Rudi's View | Jul 07 2017
All had been suspiciously quiet, but bond yields are back on the move and share market volatility already has announced itself. What exactly is happening and should equity investors be worried?
-Central bankers have triggered a sudden sell-off in global bonds, with yields rising fast
-Volatility in the Aussie share market has picked up noticeably
-The timing seems odd as global economic momentum seems waning and inflation remains low
-Should investors prepare for a repeat of the reflation trade in 2016?
By Rudi Filapek-Vandyck, Editor FNArena
Traditionally, share market tipsters and commentators seldom pay heed to what is happening in global bond markets.
Rather they prefer to talk about government regulation, the economy and individual company specifics. And cheap/expensive valuations, of course, if not underlying trend lines and key technical support and resistance levels.
All this is changing quite rapidly as times they truly are a-changing and equity investors, whether they like it or not, are now forced to pay attention to what is happening in the world of global IOUs, and why.
Thirty-Six Years Of Falling Bond Yields
The main reason as to why bonds were seldom mentioned prior to last year is because the long term trend for global yields had been down, down, down (as in those ubiquitous Coles supermarkets ads). On occasion, when the subject of conversation moves to banks and the local housing market, you'll hear someone saying things along the lines of "I still remember when interest rates were as high as 18% in Australia" and that pretty much sums it up nicely.
Back in the eighties, interest rates were high, as high as they've ever been in recorded history, and they have since steadily decreased until last year. Falling bond yields are supportive of rising equities. No need to pay attention, thus.
Just how little attention was paid is still illustrated by today's witnesses/survivors of the 1987 global equities crash, also known as "Black Monday". Nearly thirty years after the event, men with grey hair and lots of wrinkles in their faces will tell anyone who cares to listen they'd turn up at work as a young brookie and there it was, a sudden collapse in share markets, all at once, in one pull down, with no warning in advance, and with seemingly no clear trigger (other than bloated valuations).
In reality, of course, all that carnage had become inevitable after the Bundesbank abruptly changed its policy on Friday, triggering a major re-set for global bond markets which then had its consequences for equities on the subsequent Monday. Who knew? Bonds can trigger share market mayhem, just like that.
Former advisor to President Clinton, James Carville, formulated it best when he stated back in 1993:
"I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everyone."
The following year, 1994, became known as "The Great Bond Massacre" when the Federal Reserve failed to properly communicate its intentions and bond markets had a massive hissy fit, simultaneously pulling everything else down into the quagmire.
Pretty much everything one needs to know, as an equity investor, lies embedded in that 30-year history of global bonds. It's why a change in trend for bond yields automatically gives equity markets participants the jitters, and why central bankers do their utmost to communicate well in advance, and then again, and again, and again, and then act gently.
US Ten Year Treasuries: 1871-2017
[graph: Dr David Brown, Monthlyinvestor.co.uk]
The End To A Long Term Trend
Unfortunately, Central Bankers are not really Masters of the Universe, they just pretend they have all the answers and everything under control (goes with the job requirements), in reality they do not. Plus markets do not always play along like central bankers want them to.
Last month, a general sense of frustration among central banks led to a global coordinated message to investors that bond yields, 10-years and beyond included, really had to move higher. The Federal Reserve is the only major central bank that is now "normalising" monetary policy after a near decade of extreme stimulus, but the in total of four hikes thus far only managed to push up short duration bonds. Bonds with a duration of 10 years and beyond had since the start of 2017 been moving into the opposite direction.
The latter makes sense because inflation, both in the USA and most elsewhere across the globe, remains stubbornly low and economic momentum had been mixed at best, missing expectations on most measurements. Let's not forget: policies in the UK, Europe and Japan are still extremely stimulatory, which also weighs upon longer term bond yields.
At the same time, Janet Yellen & Co at the Federal Reserve seem intent to further normalise policy settings, irrespective of data and/or inflation. The problem with such a context is that rising yields on shorter term bonds are merely catching up with falling yields on longer term bonds, creating what bond specialists call a "flattening yield curve". The next step, if both dynamics don't change, would be an inverse curve (short yields higher than long yields). This is negative for lenders (banks) as they make money out of arbitraging short against long via loans to their customers.
If banks stop lending, the economy grinds to a halt and the Federal Reserve is achieving the opposite of its ultimate target, which is sustainable economic growth without super-stimulatory monetary policy. Hence why I used the term "frustration", and why central bankers felt they had to send a clear message to global bond investors.
Boy, did they get the message alright! US bonds had entered June on an ongoing gradual flattening and declining path, but once the message got through, the yield on ten-year bonds quickly lifted from 2.10% to 2.31%. Australian bonds responded in synch, moving from 2.32% to 2.70%.
Looked at it through a short term window (see below), it does look pretty scary.
[Graph National Australia Bank]
The Reflation Trade, Version 1
It's about one year ago that central bankers in Japan sent the first message to the global investor community: central bank policy has reached its limit. One should not expect negative interest rates to fall further, nor to stick around forever.
