11 September 2014

Macro Strategy Update

What’s Up With Interest Rates?

To the almost universal expectation that interest rates would rise this year, we find the opposite happening. US 10-year yields have fallen since the beginning of 2014. The rush into bonds is not just a US phenomenon, bonds in most developed economies have rallied. This raises questions about the health of the global economy and naturally our bullish outlook on equities. However, despite what the bears say, we remain committed to our bullish stance.

It was supposed to be a year where interest rates would climb. Yet we see bond yields from around the world falling since the beginning of the year (Table 1).

There are several reasons why yields, particularly in the US and Europe, have been falling. First, we have seen pension plans buying Treasuries this year. After a solid rally in equities last year, many pension plans are now healthy (after the global financial crisis of 2008 had created a funding hole in most pension funds). According to Mercer Investments, the average pension plan was funded at 95% last year, compared to 75% at the end of 2012. This naturally led to pension plans de-risking their balance sheet by slashing equity exposure and increasing bonds to match liabilities1. According to fund flow data from the Federal Reserve, pension plans have been buyers of Treasury bonds and sellers of corporate equities since 2013.

A key reason why pension plans are buying bonds even though many expect bond yields to rise is the trend towards liability driven investing. Increasingly, pension plans are matching their assets with liability needs, rather than trying to beat an index. This makes even more sense given that many pension plans are now fully funded. There is little incentive for a pension plan manager to take on more risk once the plan is fully funded. On the flip side, the potential downside risk from equities creates a problem for corporate earnings if more funds have to be set aside in the event of an equity bear market. Thus we can expect that there will be a bid for long dated bonds even as more pension plans continue to match their assets to their liabilities.

A second reason why bond yields have fallen arises from increased regulation in the financial sector. Deposit taking institutions have been big buyers of bonds in recent quarters. Again looking at data from the Federal Reserve, the last two quarters saw significant net purchases of Treasuries by these institutions. US regulators have increased the amount of capital that banks need2, which would require the latter to either fund themselves with more shareholder’s funds or reduce the riskiness of their assets by buying more Treasury bonds. It is the same situation in Europe where banks have been buying sovereign bonds, especially with the ECB providing cheap funding3.

A third and more problematic reason for the increase in bond buying is associated with potential economic weakness. This is where we should be more concern since it could unravel the stock market rally. The global economy got off to a mixed start in 2014. The US suffered a surprising decline in economic output in the first quarter but rebounded in the second (Table 4). Japan experienced the opposite, with a weaker quarter right after a strong first quarter. Meanwhile, the eurozone continues to stagnate. There are valid concerns about economic growth given how long term bond yields have drifted lower.

However, we believe investors need not worry for now. Fundamentally, we still see signs that global growth can be sustained, albeit at lower rates. The OECD’s composite leading indicators continue to point to stable growth momentum for the US and the euro area4 (Figure 1). It is too early to panic about economic sustainability. Furthermore, the other parts of the fixed income market suggest to us that the preference for risk taking remains intact. High yield bonds continued to rally, recovering all of August’s losses and still maintaining a bullish trend (Figure 2).

Figure 1: OECD Composite Leading Indicator for US and Europe still positive

Image courtesy of Stockcharts.com

Figure 2: High yields bonds recovering the July losses

Equities are also not showing signs of fatigue. The fact that the S&P500 recovered its August losses quickly is a sign of investors’ bullishness. We have previously highlighted how investors were quick to scoop up cyclical stocks after the correction, also another sign that the risk taking attitude remains intact. It is also important to note that key sectors like consumer discretionary and financials are in a bullish trend and also making new 52-week highs (Figure 3). With such positive indications from the equity markets, it is difficult to make a case to turn bearish on economic growth and the stock market.

Image courtesy of Stockcharts.com

Figure 3: Consumer discretionary and financial stocks are in an uptrend

Nonetheless, the bears would point to a flattening yield curve to support their bearish outlook. A flat yield curve is a precursor to an inverted yield curve, which has been a reliable indicator of a recession. While the current yield curve appears to have flattened, we would like to point out that much of the flattening is caused by long term bond yields falling, rather than short term bond yields rising. Apart from the 2-year bond, the 1-year and the 5-year bond yields have stayed largely flat since the beginning of the year. Also, when bond markets are discounting a possible recession, bond yields across the spectrum from the 1-year to the 30-year would fall in tandem (Figure 4). That is not what we are seeing today. Hence we are inclined to believe that the price action in Treasuries is driven by other factors, rather than a hunt for safe havens.

Image courtesy of Stockcharts.com

Figure 4: Bond yields today and in 2007/2008


We can draw several conclusions from our investigation and assessment of the bond markets. One, there is no need to fear an imminent recession or bear market in risk assets. While long term bond yields are falling, they do not look like the typical ‘flight to safety’ trades which foreshadow recessions. Two, there remains little scope for long term bond yields to fall further if the economy continues to recover. The impact of purchases of long term bonds by pension plans and banks is likely to diminish over time. Other factors will likely come into play, especially when the Federal Reserve starts to tighten. Three, until long term bond yields start to trend upwards, emerging market assets are likely to enjoy the breathing space afforded to them, even as their economies continue to adjust to slower growth rates.

In addition, the various financial stress indicators including our own proprietary GYC crash alert indicator do not show that a market crash is imminent.

Impact to Portfolios

In view of the above, we remain committed to our current asset allocation and do not recommend any changes.

1. U.S. corporate pensions bet on bonds even as prices seen falling. 24 April 2014. Reuters.
2. Big U.S. banks must boost capital by $68 billion under new rules. 8 April 2014. Reuters.
3. Europe’s banks load up on sovereign debt. 1 April 2014. Financial Times.
4. Composite leading indicators continue to point to stable growth momentum in most major economies. 9 September 2014.

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