Recent spikes in global bond yields are awakening fears of a sustained fixed-income melt-down. Are these fears justified? Is the global economy ready for sustainably higher financing costs. In short, though this move could have further to go, we think not.
First, we need to separate the strategic view on bonds from the tactical.
Our approach to long-term risk adjusted return projections, shown visually below, shows most developed fixed income markets falling below the bottom of our “zone of indifference”. This suggests MANY developed fixed income markets are attractive candidates for opportunistic shorts. As we have been saying for a while, we prefer cash to developed govt bonds. Not a single developed market sits “above” the zone, meaning not one candidate for an opportunistic overweight for a strategic investor.
Our “ranker” outputs this same information in tabular form. Breaking projected long-term returns into growth, income, and value factors, we show below who’s bottom of the heap. No surprise, we project UK gilts will deliver an excess return to a $ base investor of -4.2% PER YEAR over the next 5 years!
We own very few developed govt bonds in our strategic model portfolio – only Portugal, Singapore and New Zealand. Although it currently holds 40% in global govts and 14% in linkers, if we were to constrain our exposure to EM, this FI exposure would fall dramatically.
How has the recent sell-off impacted the long-term outlook for developed govt bonds? The chart below shows the history of our out-of-sample long-term projected returns. Projected long-term annualised returns for the whole DM govt space have risen from -1.4% p.a. to -0.7%. Still miserable, and a Sharpe of -0.3.
So, what’s been driving the sell-off?
It’s not institutional flows. Below, we aggregate active and passive mutual fund flows, at the global level, using our normal 1 (max bearish) to 10 (max bullish) signals. Although flows have very recently begun to turn down, they are still above our long-term mean of 5.5, indicating institutional money flows are not participating meaningfully in this sell-off.
Clearly, a large-part of the sell-off has been technically driven by shorter-horizon money flows. The market was highly over-owned speculatively going into the summer, and this has now corrected.
We saw a similar profile with our sentiment signal for spec investors. Highly over-bullish going into the summer, and this has now corrected.
Is the move justified by the growth outlook? We are huge believers in growth MOMENTUM being a much more significant driver of asset class performance then the LEVEL of growth. Of course, we monitor both, but below we focus only on momentum.
US growth momentum, as proxied by our flagship activity score, scanning data across 50+ data sets, has picked up marginally over the last few months, but is still sitting around the long-term mean, and, in our humble opinion, doesn’t justify, sustainably higher bond yields.
Focusing only on the momentum of the range of lead indicators that we follow, these have been extremely volatile this year, but are now in a range, having spiked earlier in the summer.
There are 2 key fundamental culprits we should look to for the causes of the sell-off. First, the inflation outlook has been trending up materially since the back end of last year. We generate signals from 20+ inflation data sets. Whilst still below the long-term mean, this is a trend we should all watch very carefully, and every portfolio should have an appropriate exposure to inflation assets.
One of our key long-term inflation signals, Crossborder Capital’s Monetised Savings Index, suggests that the medium-term picture for global inflation pressures is for them to continue to rise.
The critical second culprit for this move in bonds is the dramatic shift in developed market policy bias since the beginning of the summer. We think developed policy makers have been desperate to tighten policy for at least 2 years now, and will continue to take any opportunity that rallies in risky assets provide them with, to “have another go”. We’re at another of those forks in the road right now. Our policy bias signal, shown below, and derived from Prattle’s unique central bank scanning technology, shows a clear move to hawkish communications (low score). The biggest drivers are UK, US, Sweden, and Norway.
So, this is the shorter term picture. Longer term, we remain VERY concerned about the dramatic tightening underway in developed market liquidity conditions. This tends to act with a lag on asset prices and economic conditions of 3-9 months.
So, the combination of tightening policy bias, higher inflation, higher yields, middling growth, and then a Q1/Q2 liquidity wall is potentially VERY TOXIC for risky assets in the first half of 2017.
In the short run, we remain neutral on risk tactically, but with a bias to the downside. Our shorter-term signal for equity positioning is now out of the danger zone, having suggested a wobble 2 weeks ago. We would NOT be surprised however by a major equity sell-off going into the end of the year, and would be looking to rebuild core positions into this, depending on the size of the move.