Rudi’s View: In Bonds We Must Trust

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 | Oct 27 2022

In this week's Weekly Insights:

-In Bonds We Must Trust
-Conviction Calls
-Research To Download

By Rudi Filapek-Vandyck, Editor FNArena

In Bonds We Must Trust

Normally, when economic recession is coming, you'd expect defensives and solid & reliable Quality industrials to be among the outperformers in the share market but 2022 is not following that script - at least not thus far.

Shares in supermarket operators Coles ((COL)), Metcash ((MTS)) and Woolworths ((WOW)) are down since the start of the calendar year, while packaging giant Amcor ((AMC)) and its local offshoot Orora ((ORA)) are equally notably absent from this year's star performers on the ASX.

What to think of Australia's third largest index weight, global plasma-leader CSL ((CSL)), which only a week ago increased its profit guidance for FY23, but whose share price cannot hold on to positive momentum for longer than a few days this year?

A similar observation can be made for ResMed ((RMD)); the global leader in diagnosing and treating sleep apnoea stands to extra-benefit from a major competitor's problems. ResMed's also not so flash when it comes to sustaining share price momentum.

Is it possible, maybe, investors are simply not that convinced economies stand to lose most of their momentum in the year coming?

Not so, according to the latest global fund manager survey by Bank of America, which, according to BofA market strategists "screams" of mass capitulation.

Average levels of cash at 6.3% have never been as high since April 2001 (in the midst of an extremely brutal bear market). Fund managers are now three standard deviations underweight equities.

A net 72% of respondents sees a weaker economy on the horizon, only a smidgen off the record high print of the July survey. 91% says corporate earnings will be lower than is forecast today.

A net 74% of survey respondents sees a global recession in 2023; the highest percentage since April 2020, at the very beginning of the global pandemic.

So how then can we explain this great discrepancy between the overwhelming acceptance of recession next year, with negative consequences for corporate profits, and the failure of the usual, defensive stalwarts to perform?

I believe the answer lays with global bonds.


It was the lauded Benjamin Graham himself who in The Intelligent Investor highlights that bond yields are an important input for determining the value of companies.

But after four decades of mostly positive impact from bonds, most analysts and investors in shares could be forgiven for paying scant attention.

In 2022, however, the direction in bond yields matters - it has mattered whole year.

For the record: higher bond yields, as we are witnessing throughout this year, impact on all listed assets, but the impact is most felt for those equities that trade on higher valuations. In a theoretical example: stocks that trade on a forward PE multiple of 32x might be pushed back to 26x while a stock trading on 9x might only be pushed lower to 8.5x.

It's not difficult to see how rising bond yields benefit the so-called Value segment in the share market, while Growth and higher valued Quality stocks suffer.

Usually, when a recession shows up on the horizon, bond yields fall in anticipation of lower inflation and central banks cutting interest rates, which also adds that extra valuation support to the more defensive-oriented stocks I mentioned earlier.

Thus far, however, inflation is still on the rise and central bankers continue lifting interest rates in response. This explains why going all-in defensive in preparation for next year's recession hasn't worked so well this year.

The obvious point to make is that virtually no-one believes inflation will not respond to central bank tightening and slowing economies, hence a time will come when bond yields stop rising as markets try to anticipate a change in direction for inflation and global interest rates.

But don't get excited just yet. This global inflection point can be as little as a few weeks away, or it can be as far away as a number of months.

Taking guidance from the above mentioned global fund managers survey, a majority of investors sees the Federal Reserve lifting its Fed Funds rate to 4.5-5% from 3-3.25% currently, implying there's still more to go if current forecasts are correct for 75bp and 50bp hikes before year-end.

The good news nevertheless is the end of this cycle of interest rate hikes is drawing nearer, unless those forecasts need another reset.

Central bankers are all too aware too much tightening might break the system, thus if inflation stays higher for longer, their first response is likely to leave interest rates higher for longer, delaying any loosening as inflation simply cannot be left footloose and free.

When it comes to the next Black Swan event, BofA's survey suggests investors are most worried about Europe and European financials.

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