Will Bonds Break the Bull? | The Big Conversation | Refinitiv


ROGER HIRST: The ongoing dislocation between
valuation and earnings has led many investors to question the very nature of the equity
market and wonder what could be a catalyst for future weakness. Higher bond yields probably seem very unlikely
in the current environment, but many believe that yields are still one of the biggest threats
to this framework. And that’s the big conversation. When investors are hunting for a top in equity
markets, they’re usually on the lookout for a catalyst, and valuation itself is not a
reason for a top. Markets can and do stay over and undervalued
for very long periods of time. And currently we have seen an extended period
in which the median equity within the US is more overvalued than at any other time in
history. The S&P was more overvalued in 2000, but that
was a period defined by a very small number of incredibly expensive tech names. Today, the broad market is at an extreme. Although overvaluation is often a condition
that we see at market tops, it is not itself the reason for a reversal. Active investors have been underperforming
the broad market for a number of years, and some analysts have calculated that the stock
of active funds has now been overtaken by the stock of passive funds. And this is a trend that shows very little
sign of abating. So has the investment framework therefore
changed? Well, central bank liquidity over the last
decade has been responsible for the hunt for yield and the dampening of volatility in macro
data, in asset performance and in asset prices themselves. Investment mandates have followed these trends
and flows have increasingly been allocated to passive and rules based funds. I think it’s worth making a sort of distinction
here. When we refer to passive funds, many perceive
it just index funds and ETF. But I would include rules based funds investing
in this category and rules based investing comes under a myriad of names such as risk
parity or minimum volatility to name but two of the very, very many types and styles that
are out there. These funds are model based and they dispassionately
follow their investment rules. They don’t have emotions. They do not do surveys. And therefore, many of the sentiment indicators
that we’ve all historically used are irrelevant to these funds, which are increasingly dominating
the longer term investing landscape. And I think the size of this community is
probably even larger than many people realize. A couple of years ago, when I was working
as a macro derivative strategist in an investment bank, most of the new funds being gathered
across, for instance, northern Europe were heading into multi asset funds. And how do these funds operate? And clearly there are,as mentioned, a very,
very large number of styles, but many of them will use inputs such as yield and volatility
as their guides. Now, what I’m going to talk about here is
intentionally oversimplistic, but for instance, levels of realized volatility can often define
the level of equity allocation within these funds. Some funds, for instance, may use something
like a three month, which is about 100 day, realized volatility as an input. That’s the actual historical volatility of,
for instance, an equity index rather than the implied volatility, which is a market
price and realized volatility bands may set the equity allocation. And what I mean by that is, for example, if
realized volatility is under 16, a fund may well be increasing its equity allocation. If realized volatility is, say, below 12 or
lower, then they may be adding equity at the maximum allocation that their model allows. And if realized volatility is above 16, then
the fund may become at that point a net seller of equity. As mentioned, this is really just to give
a very rough idea, but it also helps to explain why each selloff has so far not morphed into
anything deeper. When we had volmageddon in February 2018,
these funds would still have been buyers into the dip because three month realized volatility
takes time to rise. It has a lag and most probably these types
of funds would also have been sellers of volatility into that spike. This is implied volatility and in effect this
becomes a stabilizing mechanism and although realized volatility did eventually pick up
and did reach the trigger point of 16 and above, this was with a lag and by then the
central banks had already reacted with more easing and more liquidity, which then helps
fuel the other great structural support of the market, which is the corporate buyback. And one of the features of markets, particularly
the second half of the last decade, was the speed with which equity markets, particularly
in the US, recovered after each period of contagion. The markets are certainly come close to catastrophe
on a couple of occasions, with many analysts suggesting that the S&P 500 came within probably
a couple of 100 points of a major sell trigger near those lows in late 2018. This is why many people are looking towards
the bond market, thinking that yields maybe that trigger that eventually break the market
framework. But so far, bonds have generally provided
a stabilizing influence by rallying, that’s when yields are falling, when the equity market
has had a significant sell off. But in late 2018, it was arguably the bond
market that triggered that fourth quarter decline. The US 10 year yield had increased to around
about 3.25 percent shortly ahead of the S&P rolling over, and this gives some idea of
where yields may need to go in order to undermine equities in the current framework. And the question is, what would take yields
higher from here? Well, the manipulated inflation figures have
been stable for an extended period of time, though almost everybody has a story or an
experience of inflation that is painfully higher than the headlines would suggest. But for yields, we don’t actually need inflation
itself to pick up, just the expectation of inflation. Term premiums, and this is sort of the additional
amount on longer dated bond yields that represent the inflation risk. Well, they have been extremely depressed in
terms of their absolute level. But if they start to turn, then yields could
catch light. The year on year surge in the Fed’s balance
sheet suggests that there are significant risks of a steeper yield curve and of higher
absolute yields. And as we’ve discussed before, steepening
of the yield curve has occurred ahead of the last few U.S. recessions. But on those occasions, those previous occasions,
the curve is steepening because front end yields were falling due to the Federal Reserve
cutting rates. But nonetheless, the impact could be the same
this time round. Significantly higher yields would impact many
of the rules based funds, especially if the move in the yields was very sudden. But speculative positioning in bond futures
is still, however, generally on the short side. We also know that there is still pent up demand
for bonds due to the massive unfunded liabilities that exist across the whole of the developed
world’s pension system and the average hourly earnings in last week’s job numbers weren’t
exactly pointing to an imminent surge in inflation. Data either was a bigger threat to equities
in the short term is more likely to come from the Fed withdrawing some of its emergency
liquidity measures. But if we’re looking for a protracted decline
in the equity market rather than just another short, sharp shock, then higher yields, steeper
curves and higher volatility in the bond market are a very credible threat to this new investment
framework. A hedge within the equity space could be a