At that time, the relative valuation gap between defensive assets and growth stocks on one side, and financials and cyclicals on the other side had ballooned to a seldom witnessed extremity. As one would expect, market positioning from professional funds managers had followed in equally extreme fashion.
Suddenly bonds started selling off, pushing yields higher. Next everyone started talking about "portfolio rotation" and "the reflation trade", which essentially meant highly valued stocks had to be sold and lowly valued stocks had to be bought. Previous winners turned into losers and vice versa. It proved good news for stocks like BHP Billiton ((BHP)), Rio Tinto ((RIO)) and Woodside Petroleum ((WPL)), not to mention Whitehaven Coal ((WHC)), South32 ((S32)) and Monadelphous ((MND)), while the banks also joined in with the party.
Instant victims were so-called bond proxies, the likes of Goodman Group ((GMG)), Vicinity Centres ((VCX)) and Asia-Pacific Data Centres ((AJD)), as well as anything trading on above market PE multiple, including stocks like Domino's Pizza ((DMP)), CSL ((CSL)), REA Group ((REA)) and Brambles ((BXB)). Ask any fund manager specialised in small and medium cap stocks and they'll tell you what a horrible time they had between September last year and February. If they only invest in micro caps they are still suffering nightmares today.
Most investors in Australia only remember the positives since their portfolios are fully stacked with banks and the large resources stocks.
The reflation trade really gained traction upon the election of Donald Trump as President of the USA, with promises to unwind regulatory shackles, bring jobs back, lower taxes, spend billions on infrastructure and lift GDP growth sustainably above 4%. In the background, US ten-year yields jumped, initially from 1.36% to 1.8%, then following the surprise election result to 2.6%. Those are big moves. Equity investors might make a mental comparison with how much a share price has to weaken before a stock's dividend yield lifts to nearly double!
But just when it appeared the world had changed for good, all came to naught and market dynamics reversed back to pre-mid 2016 conditions. It wasn't long before Goodman Group shares were back to where they were before sell-off; next they rallied a good deal higher. The same can be said about CSL, Transurban ((TCL)), REA Group, NextDC ((NXT)), Aristocrat Leisure ((ALL)) and many others that had been left behind in the post-Trump rally.
In central bank circles, the Federal Reserve had stayed true to its communicated intention to further hike interest rates, but extreme policies remained in place in the UK, in Europe and in Japan, while Chinese authorities had taken the foot off the stimulus pedal. Oil prices deflated, yet again. The rest of the commodities spectrum followed suit. Inflation numbers dropped around the world, despite ongoing positive labour market indicators. Economic data also largely disappointed. US ten year bond yields reverted back to 2.10% by June.
That's when global central bankers decided they must act. The scenario for unwinding extreme stimulus implies bond yields should go the other way. Quickly, US ten-year yields lifted to 2.34%. In Australia, investors have already seen a notable spike in asset price volatility. Equally noteworthy is that following the swift reversal in bond markets, central bankers are now trying to smooth market sentiment. They do not want the second half of 2017 to become a case of be careful what we wish for.
Also, apart from declining bond yields, the timing of the coordinated central bankers message to financial markets seems a bit off, to say the least. Economic momentum appears to be rolling over, raising justifiable question marks about the immediate outlook for inflation.
Reflation Trade 2.0
In a simplistic comparison, bond yields act in the same manner as does a country's currency or the global oil price. At first a rising oil price is seen as a positive for the global economy, as it signals increasing demand and thus healthy growth, but if the price continues to rise it'll choke off demand and thus stymie economic growth.
Equally important, it's not only about the magnitude of the rise, just as important is the speed at which the oil price rises. If it happens too fast, too high energy users have no time to adjust and a recession next is but the logical outcome. (Something investors and the world temporarily lost sight of in mid-2008). The same applies to a country's currency just as it does to interest rates and bond yields.
Given the unique circumstances in which the world finds itself today, with never before witnessed levels of debt, alongside structural changes to economies that have a significant impact, it is anyone's guess why inflation today is as low as it is, and how high exactly bond yields can rise before we start seeing negatives popping up.
Economists have been debating these matters for a number of years now and all we have today is some guesswork, at best. There are no historical precedents except, maybe, the 1930s. What we do know, we think, is that interest rates and bond yields cannot possibly rise to pre-GFC levels, let alone to levels seen during the nineties. The world has changed so much since.
What we don't know is how exactly this scenario of "normalisation" is going to play out. Or where exactly the pain threshold is located. While parts of the global investment community are once again becoming fully absorbed with, let's call it "reflation trade 2.0", following central banks guidance and the bond market's response in late June, a cynic would observe that moving away from extreme central bank policies to potentially less extreme policies is still a whole lot different from monetary policies turning "hawkish".
Both might look the same from a distance, but they're not.
Within this context it is remarkable how eager economists and investment experts are to jump on the central banks are turning "hawkish" narrative. In Australia, this led to increasing anticipation the Reserve Bank too would use its policy statement in July to signal it was preparing to start hiking interest rates. Clearly, those people are living in a different Australia than I do.
