Bonds seem to be predicting a different outcome for the world economy to that suggested by the equity market and its continued buoyancy. Given the bond market’s reputation for sober economic analysis, is now a good time to panic?
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Whose price is right?
For an investor, the sight of a flattening curve holds a similar level of dread to that experienced by an England cricket fan watching Mitchell Johnson pawing the ground at the end of his run-up: difficult times, apparently, lie in wait. But whatever bonds are telling us now, the equity market doesn’t seem to agree. The US stock market continues to flirt with all-time highs, bolstered by rising revenue and earnings forecasts. Fixed-interest magi will waste no time in telling you that bonds tend to be right more often than equities – a near-impossible statement to corroborate – but does this mean it is time to strike a more cautious strategic and tactical pose on behalf of our clients?
Nominal growth and the cost of capital
The idea that the prevailing interest rate in an economy, plus a compensation for taking risk, should broadly equal the rate of return on productive capital is intuitively sensible. Intense competition for the use of capital in an economy by governments, corporations and households should, in theory, mean that the margin between the cost of capital and the return on capital is minimal. Furthermore, if one accepts that a “neutral” interest rate might be roughly in line with trend nominal GDP growth, one can understand why the 10-year US Treasury, offering a yield of c.2.5%, has many market observers scratching their heads about the future growth trajectory of the US economy.
The talking heads have obviously leapt into the breach with a multitude of explanations, most of which are based on a continuation of trends in productivity, inflation and labour-force growth seen over the last five years. This may be the case – but the bond market’s reluctance to believe in a brighter future for much of the developed world has surely also been helped by the “richness of embarrassments” suffered by capital markets over the last several decades. While markets have lurched from crisis to crisis – from the Asian Financial Crisis all the way up to the still-smouldering euro crisis – bond yields in much of the world have continued to fall (Figure 1). So ingrained is this trend that bond investors could perhaps be forgiven for assuming that recent trends in productivity, inflation and labour-force growth are indeed the ‘new normal’. The US economy looked to be on the cusp of delivering a rebuff to the new normal in the second half of last year but then the winter got in the way and bond yields retreated. Looking at incoming business confidence and consumer spending data, the economy may be about to offer such a rebuff again.
Changes in measured productivity often have more to do with changes in the labour market
There may be other factors at play in the short term too: alongside continuing dogged demand for bonds, the supply story could remain supportive (net Treasury supply has been following the government’s net requirement to borrow lower (Figure 2) and will likely continue in this vein). So, while we hesitate to make a more forceful call on whether Treasury yields will soon reverse their long-term slide, our very low strategic weighting should tell investors that we don’t believe the prevailing consensus on the ‘new normal’.
Productivity is notoriously difficult to measure, particularly in the service sector. In the US, statisticians focus on output by private sector non-farm businesses per hour worked, which means that changes in measured productivity often have more to do with changes in labour demand than broader changes in efficiency. However, mankind’s ability to invent, apply and get better at using new technology is at the heart of the improvements in living standards evident over the centuries, and even millennia, of recorded history.
Trends in productivity obviously do not travel in a straight line. New technology is not always immediately assimilated into the wider economy – it often takes companies and consumers decades to adopt and work out how to best use it. Around 120 years ago, US factories started switching steam power for electric power, however, productivity gains were reportedly muted for several decades after the switch.1 It took the next generation of factory owners to redesign manufacturing processes around this more flexible power source for the gains in productivity to be more effectively reaped. The same is true now – much of today’s global workforce grew up in a world where computers were a rarity and experts were figures of fun. It seems perverse to start betting on a structural decline in innovation as the workforce shifts towards a generation that has been immersed in this general purpose technology from birth.
Trend nominal GDP
Figure 3 suggests that over the very long term – with the labour force getting better at what it does, alongside new technology – around 2% per annum is added to GDP growth. Set alongside this, the US labour force could reasonably be expected to grow at an average of 0.5% per annum over the next decade. If, on top of that, inflation hits the Federal Reserve target of 2% – which seems plausible in a recovering economy with diminishing labour market slack – nominal GDP growth in the 4-5% range should not be an outlandish expectation.
