23rd April 2013
The manager of the world’s largest bond fund – Bill Gross at Pimco – says that the bond bubble is going nowhere, at least for the next few years. His argument is that the global governments have yet to find a way to create organic economic growth and until that happens, supportive conditions for bonds remain. Investment journalist Cherry Reynard asks does this mean that investors do not have to worry about any imminent meltdown in fixed income and can cling onto their bond holdings? “I don’t see a bond bear market on the horizon until this magical potion of cheque writing and policy rate stabilisation creates some type of nominal growth.” His job, he suggests, is to work out which asset markets are ‘least bubbled’. This, he concludes, is the US treasury market, which are the ‘most stable of the over-valued asset classes’, as FT.com reports.
But is Gross’s gloomy prognosis on the global economy correct? Certainly the latest PMI data to emerge from the Eurozone suggests that – while there may be pockets of improvement – there is no overall recovery as the BBC reports. Germany has long been the backbone of the Eurozone economy and even it is increasingly seeing weakness. Markit data showed German PMI falling to 48.8 in April, below the significant 50 point mark that separates growth from contraction. The weak data prompted talk of a rate cut, but few believe that tweaking monetary policy at this stage is likely to stimulate economic growth.
China, another key source of global demand, has also reported weaker PMI data. The HSBC China Purchasing Managers’ Index, the first economic indicator for the second quarter, showed the expansion in factory activity eased in April. The UK seems unlikely to buck the trend. With all these key economies heading South, it seems Gross may be right and bond investors are safe for the time being.
He is not alone is suggesting that the developed world has gone ‘ex-growth’. Philip Poole, global head of macro and investment strategy at HSBC Asset Management says: “Just like a human life cycle, as economies mature they tend to grow less rapidly and at some point can stop growing altogether and even start to shrink, particularly if their populations age rapidly.” He points to academic research that suggests 2% per capita growth is about as good as it gets for wealthy countries.
However, the two ‘danger’ economies (for bond investors, at least), likely to surprise on the upside, are Japan and the US. The OECD revised its estimate of Japan’s GDP growth higher to 1.4% this year and next. This is below the 2% growth last year, but still an encouraging trend. In its estimates, the OECD is factoring in a decrease in sales tax from 8% to 5%, plus the impact of a weaker yen and higher share prices as MNInews reported.
That said, many believe that the Japanese government’s actions to weaken the yen will see money move out of the domestic fixed interest market and into global fixed income markets, though that hasn’t happened yet. Jim Leaviss, manager of the M&G Global Macro Bond fund says: “We expect some overseas buying, but at the moment we are seeing some front-running of that trend by investment banks to sell to Japanese investors.” As a result, any indication that stronger Japanese growth would lead to higher global growth, which would put pressure on the fixed income markets seems far-fetched.
The real swing factor is the US. Here growth is picking up: Official estimates are revealed later this week, but early assessments suggest that US GDP may have grown at an annualised growth rate of 3.1% in the first quarter of the year, up from 0.4% in the last quarter of 2012 reported on Bloomberg Economists point to strong gains in US consumer spending and an acceleration in the housing market as reasons why growth is likely to surge ahead.
It may be the strength of the US that will unseat Gross’s predictions. He has been wrong before. In 2011, he avoided US debt entirely, believing that quantitative easing would create significant inflation. The position let to a rare run of weak relative performance. He has changed his view because of the failure of quantitative easing to create any type of inflation. He also believes that bonds will continue to have a place for older people and there are an increasing number of old people to create demand.
Ultimately, Gross’s contention that Western governments have failed to create conspicuous growth is uncontroversial with the possible exception of the US. Equally, it is difficult to argue that there is still a lack of inflation in the system. However, it is more controversial to suggest that these are the only things that would unseat the bond market. The bond market looks vulnerable both from a valuation and a liquidity point of view and it would not take a significant shift in sentiment for yields to start to slide.