Fund managers are holding the highest cash levels in almost 15 years. The question becomes: will that cash find its way into global cyclical equities as the bond bubble deflates?
A respected survey by Bank of America Merrill Lynch of 195 global investors (between July 8th and 14th) confirmed those surveyed were holding 5.8% of their portfolios in cash. That’s up a tick from 5.7% in June and the highest cash reading since November 2001.
What needs to be remembered is the cash alternative for these global investors is generally a 0% return. That means the global investors surveyed feel that asset prices are so stretched they would rather park somewhere that will generate no return, rather than potentially a negative return.
Obviously, there remain a myriad of global macroeconomic and geopolitical issues that cause anxiety among professional fund managers, myself included.
Similarly, there is a growing chorus of concern about bond markets and any equity that is priced inversely to bond yields. Again, they are valid concerns.
The great Sir John Templeton described the stages of a bull equity market. I’ve used this quote before and I’ll use it again. Bull markets are born of pessimism, grow on scepticism, mature on optimism and die on euphoria.
You could hardly argue equity investors are “euphoric” when holding the highest cash levels since 2001. In anything, that confirms “scepticism”.
Where I believe there is “euphoria” is in global and local long bond yields. I am of the view long bonds are now “return free risk” and all investors need to be cautious in buying any asset priced off the so called risk-free rate.
This is interesting because in a highly, highly unusual state of affairs, equity markets globally and locally have been led to new highs by stocks that have bond-like characteristics. I can think of no bull equity market EVER that was led by UTILITIES, REITS and Consumer Staples, but today we have one!
To quote James Paulson of Wells Fargo Asset Management (US) “when a financial trend persists for so long and when its magnitude becomes so overwhelming large, it begins to feel normal. After years of periodic calls for higher bond yields, most have simply given up and jumped on the lower for longer bandwagon. But the Nifty Fifty, oil prices, dot.com stocks or house prices can’t rise forever and neither will bond prices (inverted to yield)”.
He goes on “Currently the US 10-year bond yield is near and all-time low dating back to 1870! Today, more people are employed in the USA than ever before, the unemployment rate is lower than about 72% of the time since WWII, nominal GDP is about +25% higher than at the end of the last expansion, disposable personal income is about +30% higher, core consumer price inflation and wage inflation are between 2% and 2.6%, the annual auto sales rate in the US is near and all-time record, bank lending is up by +8% in the last year, corporate profits are almost +15% above peak levels of the last recovery, the stock market is at an all-time high and the current US economic recovery is now the third longest on record.”
“With this as a backdrop, does it make sense that the 10-year Treasury bond yield is currently lower than it was at any point during the entire Great Depression?”
Fast forward to recent history “prior to the 2008 crisis, the 10-year US Treasury yield was between 4.5% and 5.0%. Even at the worst of the crisis in late 2008, the 10-year yield briefly only declined to 2%. Despite being the eighth year of the US economic recovery, the current 10-year yield of 1.58% is near an all-time low, more than 50bp lower that at any time during the GFC. The current US 10-year bond yield appears ridiculous. Increasingly, US Bond yields appear alarmingly divorced from many measures of US economic activity.”
I have to say I agree with all those thoughts, and that the idea of buying a US bond at these prices is most likely for those desirous of losing their capital, or at best, making negative real returns as inflation edges up and the Federal Reserve raises interest rates.
Below is a chart of the Citigroup US Economic Surprise Index and the US 10-year bond yield. US data continues to beat expectations (surprise), yet US 10-year bonds are plumbing record lows. It makes no fundamental sense.
Now let’s look at the Citigroup US Economic Surprise Index and the S&P500. This does make fundamental sense!
We all know actions of global central banks in driving their own bonds negative through QE have led to US and Australian bond yields declining to record lows. An ever-decreasing pool of positive yielding bonds has spurred a mad dash for any asset with some kind of fixed return. But that relative investing by investors who have to be invested in bonds is dangerous. It will not end well in my opinion, particularly if global growth and inflation surprise to the upside.
What I am trying to tell you today is I think that the biggest risk to equity markets is a sharp (and unexpected) rise in bond yields. That will be much worse for bond investors themselves (capital losses), but the ramifications for equities will be a rotation from bond sensitive equities to GDP and growth cyclical equities.
Under the rising long bond yield scenario, which I think is a plausible one in the months and years ahead, the equity losers will be Utilities, Telco’s, REITs, infrastructure and consumer staples stocks. This would be a global and local event.
The winners would be financials, led by US banks, consumer cyclicals, industrial commodities, technology and growth stocks. Basically, cyclicals would see rotational support from defensives, or any equity with bond-like characteristics.
Just to put this in context, so far in 2016, the US S&P500 is up +6%. Telco’s and Utilities are up +20%, while REITS are up +10%. Financials, led by Banks are down -1%. That sector performance has in general been matched globally, including in Australia.
Don’t get me wrong, a sharp rise in bond yields would cause a bumpy ride in equities as investors rotated from market leading defensives to cyclicals/growth, but for a long/short global equity fund like my own, it would provide wonderful opportunities.
Put it this way, if bond yields rise because global growth and inflation surprise on the upside, it is BULLISH for equity earnings growth. Equities love GDP growth and a little inflation, and you would also see asset allocation rotation from bonds to equities in all of this.
You should never, ever buy ANY asset purely for its yield. Yes, yield plays a role in the overall investment decision making process, but for equities, I can assure you that dividend GROWTH is far more important than raw dividend yield. High yield usually means low growth.
What I want to invest in are companies who are GROWING their revenues, profits and eventually dividends. Solely buying dividend yield because bond yields are at record lows will prove a mistake. You need to focus on dividend GROWTH from here in companies that are GROWING their profits.
In the next half, I am forecasting the US 10-year bond yields to rise to 2.00% from the current 1.58%. While many of you will think that’s a small move, believe me, if that does happen, it will have profound short-term effects in both directions on sectorial performance in the global and domestic equity market. No doubt it can ONLY be driven by further good US economic news (likely in my view), but we need to prepare for it now.
It would almost certainly lead to the US Dollar itself rallying further as a Fed rate rise (or two) would be in the mix this year. This is important for Australian based investors as it would lead to the AUD/USD cross heading back to 70US cents, or a touch lower.
At the AIM Global High Conviction Fund, we have already started to position for higher US 10-year bond yields and equity sector rotation. In our Australian holdings we have used the strength of bond sensitives to lower exposure to infrastructure, telcos and REITS. We have added further to ASX listed growth stocks such as Aristocrat (ALL) and Treasury Wine Estates (TWE) as we think their earnings growth in AUD will be underestimated by analysts.
In our global investments, we are adding growth and cyclicals, with our key focus being in US financials who will finally benefit from high US interest rates under the scenario above. Stocks such as Wells Fargo, JP Morgan, Bank of America, Visa and Morgan Stanley look interesting to us as the US yield curve steepens.
Let’s see what transpires, but long bonds could be about to “die on euphoria” and it’s time to head for the exit in my opinion. Either way, bonds and bond sensitive equities have NEVER been more overvalued versus economic and earnings fundamentals. That in itself should be a reason to lock in some of the profits you are all sitting on, and rotate to more cyclical sectors, or those that benefit from rising bond yields.
It’s not different this time …
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