The term structure of yields is, of course, already pencilling-in a marked rise in short- and longer-term interest rates, but not sufficiently, in our view. We’d expect 30-year and eventually 10-year yields to trade within that 4-5% region in both the US and the UK at some stage in the years ahead.
For their part, central banks are likely to remain very accommodative with inflation still easy and some wiggle room over output gaps remaining. This month, the Bank of England (BoE) raised its forecasts for UK economic growth with one hand but tried to push higher interest rate expectations further into 2015 with the other. This is in the context of an economy that is just as consumer driven as the US, where retail sales are positively booming (Figure 4). The market has already proved that it is perfectly capable of making up its own mind here, and it is markets that tend to set borrowing costs for an economy at all but the very short end of the yield curve, as we’ve noted before. We would still suggest that clients should not be shocked if interest rates were to rise towards the end of 2014, rather than later in 2015 as the BoE is suggesting. Nascent cyclical risks are currently most visible in the UK, in our opinion, risks that still appear largely absent across the rest of the developed world.
Where best to shelter?
Of the big sovereign markets, we think the eurozone will continue to outperform in what we still think will be a testing time for most bonds – we expect recent gains to be eventually reversed. Bonds there are not cheap either, but there is less inflation and growth, the European Central Bank (ECB) seems poised to, if anything, loosen policy further, and the peripheral euro markets trade pro-cyclically (for lower-quality bonds, growth is viewed more positively: creditworthiness matters more than inflation and interest rate risk). Bund yields have already risen more slowly than Treasuries and gilts, and Italian and Spanish yields have fallen dramatically over the last two years, even after some profit taking this month in advance of European parliamentary elections. We think these trends can continue, although the peripheral markets are certainly running out of headroom.
Credit markets can outperform too, but we favour the high yield segment over investment grade. A further reduction in spreads (Figure 5) is quite likely, and may excite institutional credit analysts, but it will not help most private investors if it reflects rising government yields. It can, however, offer a buffer against price falls. Interest rate risk (duration) is smallest – and pro-cyclicality greatest – in the speculative grade markets, and the buffer is also greatest there.
GDP growth and corporate revenues
The idea that the US, and therefore the world, is somehow condemned to a lower trend-growth rate as the returns from innovation dry up is not just relevant for bond investors. For much of the last few years, those who have doubted the sustainability of the equity market’s rise have highlighted allegedly stagnant top-line growth in the corporate sector with the unprecedented rebound in corporate earnings per share being almost entirely a function of management parsimony and share buybacks – both of which are finite. At the index level, the revenue picture has indeed looked becalmed in several quarters of the last few years, but this has often been due to less-concerning trends at the sector level, with revenues in the energy sector (mostly a function of the year-on-year change in oil prices) sometimes struggling to make headway for example.
In reality, corporate revenues have increased by close to a quarter since 2009 and, although top-line growth had weakened a little last year, the closing first-quarter earnings season seems to be indicating a reacceleration in corporate revenue growth in the region of 3%, in spite of the extreme cold snap in January and February. Forecast revenues for consumer discretionary, consumer staples, health care and industrials in the US are now at, or close to, all-time highs, with the latter two sectors recently seeing revenue upgrades, suggestive of a broad improvement in business prospects. Meanwhile, forecasts for index revenue growth for 2014 and 2015 at a little less than 4% sensibly chime with consensus forecasts for real global GDP.
We continue to feel that the economic pride that usually comes before a cyclical fall is missing. The world economy still feels likely to accelerate this year; in particular, there remains a backlog of economic opportunities still to be made good in the US, as illustrated by the average age of the capital stock (Figure 7). This means that we think investors will continue to be better served by owning companies – and the growth that they should generate in this backdrop – than lending to them. Against this improving economic backdrop, we don’t see major governments defaulting on their bonds, but monetary normalisation is coming and this is not yet adequately reflected in bond prices.
Theory suggests that – other things being equal – rising bond yields should be bad for equity valuations (indeed, some suggest that the approach of monetary normalisation has driven recent turbulence in some of the growthier areas of the market) because a rising discount rate should mean a lower present value for future corporate cash flows. In reality, rising yields may well clear the air a little, in investment terms, by confirming that the economy is on the mend and the bond market believes in the ongoing economic recovery as much as the equity market seems to.