics about Transurban’s 65x PE for FY18. Yes, monopoly motorways are “defensive” and have built-in inflation hedges via toll rises, but 65x P/E as bond yields rise from generation lows will not prove “defensive” in terms of share price in my opinion. I say again this stock could fall -20% in the scenario I believe in, and my view is investors would be better off rotating from a TCL, as an example, to a bank or insurance company. That rotation for an Australian investor would also increase the percentage of franking credits to your dividend stream.
The search for income has gone too far. Many Australian stocks have been priced inverse to their spot dividend yield. It is time to be far more selective in your yield based investments and consider the potential capital losses in “defensive” sectors as global growth accelerates and bond yields and cash rates rise.
In a rising global growth/ rising interest rate environment, which is what I see for the next few years, your portfolio must favour cyclicals over defensives. It’s that simple, cyclical value will beat defensives in terms of total returns, and you can see that rotation has started globally.
On Tuesday night, the worlds cyclical bellwether, Caterpillar (CAT.US), issued profit guidance miles above Wall St’s expectations and rallied +6%, taking the Dow with it to all-time highs. That CAT upgrade, the third this year, alongside others from cyclical companies like MMM is telling you the world is growing in a synchronised way. It is telling you to own more cyclical companies and lighten your exposure to defensive companies as the interest cycle changes.
So, consider this a strong warning on the capital loss risks in long bonds and the capital loss risk in overvalued defensive equities that have been masquerading as bonds. It’s time to rotate to cyclical value. That may also mean the FANGS see rotational profit-taking, as the investment world rotates to cyclicals. I sense the beginnings of a genuine leadership change in markets, and I have my fund positioned for that change being short long bonds and long financials around the world.
Below, just remind yourself where a US10-year bond yield is….it should be 4.00% today, and that’s where it will head.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
