13th May 2015
Jason Hollands, managing director of Tilney Bestinvest looks at the dramatic movements in bond markets and what they mean for investors…
Global bond markets have experienced nothing short of a rout in recent days, led initially by a spike in European yields, but with the aggressive re-pricing of bonds extending out to the US Treasury market. Over $450 billion is estimated to have been wiped off the valuation of global bond markets in the past few weeks.
The scale and velocity of rising yields and fixed income price declines have taken many by surprise despite numerous market watchers and professional investors having long opined on the growing risks of a bubble in this asset class and looming fears of a Greek debt default. Bonds more than any other asset class have been distorted by the misallocation of capital from central bank stimulus programmes – known as Quantitative Easing – and the ultra-low interest rates seen across much of the globe in the aftermath of the financial crisis.
Given the current turmoil in the bond markets, the question on the mind of many investors will be: is this is the decisive bursting of an asset price bubble, or will it prove to be rumblings based on shorter term factors?
In mulling this, let’s try and unpick the factors behind what has been driving yields. While European bond yields had fallen in anticipation of Eurozone QE, which after all involves a programme of monthly bond purchases, Tilney Bestinvest’s house view has been that QE, if successful in achieving its goal of boosting economic growth, would ultimately lead to rising yields – after all, if growth is returning, it makes little sense for investors to park assets in securities offering little in the way of real returns.
With the ECB having recently raised its growth forecasts, this appears to be playing out and GDP growth data released this week showed a pick-up in growth across the Eurozone. Although weaker than expected for Germany (the Eurozone’s biggest economy), in the first quarter the French economy grew at 0.6%, the fastest level in two years after a period of stagnation. Spain, which has undergone significant reform, saw its fastest growth in in seven years during the quarter.
But the markets have also been rattled by recent softer US data and the staunching of the Dollar rally, which have combined with a sharp rebound of 40% in oil prices since they hit the floor in January. Those factors have led to expectations of the return of inflationary pressures over the coming months after a brief disappearing act and, along with that, renewed anxiety about the US Federal Reserve hiking interest rates, potentially in September. Holding bonds with negligible yields at a time when inflation spikes, means negative real returns.
These current fears about the return of inflation and monetary tightening from the US appear to be major factors impacting and driving the bond markets. Investors might reasonably expect the beneficiary of reduced appetite for bonds to the equity markets but in fact there has clearly been contagion into other asset classes from the bond rout, with turmoil extending to the equity markets and emerging market currencies as investors pull risk off the table.
A tightening of global liquidity and sustained rise in the cost of capital would undoubtedly represent a serious headwind first and foremost to key emerging market countries with large Dollar borrowings, but also to equity markets, since a major driver behind the incredible bull-market in US equities of recent years has been the ability of companies to refinance or issue new debt inexpensively and use the proceeds to buy-back shares, inflating share prices. A sustained or abrupt end to easy money risks applying a brake to the equity bull market, as well as a period of dislocation for bond investors.
In the context of our beloved UK stock market, shares particularly at risk of a reversal in fortunes in those circumstances could be certain income stocks in traditionally “defensive” sectors, since these have been heavily bought by income refugees who have been enticed further up the risk spectrum in the quest for yield as “bond proxies”. We are certainly not there yet, but were bond yields to crossover with dividend yields and once again deliver higher yields than equities, the effect on bond-proxy stocks could be pretty brutal. Below is a chart that shows the historic relationship between UK dividend yields and corporate bond yields.
But we need to return to the question as to whether the current bout of volatility is the sign of a definitive lancing of the bond bubble, or more temporary rumblings based on shorter term anxieties over a pick-up in inflation. On balance we think it may be the latter, a view that’s predicated on what might happen to in the commodities markets, including the oil price.
Markets have habit of over-reacting, and the rebound in the oil price since January undoubtedly reflects the fact that it was oversold. But this rally could yet prove to be overdone as well, based on the mismatch between supply and demand. This week the US Energy Information Administration estimated global oil demand will grow by just 1.3 million barrels a day next year, way below the 2.89 million level seen in 2010 after the last significant oil price slump – a pace of demand growth that won’t absorb the overhang in supply given the soaring output from Saudi Arabia. With talks continuing to secure an agreement to limit Iran’s nuclear ambitions, a final agreement this summer could also see a material increase in Iranian supply to add to the current over supply.
And then there is China, which continues to grapple with a structural economic slowdown and attempts to shift its economic model away from credit financed, commodities-intensive infrastructure development, in favour of growing the Chinese consumer market and service sectors. That should lead to continued weakness in the prices of many resources and when combined with the release of excesses inventory by China, this risks exporting deflation pressures around the globe.
So what does all this mean for investors?