Bonds Are Crying Wolf

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Always an independent thinker, Rudi has not shied away from making big out-of-consensus predictions that proved accurate later on. When Rio Tinto shares surged above $120 he wrote investors should sell. In mid-2008 he warned investors not to hold on to equities in oil producers. In August 2008 he predicted the largest sell-off in commodities stocks was about to follow. In 2009 he suggested Australian banks were an excellent buy. Between 2011 and 2015 Rudi consistently maintained investors were better off avoiding exposure to commodities and to commodities stocks. Post GFC, he dedicated his research to finding All-Weather Performers. See also "All-Weather Performers" on this website, as well as the Special Reports section.

Rudi's View | Mar 28 2019

In this week's Weekly Insights:

-Bonds Are Crying Wolf
-Conviction Calls
-CSL Challenge: The Real Challenge Is Inside Us
-Have Your Say - The CSL Challenge

-Rudi On TV
-Rudi On Tour

By Rudi Filapek-Vandyck, Editor FNArena

Bonds Are Crying Wolf

At risk of quoting the wrong investment legend, which is why I am sticking with anonymous, a smart cookie once observed that only after the infamous stock market crash of 1987 did investors the world around start worrying about the potential for a crash.

In similar vein, I'd like to put forward that selling risk assets because you might be worried about the world and the US economy sinking into recession looks well behind the curve at this stage. It is for this reason that commodities and equities sold off in the final four months of calendar 2018.

The world has seen a few dramatic changes since, and this has allowed for a quick V-shaped recovery. The first one is a significant policy change at the Federal Reserve, which not only has abandoned its intention for two more rate hikes medium term, Powell & Co have also decided that balance sheet reduction is no longer of the highest priority.

On top of this, the ECB is essentially back to being ready to re-start Quantitative Easing, while central bankers in New Zealand and Australia are watching further developments very closely in case domestic interest rates might need to be reduced. China already is stimulating its economy. The Japanese have shown no sign of ever quitting their perpetual QE policy.

The chart below has featured prominently in my on-stage presentations to investors this year. It shows why financial markets lost their nerve in the final quarter of calendar 2018; leading indicators for the US and for the global economy kept on weakening, and by the end of the year they were accelerating into negative territory.





The chart above shows one leading indicator for the US economy, but the situation was similar for the global economy as a whole.

There is an important similarity with two prior periods when leading indicators fell below the zero/neutral line. In early 2016 an imminent crisis was averted after the Federal Reserve, back then chaired by Janet Yellen, communicated to the market it would take a much more patient approach in normalising the cash rate back to neutral.

Back in 2011-2012 the crisis was all about Greece, and debt, and potential disintegration of the eurozone and it wasn't until Mario Draghi, president of the ECB, declared on July 26, 2012 he would do "whatever it takes" that worst case scenarios got buried and forgotten about.

Most importantly, and as shown on the graphic above, in each case economies recovered and so did risk assets. Until central bankers started "normalising" again, which in modern times means they reduced the virtual printing of money and even dared to start shrinking their bloated balance sheets.

Nobody really knows for how long this process can continue without creating the next financial crisis, if that is the inevitable end result of all this central banking Houdini-magic. But the impartial observation is that it has worked on both prior occasions, and it is likely to exert its magic again this time around.

The leading indicator that is shown on the graph above as falling steeply has already tentatively reversed course, posting a small rise in January. This, all else remaining equal, should in a while from now show up via improving economic data and indicators, feeding into market confidence that, yet again, worst case scenarios have been averted.

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It is generally accepted that bond markets represent more wisdom and gravitas than equity markets where daily sentiment and other factors of lower quality and sustainability can more easily grab the upper hand, certainly in the short term.

There is therefore a general acceptance that if ever a conflicting message is provided by movements in bonds and equities, wise investors take guidance from the former over the latter.

I would fully back up that view. But no market is infallible. And bonds do at times interpret the world incorrectly. This time might be one such example.

Or maybe the bond markets are not wrong, but the humans trying to interpret their message and its consequences are too much relying on the past?

What if bond markets are anticipating more Quantitative Easing from central banks, starting with the ECB in Europe? In that case, bond yields need to go lower, and investors believing a recession is on the horizon might panic out of equities and commodities. But if central bankers succeed in their quest, that will prove to be the wrong decision.

A recent study of bond market behaviour by analysts at Macquarie supports this view. Bond markets, reports Macquarie, in 2011 and 2016 troughed some 3 months later than equity markets, whereas further back into the past, bonds used to lead risk assets, not lag.

The problem post 2011-2012 is, of course, that central banks are very much engaged and actively intervening. It is well possible that, for the time being, bonds have lost their accuracy and their leading role, not to mention their predictive powers. This time around, suggests Macquarie, the observed lag might get even longer as some investors anticipate not only rate cuts but also the return of QE in response to slowing economic growth.

With other indicators such as copper, iron ore, and, yes, global equity markets themselves suggesting things have actually started improving for the global economy, Macquarie analysts firmly suggest this time around investors should back those indicators instead of bonds.

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None of the above means equity markets can never ever experience another sell off or meltdown. The last near abyss experience only ended less than four months ago. But it does appear that fears for the next recession are both late and premature.

The one scenario I am most worried about is that central bankers' race to the bottom might somehow feed into a much stronger US dollar, and this almost by definition will trigger money outflows for commodities, emerging markets and likely US equities as well.

Central bankers might feel like they're acting as the proverbial cavalry storming over the hill whenever things get hairy in the real world, but they do not meticulously control everything under all circumstances.

And yes, QE really has put those central bankers in a situation from which there simply is no easy escape. But that's a narrative for another time.

P.S. buy gold if you are really worried the end of this monetary experiment is nigh, and it won't be pretty.

P.P.S. Yield is in, not out. (But be wary of shopping mall owning REITs - see Premier Investments last week).


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