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Are bonds failing us as a warning signal?

The Montgomery team has written extensively about the stunning decline in bond yields. This is occurring despite terrorist attacks, political turmoil in the UK, violence in the US and the prospect of ‘last resort’ helicopter money in Japan. Life isn’t changing, which makes one wonder, are investors frogs in a pot full of gradually heating water?

Confusing and ambiguous signals

Since the US Federal Reserve raised rates in December 2015, usually a sign that the economy is strengthening, US 10-year government bond yields have fallen from 2.3% to 1.47%.

Traditionally, a rising stock market signalled an improving economy while falling bond yields signalled deflation or disinflation, implying the virtual certainty of a recession. We have both. Tradition doesn’t apply when the source of the declining bond yields aren’t regular investors but massive, globally coordinated central banks. This then begs the question, are the signals we, as equity investors, are used to seeing being obscured by ‘official’ central bank activity?

In others words, perhaps the recent new highs in the S&P500 are anything but a sign of a strengthening economy. The reality is that the rally has been confined to ‘minimum volatility’ or defensive stocks, those that might be seen as a substitute for bonds like utilities, telcos and REITs. The same is true in Australia, with the likes of Transurban and Sydney Airport benefiting the most from investor affection. In the past, such behaviour has presaged a fall in aggregate corporate profits and a recession.

Putting aside the probability that declining bond yields will continue to fuel equity price appreciation as capital continues to pursue higher yields, it is worth considering the deeper issues that may, like rust, be now emerging through the paint on the surface of equity markets.

Some commentators took delight from the recent US jobs numbers with one TV personality writing, “the pessimists on the US economy have been proved wrong”. Such responses are simplistic. While the payroll gains of 287,000 jobs beat economists’ expectations, the trend numbers remain firmly negative. Monthly payrolls in the second quarter averaged 25% less than the first quarter and were half the average number for the fourth quarter of 2015. More importantly, the one million new jobs created in 2016 is still 33% below the total increase in working age people. In the past six-and-a-half years, the total number of new US jobs created has lagged the growth in the working age population by 1.6 million.

According to a report by Deutsche bank, $US15 trillion or 40.5% of the $US37 trillion in developed market sovereign bonds are carrying negative yields and 80% are carrying yields of less than 1%.

Think about that for a moment. If you lend CHF100,000 to Switzerland for 30 years by purchasing a 30-year Swiss bond, you will receive CHF96,172 in three decades’ time. The same thing happens if you lend money to the governments of Germany and Japan for 10 years, and the list over five years includes The Netherlands, Finland, Austria, Denmark, Belgium, France, Sweden and over two years you can add Ireland, Spain and Italy to the list. Italy’s banking system is in crisis and in need of a bailout. It is estimated it is harbouring $US400 billion of problem loans or 25% of the country’s GDP. Yet despite this, Italy can borrow at lower rates than when times were good.

All of this has been driven by heavy-handed central banks, not the weighing scales of the market’s price discovery process. The combined central bank balance sheets of Switzerland, the UK, the European Central Bank, the US and Japan have grown from $US3.5 trillion in 2007 to $US12.5 trillion today.

The justification for many equity investors to be fully invested is that the earnings yield – the inverse of the price to earnings ratio – on equities is more attractive than bond yields. But if bond yields are an artifice created by central bank buying, should they be the benchmark against which we measure the attractiveness of stocks?

Where would bond yields really be if not for central bank buying? Where would they be if the market were allowed to adjust for risk and uncertainty, without central bank intervention? Would earnings yields of stocks trading on 25, 35 or 55 times earnings look attractive?

Corporate debt has expanded to epochal levels, used to drive shareholder returns through share buybacks and dividends and to fund mergers and acquisitions.

In the first half of 2016 alone, US corporates issued a record $US700 billion. As the following two charts demonstrate, the level of corporate debt puts us in unchartered territory. And don’t forget, it’s the level of gearing that ultimately determines the toxicity of a burst bubble.

Chinese corporate debt and US leverage

Source: DB Global Markets Research

Perhaps because the accumulating debt has been used for ‘financial engineering’ rather than productivity or productive capacity improvements, US business capital expenditure is at six-year lows and corporate earnings have not grown.

Since 2011, dividend payout ratios in the US have increased from about 25% to 37% today. In Australia, the payout ratio since 2010 has increased from 55% to approaching 80%, as shown below.

Australian payout ratio increase at expense of earnings growth

When companies don’t retain earnings to reinvest in earnings growth, the only other avenue to grow is to borrow money or raise capital. Given companies are borrowing record amounts to buy back their shares, it effectively rules out borrowing more money or issuing new shares.

Depressed earnings growth becoming entrenched

In the US, S&P500 companies have, in aggregate, posted negative earnings growth for six consecutive quarters. The S&P500’s peak earnings was in 2014, and earnings stand at 18% less today, although the fall is not as great as the 36% slumps registered in the four worst recessions. The decline is more concentrated among commodity companies, but excluding them reveals earnings growth since 2014 of just 0.2%.

