“Prediction is very difficult, especially if it’s about the future”
– Niels Bohr, Nobel Laureate in Physics.
Stock markets can often be likened to spoiled and obstreperous toddlers and the role of central bankers to that of the harassed parent. As a parent you must inculcate sufficient discipline whilst also making sure the youngsters can stand on their own two feet and accept that they will gain their liberty, eventually.
In stock market terms, episodes of difficult parenting have occurred several times since the financial crisis of 2008/09. Most notable was the taper tantrum of 2013 when US treasury yields surged and prices tumbled, as the US Federal Reserve Bank announced that it would begin tapering its policy of quantitative easing. Stock markets took fright at the prospect of higher interest rates and stumbled.
Another episode of yield tantrums and difficult parenting descended on stock markets a few weeks ago.
From very low levels, bond yields around the world have shot up this year. At the end of February, the yield on 10-year US Treasury Bonds hit 1.6 per cent. It is now just shy of 1.8 per cent. This is very low by historical standards, but the yield has tripled since last summer and capital values of long dated government bonds have tanked. This reflects confidence that vaccines will bring an end to the coronavirus pandemic and with plenty of pent-up demand waiting to be released, combined with monetary laxity, bond markets fear this could lead to inflationary pressures and an eventual rise in interest rates.
The tiger of inflation has been stirred by the extraordinary events and policy responses of the past 12 months and markets are looking for a soothing parental response. If bond yields go up half a percentage point in short order (the monetary equivalent of the children threatening to scream until they are sick), will central banks relent at the risk of an even bigger tantrum next time or opt to draw a disciplinary line and put up with the screaming?
So far it looks as though they have decided to give markets what they want and risk spoiling the children. Soothing words from the Australian, UK, European and Japanese central banks reinforced earlier commitments to keep interest rates lower for much longer this time and to continue with the enormous stimulus levels. Markets were becalmed, at least temporarily.
Enter the Daddy of all central bankers, Jerome Powell, Chair of the Federal Reserve Bank of America who stated that “the American economy is a long way from the Fed’s employment and inflation goals, and it is likely to take some time for substantial further progress to be achieved”, thus playing down the threat of inflationary pressures and the possibility of higher interest rates. The sharp rise in bond yields was arrested but again the market questioned whether this was sustainable and for how long?
For the ordinary investor, the direction of bond yields matters a great deal. For the past 40 years, bond yields have been falling and bond values have been rising. Bonds have been used to offset the risk of investing in equities. A traditional balanced investment portfolio is made up of 60% equities and 40% bonds. Equities are the best long-term asset in which to be invested but are prone to periods of ‘boom and bust’ so we need something to steady the ship. When equities go through periods of bust, the bond part of the balanced portfolio comes to the rescue, so investors have a feeling of security.
But now we seem to have a change in direction and the problem is a simple one. The protection an investor gets from bonds comes from yields falling, and hence prices rising, but yields can only fall so far. If they are already close to zero or negative, they cannot possibly fall much further and hence investors do not have much protection from traditional portfolios.
After weeks of turmoil in the bond markets with yields rising and prices falling, a familiar oracle voice from Omaha, Nebraska, reminded everyone of just how extreme the fixed interest market had become. Warren Buffett, still CEO of Berkshire Hathaway Inc at the age of 90, recently published his annual letter to investors in which he offered this gem on bonds: “Bonds are not the place to be invested these days. Can you believe that the income recently available from a 10-year US Treasury Bond—the yield was a meagre 0.93% at end of 2020—had fallen 94% from the 15.8% yield available in September 1981. Fixed income investors worldwide, whether pension funds, insurance companies or retirees, face a bleak future”.
That statement puts the recent bond market ructions into all the perspective we need, if not too much perspective and adds weight to the Clarion strategy of avoiding exposure to long dated bonds in the fixed interest allocation of the Portfolio funds and model portfolios. For some time, we have favoured short-dated, and index linked bonds which are less sensitive to credit, interest rate and inflation risk.