short position or preferably maybe put options on things like the US utility sector. And this is a sector that has been in an upward
trend, a very clear one along with the rest of the US equity market over the last 10 years. But when yields surge, this sector usually
starts to struggle in both relative and absolute terms. And on the bond market itself? Well, no one is gonna be too concerned as
long as US 10-year yields are below the 2 percent level. But if that hurdle is cleared, and especially
if that also comes with higher level of realized equity volatility, then at that point it will
be a good time to start thinking about hedging for a shift in the investment framework by
buying some medium term protection on equity markets. There’s always a lot of chatter around reporting
season. 2019 was pretty much a lacklustre year, we’re
still waiting for Q4 to come out, obviously, but full year earnings are expected to grow
by just 1 percent compared to 24 percent in 2018, according to Refinitiv data. 2019 will be the worst year since the earnings
recession of 2015, and fourth quarter earnings are expected to fall by 0.6 percent. And this maintains the recent trend of flat
earnings, even as U.S. equities have soared, in fact, last year, equity performance was
all about the recovery off the 2018 lows and then a Federal Reserve driven multiple expansion
that saw equity prices soar away from underlying profitability. According to Goldman Sachs, 92 percent of
S&P returns last year were attributable to higher valuations with only 8 percent were
due to earnings growth. And ever the optimists, Wall Street analysts
think that corporate profits will rebound in 2020 by nearly 10 percent, with 90 percent
of companies in the S&P expected to have positive earnings and positive revenue growth. But even a 10 percent bounce will leave the
market at historically elevated valuation levels. And also, is the optimism of an earnings rebound
misplaced? Analysts have already cut forecasts in 10
of the 15 companies that have reported fourth quarter earnings, including big names such
as Nike and FedEx. And this is following that well trodden path
ahead of almost every earnings season in which estimates start high and then a walk down
into the actual results, which then miraculously beat expectations. And by way of example, Q4 2019 earnings, which
are now expected to drop by nought point six percent, were forecast to grow by eleven point
eight percent in November 2018. So in terms of what to look out for in the
season, energy, consumer discretionary and industrial earnings are expected to drop the
most. But does any of this really matter when buybacks
and Federal Reserve liquidity have been the key drivers? And this is where earnings may actually matter. Firstly, with earnings season comes the buyback
blackout period. This is where companies are not allowed to
buy the shares for a short period of time ahead of their reporting. And we are currently in that blackout period. So the U.S. market has temporarily lost one
of its key supports. But this all comes at a time when the Fed
have to decide whether they will step back from the short term liquidity operations. The last of the emergency year end facilities
ended on January the 14th, and last week, the Fed’s balance sheet contracted for only
the second time since emergency repo operations began in September 2019. And the last time the Fed balance sheet declined
also saw the S&P 500 decline on a week by week basis, and that was back in November. So given that we’re entering earnings season
with the S&P at an all time high, this could actually be an extremely sensitive period
for equities if earnings miss. The Fed is stepping back and we’re still deep
into that buyback blackout period. And remember those charts from last week in
which 2019 looks just like 2013 and 2014 started off with a wobble in late January. Remember, 2019 also looks like 1999. And the S&P 500 also struggled in the early
part of 2000 before making a final high in April of that year. And who of us can forget the Volmageddon of
February 2018 where we had that big drop? So put buying is like fire insurance are buying
protection. You hope you never need it. But this may be a very good time to think
about short dated, that’s one to two month puts while we navigate through this time of
central bank uncertainty during this buyback blackout period. There’s been quite a lot of talk about the
increased government expenditure and the rise of fiscal policy to complement monetary policy
and money printing. But what will the fiscal expenditure in the
future look like? What’s the size going to be and where are
these likely to take place? Existing monetary policy has failed to meaningfully
create economic growth or inflation, with cash mainly finding its way into asset price
inflation or non-productive consumer inflation. Now, we may already have seen peak bonds when
last year we saw nearly 17 trillion in global yields fall into negative territory. But global interest rates are expected to
remain close to the lows well into 2021, with only a handful of emerging markets expect
to have interest rates anywhere significantly above 2 percent. And governments will not want to wait until
those yields move significantly higher before they embark on their spending sprees. Christine Lagharde has been installed at the
head of the ECB to try and coerce Europe’s leadership into spending on projects and providing
the ECB with yet more bonds to buy. And Germany may well be more predisposed towards
financial profligacy, given the current weakness in global manufacturing. The UK government has also committed to a
high level of expenditure than has historically been the norm for conservative governments. In fact, this party looks likely to break
with over 50 years of tradition in which the conservatives usually cut government expenditures. What are the sorts of projects that governments
may undertake and what sort of scale should we expect? Well, the big daddy of infrastructure projects
is obviously China’s belt and road with two thousand eight hundred eighty one individual
projects and a value completion of around about three point four five trillion US dollars,
according to Refinitiv data. And just over half of those projects involve
non Chinese companies. The Asian Development Bank estimates that
the region has a funding gap of one point seven trillion per year until 2030. The global infrastructure hub estimates the
global infrastructure gap is at 15. That’s one-five trillion dollars between now
and 2040, whilst McKinsey estimate a three point seven trillion requirement per year
until 2035. So will 2020 be the year that infrastructure
emerges as an asset class in its own right rather than being lumped into the alternative
bucket? Clearly, these projects are very long term
and this is not an asset class that can be switched on quickly. The UK should be an early mover to anyone
who’s witnessed the UK’s attempts to build an extra runway at Heathrow or a high speed
railing from London to Birmingham know that British bureaucracy will continue to be a
drag, but from an investment perspective, whilst people may focus on things like construction
companies, that’s going to be a little bit of a hit and miss strategy. But what fiscal expenditures should do is
shift the inflation risks to the upside. And this should therefore have an impact on
bond yields. The long end of the UK market is still very
low compared to its historical performance versus the US, although the absolute levels
will be defined by the broader growth outlook. The potential for the UK government to come
out swinging the bat should help steepen the UK yield curve and help 10-year yields close
that gap to the US equivalent.