As it happens, the RBA not only failed to live up to such misguided speculation, the public statement issued marked a gentle switch into the opposite direction. Such is also the conclusion of virtually every assessment by a credible economist in the country I have read since. "On hold for the foreseeable future" seems but the most appropriate conclusion. Don't expect any change before 2019, at the earliest, say the likes of Westpac.
The latter sounds a lot more credible to me than predictions for a first rate hike on Melbourne Cup Day in November.
The RBA wasn't the only central bank not abiding by the new reflation script this week. The Swedish Riksbank also held rates steady and argued now wasn't the time to hike rates or cut its QE program, this despite the fact Sweden is one of the fastest growing economies in the EU. (Now there's a hint for us all)
The Bank of Canada, on the other hand, is widely seen as the likely next to hike interest rates. The Bank of England might join in November, but economists at CommBank suggest, if the BoE does raise by 25bp, it will not signal the start of a new tightening cycle. Rather it shall remove the cut delivered post Brexit referendum in 2016.
Again, it looks the same from afar, but it isn't.
Volatility, Here We Come!
Combine all of the above and we can safely make the prediction that volatility will be a lot higher in the period ahead than what we've experienced thus far. Already movements in the local share market have been noticeably larger in the past week and this may well prove an indication of what is yet to come as financial markets will be to-ing and fro-ing on the global reflation theme led by rising/stabilising/falling bond yields. Right now the trade is "on" again which has seen BHP shares rise 9% in the blink of an eye, and Sydney Airport ((SYD)) shares drop by -7.7% in that same short time slot.
Irrespective of whether one agrees with my assessment, there is always a chance the share market might do what the share market does best; running too far into one direction. After all, some scientists believe we, homo sapiens, have managed to climb on top of the food chain because we have the ability to unite behind a convincing narrative. There is no place where this is as obvious as in the share market.
Things can also turn out differently; it's why we call it a surprise. Then there's difference between portfolio damage and carnage.
Which is why investors might want to take note from the latest investment strategy update by the team of strategists at Credit Suisse who have remained faithful to the reflation trade throughout the past five months. On their projection, the ten year bond yield in the US will rise to 2.80% by year-end, implying a mini-repeat of the dynamics during the second half of last year is starting in the here and now.
Credit Suisse likes to call it the "Bondcano", which seems to be a derivative from "Sharknado" but Google tells me it's meant to be a play on "vulcano", in reference to the potential fall-out from an eruption a la Vesuvius (see Pompeii).
Aussie stocks most sensitive to rising real bond yields are those that share a combination of:
(1) high valuation (a low discount rate is in the price),
(2) a high payout ratio (here is where the 'coupon' is likely to be fixed so a stock that most looks like a bond) and,
(3) high financial leverage (a low cost of debt has supported profits)
As such, Credit Suisse has identified the following stocks as most at risk when bond yields rise:
as well as the following financials:
The following stocks should be prime beneficiaries:
-Beach Energy ((BPT))
-BlueScope Steel ((BSL))
-Caltex Australia ((CTX))
-Fortescue Metals ((FMG))
-Here, There and Everywhere ((HT1))
-Mayne Pharma ((MYX))
-Tassal Group ((TGR))
and the following financials:
Equally interesting is that Credit Suisse's Conviction Short ideas are 100% dominated by potential bondcano fall-out, with the following stocks on the Short List:
Countering Credit Suisse's steep yield rise prediction for the second half of calendar 2017 are, amongst others, economists at Citi who maintain the US ten-year yield is more likely to average 2.10% in the final three months and next year, when the Federal Reserve is expected to deliver three more rate hikes, the ten-year is projected to rise to 2.75% by the final quarter. Most of the upward lift is expected to take place in the June quarter, or in about ten to twelve months.
A steeper US yield curve on the back of rising yields is likely to trigger a revitalised US dollar, says Marc Chandler, Global Head of Currency Strategy at Brown Brothers Harriman & Co (BBH).
Chandler's view is that:
"The story that is spun suggests that officials everywhere are telling investors that the gig is up, that peak QE is behind us and a new monetary cycle is at hand. We are skeptical and suspect that the narrative is getting ahead of itself. "
The Global Investment Committee at Morgan Stanley reiterated its view this week as to why investors should remain optimistic on global equities. For the first time in a long while, major economies are in a synchronised growth phase and inflation won't derail the uptrend. Morgan Stanley is forecasting inflation in the USA will actually drop in the second half.
In simple terms: "Growth is picking up, but inflation is not." This is more likely creating a sweet spot for equities, says Morgan Stanley. Others mention the term "Goldilocks scenario".
The Committee predicts 2018 is likely to offer a different, much tougher environment with the Federal Reserve not only shrinking its balance sheet, but on Morgan Stanley's prediction the Fed will also deliver four rate hikes next year. At the same time, the European Central Bank will be tapering and the Bank of Japan exiting its yield curve control.
The Committee's advice? This is not the time to start worrying. Make hay while the sun shines.
(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions.)
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