This quarter has witnessed a dramatic correction in bond markets. Market commentators have more or less ceased to wonder what economic horrors must surely follow from investors theoretically paying for the privilege of lending to governments. The question now is where next? Have we finally arrived at the long anticipated end of a bull market in bonds that has far outlived the careers of many of its detractors? A little less pessimism on inflation and a less and less questionable growth outlook for the world economy would certainly suggest that tougher times lie ahead for fixed income investors.
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US economy – What’s up doc?
Data out over the course of the second quarter have convincingly squashed worries over whether the weakness seen at the beginning of the year in the US economy had metastasized into something more sinister. Trends in consumption and investment are barely distinguishable from those seen in the supposedly halcyon days before the great financial crisis (Figures 1 and 2). It is increasingly apparent that the main thing that is genuinely unusual about the US economy right now is the fact that its central bankers still have it locked in monetary A&E.
The Federal Reserve is admittedly planning to start removing the economy from life support later in the year, likely in September, but is still promising markets that this process will proceed at no more than a pedestrian pace. Judging by the shape of the swaps curve (Figure 3), investors remain sceptical that the economy is sufficiently robust to even stomach this very shallow assumed path of interest rates.
The prospects for inflation dominate our thoughts on the appeal of bonds as an investment. The yield on any particular bond can be decomposed into three indirectly observable components – expected inflation, expectations for the path of real short-term interest rates, and term premium. Though they are all distinct, all are influenced by the prospects for inflation – the long-term decline in the term premium for example maps well to the downward trajectory of inflation over the last several decades. That would make sense – traditionally, the biggest risk for an investor choosing to lend to governments or companies over a longer time frame, rather than opting for a series of short-term securities, is the threat of unanticipated inflation.
Inflation – a subdued consensus
Those who believe that inflation will likely remain a vanquished foe, a horror story from dusty text books for many of today’s youthful economic forecasters, will likely take some convincing. Inflation has been largely absent in the US economy for much of the current economic recovery and, in truth, has been on a downward trend since the early 1980s when President Ronald Reagan and Fed Chairman Paul Volcker came together (Figure 4). Union membership waned in both the US and the UK and with it the bargaining power of the labour force. The end of the Cold War then brought with it a fresh wave of globalisation, with workforces in emerging markets providing ever cheaper alternatives for a corporate sector whose geographic revenue footprint was spreading and deepening in any case. Alongside this, rapid technological advances sparked by dramatic increases in computing power, robotics, artificial intelligence (“Glass half full”, In Focus, 29 May 2015) have surely helped to further compound these disinflationary trends and will likely continue to do so. Greater independence for some central banks and flexible currencies have provided further sources of disinflation over the decades.
Adherents to this argument will waste no time in telling you that the more recent fears around deflation have coincided with a period of near unprecedented central bank balance sheet expansion. This chimes conveniently with the argument that consumers, overburdened already with debt, are reluctant to borrow more, suggesting that easy monetary policy has lost its teeth. Some would add that quantitative easing has served to increase global supply more than demand, pointing to the parlous state of the commodity complex as the perfect illustration of the broader secular stagnation with which the world economy is apparently blighted. Whatever mix of explanations you subscribe to, all of this adds up to a world where historically low bond yields make sense (Figure 5).
What are the risks?
However, this heavy consensus on deflation and disinflation may just be starting to fracture. Our colleagues at Barclays Banking run a quarterly survey, where they ask their institutional clients a range of questions on their view of various components of the economic and capital markets outlook. For the first time in three quarters, the most recent survey saw more respondents worrying that inflation is now a bigger risk than deflation. Even so, it was notable that some 40% of respondents still see deflation as the bigger threat (this figure was closer to 80% at the end of last year) – (Figure 6).
We have long contested that inflation should be higher up the list of things for investors to worry about than deflation. This is not to suggest that we see a return to the double-digit levels of inflation that dogged much of the 1970s. It is more the case that on a one- to two-year view, we see inflation as more likely to surprise current expectations positively rather than negatively.
Wages are at the heart of this belief – as unemployment continues to fall in both the US and the UK, the increasing scarcity of labour in these economies, even allowing for compositional changes to the workforce, should see wages continue to turn up more forcefully (Figure 7). As an aside, it’s interesting that Kristin Forbes (external Monetary Policy Committee member for the Bank of England) recently observed in a speech to the London School of Economics that the mean of various measures of domestically generated inflation in the UK economy – an estimate of inflation that excludes movements in sterling and other external factors – has remained more or less stable at around 2% through much of the post-crisis period.1
More widely, it is also worth noting that we are now starting to see an appetite to borrow being increasingly met by an ability to lend on the part of the banks in much of the developed world, which may suggest that the fruits of some of those quantitative easing programmes may start to reach the high street before too long (Figure 8).
What about Europe?
Europe surely remains some way away from creating durable inflation. Unemployment in aggregate remains high, suggesting there remains ample scope for the economy to expand before bond investors or central bankers need to pay too much attention.
However, there may not be as much spare capacity as the headline numbers would suggest(Figure 9). For a start, many who are registered as unemployed in the periphery in particular may not be actively looking for work – the enduring presence of a large unofficial economy in ;places such as Spain and Italy may be among the reasons to suggest that there is less economic slack than there appears at first glance. The noticeable turn up in wages on the continent, even excluding Germany, perhaps hints as much (Figure 10).
For its part, the German labour market is currently enjoying strength not seen in a quarter of a century. Effective in April this year, IG Metall, Germany’s largest labour union agreed a inflation (deflation) busting 3.4% increase for its workers in Southern Germany, with more wage rises across the wider German workforce surely to follow. The recent spike in German retail sales may even suggest (Figure 11) that we may be close to the peak in the much criticised German current account surplus (Figure 12). If Germany starts to provide the wider world with a source of demand commensurate with, or even greater than, the value of goods and services it supplies, this will likely have important implications for the prospects for growth and inflation for both its immediate neighbours and the global economy.
What does this mean for bond markets?
As we have suggested, the ongoing correction in bond yields around the world likely has its roots in a little less pessimism on the prospects for growth and inflation for the world economy. This is a journey that may only be in its infancy if we are right about the US economy, in particular, warming into the rest of the year.
Of course, none of this is to suggest that clients should have no exposure to fixed income. We are regularly at pains to point out that the future remains, as it always has been and will always be, profoundly unknowable. The best weapon against that unknowable future is an investment portfolio diversified across as many geographies and asset classes as is practicable. Bonds will always play an important part in that diversified portfolio, even if at the moment, the continuing prospects for growth and inflation and relative valuations suggest to us that equities are likely to provide the greater reward in the immediate future.
1 Forbes, K, 2015, “When, why, and what’s next for low inflation? No magic slippers needed” Bank of England.