Margins will come under further pressure. Wages are rising in the US, and when combined with full employment and declining productivity, it becomes very hard to maintain profit margins.

Low growth, pressure on prospects and high debt unsurprisingly has reduced the credit ratings of many companies. In the US, the number of S&P AAA-rated companies has fallen from 98 in 1992 to just two today – Microsoft and Johnson & Johnson.

Number of S&P AAA rated companies

Source: S&P, Deutsche Bank

If credit quality is low, the risks for equity investors are high. But if risks are high, why are bond rates at record lows? It doesn’t make sense and it means that bond markets have lost their ability to provide appropriate signals to investors.

Any serious break in confidence, the emergence of inflation, or even the flight to safety of US company pension funds, whose aggregate liabilities trounce their assets, could cause apathetic investors to dump their now highly profitable bond positions.

Of course equities would not be immune to such an exodus. As John Authers wrote in the Australian Financial Review on 18 July 2016,

“There is no enthusiasm, but ever-pricier bonds leave no choice but to buy stocks … Is this a secure basis on which to invest? No … anyone trying to make money or preserve capital must be calm and relaxed.”

Bill Gross the founder of the Janus Global Unconstrained Bond Fund perhaps summed it up best:

“Global yields lowest in 500 years of recorded history and $10 trillion of negative rate bonds. This is a supernova that will explode one day.”

It may be some years before there is any sign of panic by investors and in the long run, you will do best being invested in businesses able to retain profits and generate high returns on that incremental equity. In other words, you will do well if you can hold your best quality assets through thick and thin.

However, when the primary justification for the rally in most asset prices is a bond price signal that is broken, holding some cash and perhaps taking some profits on the most highly geared and overpriced assets (Australian apartments anyone?), may well turn out to be a good strategy.

 

Roger Montgomery is the Founder and Chief Investment Officer at The Montgomery Fund, and author of the bestseller ‘Value.able’. This article is for general educational purposes and does not consider the specific circumstances of any individual.

 

5 Comments
Richard
August 03, 2016

Spot on Roger.

Its like we move from two behavioural situations in the economic world.

1) Where everyone with some intelligence can see that the current fiat system of the world with CB support is ultimately unsustainable and will inevitably have to change (most likely with some unrest).

2) Central banks then calm us down and pause, delay or state they need to do more and we carry on with the rally. Quality and yield gets well bid and we move through to the next volatile period of more issues from Europe, Chinese debt/growth, Japan QE, US raising rates, etc.

Rinse and repeat.

The next can-kicking episode seems like it will be helicopter money to maintain the status quo and further widen the inequality gap.

In the end we will sit back and realise that ZIRP and easy monetary policy is an unproven growth tool and the world actually needs to correct itself for longer term sustainability. Otherwise we go through this japan-like global situation for many years, which seems crazy but is more probable than a collapse involving gold, lead, bunkers and canned food.

Frustratingly, timing for the explosion of the supernova is a very low probability game.

Warren Bird
August 01, 2016

My view is different to Roger's. In relation to bond yields, the situation is debatable, but in relation to corporate credit, I think he isn't looking at the market properly. It is difficult to explain my view in a short comment so I will prepare a longer article.

Gary w
July 30, 2016

Agreed Great article, Roger. So, if bonds and equities are bound for decimation, where to go. Back to the 60s/70s and money under the bed

PaulU
July 28, 2016

Great article Roger. Agree entirely about the loss of bond signal/warnings though as noted, the amount of HY debt outstanding is a clear red flag. Importantly, the type/lack of covenants on HY should be particularly scary when we revert to PIK and low covenants- it's time to get out.

It also seems that the search for (dividend) yield is leading to a death spiral amongst corporates that, given investor preference, feel "obliged" to maintain higher payouts at the expense of re-investment. If all the Boards and senior execs can come up with for "growth" is borrow and payout, rather than achieve a decent return on cash reinvested in the Firm, they should move on.

anthony pike
July 28, 2016

There was an amazing New York Guy named David Wilkerson whom is quoted around some of the financial press as being alarmingly accurate with 25 predictions he made and published in a book called the Vision in 1974. Most of the predictions have come to pass.
He predicted in 1994 in a book about the collapse of the United States that the bond market would fail / collapse. He said the worldwide collapse would start in Germany, then affect Japan and then bank runs in USA 2 weeks later. It is caused by a the bankruptcy of a country obviously crippling German banks. With negative interest rates and economist not knowing what to do (one of the 25 predictions) , his forecast is that we are all going to need to plan for financial catastrophe and it will happen in an instant when we dont expect it! He also predicts that many connected "insiders" of New York will get their money out in time!

 

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