Quarterly Investment Outlook

by James Macpherson
The dominant feature of financial markets remains the low yields offered by bond markets, and in particular the increase in the quantity of bonds which carry negative yields.

In the third quarter world markets as measured by the MSCI World were flat. Year to date the S&P is up 18.7% and the MSCI World is up 15.7%, though much of this performance is recovering the steep losses of the fourth quarter of last year. Over the past twelve months the S&P is 2.1% and the MSCI World is down slightly.

The dominant feature of financial markets remains the low yields offered by bond markets, and in particular the increase in the quantity of bonds which carry negative yields. Approximately $15 trillion of debt is trading in the market with a negative yield, representing about a third of all Sovereign debt, which is the liquid part of the market. Perhaps more importantly about two thirds of all Sovereign bonds now offer a negative real yield (i.e. after taking inflation into account). This is historically unique, and truly bizarre in which one of the best investments this year would have been to buy assets that were already negative yielding at the start of the year, and therefore had a 100% guarantee to produce a loss if held to maturity. In such an environment investors have been desperate to find quality bonds with a positive yield.

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The US bond market has been one of the few that still does, partly explaining the strength of the dollar. The plunge in yields has led to some prices which would have been thought impossible a few years ago. For example at the end of 2017 Austria issued a 100 year bond with a coupon of 2.1%. This year it has risen 64%, in the third quarter alone rising by 23%. It now yields 0.8% for the remaining 98 years. Can a yield of 0.8% in a fiat currency that was only launched twenty years ago be deemed truly safe? A lot can happen in 100 years, and in the last 100 years a lot did happen in Austria. If interest rates were to rise by 1% it would take 26 years to break even on the current coupon. Equally bizarre is the performance of gilts which have soared despite the Brexit chaos, as the UK still offers a positive yield which is relatively attractive against other European countries where one pays for the privilege of lending to their governments. Such countries now include Latvia, Ireland and Slovenia, while Bulgaria, Lithuania and Spain are a hair’s breadth from joining them in the negative yield club. The implications of these yields are wide ranging. Vast amounts of money is sacrificing purchasing power for the next decade, for example, at minus 1% a Swiss pension that buys the ten year bond guarantees a capital loss of 10%. Worse with the Swiss interest rates negative out to 50 years there are no Swiss government bonds available with a positive nominal yield, meaning that investors will lose money in any Swiss government bond held to maturity. How do such countries provide for the social claims of a rapidly ageing world? Even stranger is that this is taking place at a time of growth not recession. For comparison in the depths of the 1930’s US depression when industrial production declined 25% the 10-year yield fell only to 2.31%. Today world growth is slowing but it is still positive. Moreover monetary policy is loose, fiscal stimulus is being advocated by most governments and wages are rising. Many of the conditions necessary for inflation are present at a time when the fixed income investor has no yield to cushion them. The last time fiscal policy was expanded at a time of full employment was in the early 1970’s, an equally febrile political period, and inflation became a problem for the next decade. The integration of the labour force of the Emerging Markets mean that labour has less bargaining power than that period, but bond prices do not provide protection against a rise in inflation or the cost of living.

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