14 comments

  1. Infrastructure expenditure? The biggest employer in future years will be seawall defence to combat rising sea levels as the COP s will never agree to cuts to GHG emissions. So, the CO2 levels will continue to rise to 450ppm and then500ppm before we cut our carbon emissions enough to make an impact on future sea levels. Total potential sea level rise is 75M if ALL the ice caps melt. The IPCC are currently predicting about 0.75 metres which will likely rise as global warming accelerates. Plan for at least 1-2 metres in the next ten to twenty years maybe more!

  2. Bonds seem pretty scary to me with the new world of negative rates, i would rather buy gold if that is the case in order to preserve my purchase power rather then pay for someone to hold my money and hand me back less.

  3. Financiers and Micro Economics guys never understand the Macro. The Macro is that the US stopped sending 20% of it's GDP overseas and tapped into so much Natural Gas it now has a NEGATIVE value here.

    They literally can't capture it fast enough, it's spewing out.

    That 20% of GDP is being invested in Natural Gas Storage, Refinery, and Conversion bc they learned how to convert it into oil and fuel, no idea, don't ask.

    They're also building giant natural gas transport infrastructure and soon the US will be the Saudi of Natural Gas.

  4. How can you not just simply know and say that the whole thing is based on a lie. And that instead of any banks business ventures being allowed to produce, the act is “we’re putting that on hold while we work on a bigger plan” . So it’s not just a lie. But it’s like they are financing it. “Lienancing” . How can the wages of that profit? Ask the Chief Lienancial Officer.
    CLO. sed

  5. "monetary policy has failed to create meaningful growth or inflation with the cash mainly finding it's way into asset price inflation or CPI" What other kind of inflation is there? or did he mean not into CPI.

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