Some commentators also fear that equities, particularly large cap US Tech stocks, are expensive by historical measures and are in bubble territory. Equities are priced with reference to the yield on 10-year US Treasuries and the shares of some technology companies have fallen with their lofty valuations making them less appealing when global economic recovery is gathering pace. A rising 10-year interest rate reduces the expected value of future cash flows, especially the more speculative prospects that are full of promise but with actual profits still some way off. Higher yields mean that the current value of future earnings is lower and therefore the share price is correspondingly lower.
As bond yields have risen on the fear of inflation, a rotation between different investment styles has also gained traction with some long out of favour cyclical stocks suddenly finding popularity again. The change in direction has created volatility and the equity market has stuttered. But compared to bonds, selectively equities offer much better return potential. Growth remains scarce and assets which provide it will continue to demand premium multiples even as bond yields edge higher. Several of the large cap tech stocks generate wide margins, solid returns on capital and amounts of free cash flow that were unthinkable at the turn of the century. While a lot of growth companies are indeed on high ratings, for some this may be justified as these are the companies which are likely to shape the future.
Central banks have unleashed a dizzying number of unconventional steps to cushion the economy from the impact of the coronavirus pandemic. The Fed’s response to the virus has been robust and ongoing. The annual increase in broad money supply in the US went from 5% to 25% last year. Almost 20% of all dollars in circulation were printed in 2020. This may well feed through to inflation in the short term, but it has also provided a massive boost to world liquidity which provides the fuel for a rise in risk assets. Liquidity has been far more important than valuations in 2020 and there is good reason to expect this will continue in 2021.
Reasonably low inflation of 2pc to 3pc a year helps to “lubricate” the economy while chipping away at real public and private sector debt levels. In an environment of gradually rising bond yields selective equity investment in well managed companies with strong balance sheets looks set fair for the foreseeable future. A return of inflation could be the friend of companies which have pricing power.
But despite the short-term tantrums in bond markets and the rotation between different investment styles, there is still no clear outlook for either inflation or interest rates. There is a meaningful chance that as fiscal and monetary stimulus combine with the reopening of the global economy, we will see a more broad-based reflationary boom and cyclical sectors, which generally fall into the value camp, could prosper again.
Growth will become less of a rarity in the future and the premium paid for it should normalise. Investors will have more diversified and less expensive ways of exposing their portfolios to growth over coming years and the stock market Laggards of recent years could become the Leaders going forward, and vice versa. The opportunity set is widening, although volatility is likely to continue for a while yet until markets have greater visibility about the economic road out of lockdown and the outlook for inflation. To quote George Soros “short term volatility is greatest at turning points but diminishes as a new trend is established”. In this environment it is sensible to keep investment portfolios well diversified.
Clarion review client investment portfolios on an ongoing basis but for investors who do not enjoy this privilege we strongly recommend that an urgent review of your investments would be appropriate, particularly with regard to the exposure to long dated bonds in cautious and balanced portfolios. A sensible blend of value and growth stocks rather than making a big style call in 2021 would also seem appropriate.
As always, we wish all our clients, their families, and friends the very best of health and good fortune as we all gradually return to something resembling normal life. In accordance with government guidelines our office will remain closed until April 12th, but we are available for contact via the office number, email address and all normal forms of communication. As always please do get in touch if you have any questions.
We look forward to updating you regularly over coming months.
Keith W Thompson
Clarion Group Chairman
Creating better lives now and in the future for our clients, their families and those who are important to them.
Any investment performance figures referred to relate to past performance which is not a reliable indicator of future results and should not be the sole factor of consideration when selecting a product or strategy. The value of investments, and the income arising from them, can go down as well as up and is not guaranteed, which means that you may not get back what you invested. Unless indicated otherwise, performance figures are stated in British Pounds. Where performance figures are stated in other currencies, changes in exchange rates may also cause an investment to fluctuate in value.
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