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My Sipp: Time to choose if you believe bonds spell disaster

I don't believe those doomsters who say record government bond prices are a prelude to a Japan-style 'lost decade'. As I become less defensive I'm investing some of my cash pile in shares in some parts of the developed world and also in emerging markets.

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by Rob Kyprianou on Sep 08, 2010 at 00:01

My Sipp: Time to choose if you believe bonds spell disaster

I don't believe those doomsters who say record government bond prices are a prelude to a Japan-style 'lost decade'. As I become less defensive I'm investing some of my cash pile in shares in some parts of the developed world and also in emerging markets.

The great bond conundrum

As investors return from their holidays what are the markets telling us? Not much new from the equity markets which were down again in August but still well within their trading range since the spring highs. But when it comes to government bonds – rub your eyes and look again! In the major western markets government bond yields have fallen further to record lows across the yield curve. Ten-year US treasury yields fell below 2.5%, German 10-year government bund yields dipped below 2.25% and even in ‘high’ inflation UK, 10-year gilt yields approached 2.75%. We have never seen yields this low.

How can this be? After all we have massive public deficits that need taming and will provide high levels of bond supply for years to come. And then there has been printing of money on a scale never seen before - so called quantitative easing (QE1) – which, once the banks have used these funds to heal themselves, surely can only stoke inflation sometime down the road. And all the talk is of more government stimulus packages and further rounds of money printing, so-called QE2.

What explains yields at such low levels?

Is it because of structural buyers such as banks and monetary authorities who are buying low risk government bonds to shore up bank balance sheets and government deficits?

Or is it a fear of Japanese style deflation that inevitably follows a broken banking system and the bursting of credit driven asset speculation? We have spoken of the significant schizophrenia that has pervaded the investment community this year and so there must be a significant pool of capital prepared to buy this story.

Or is it a fear of risk? If investors are not buying good equity valuations versus bonds, or an encouraging emerging market story, or corporate bond yields that are significantly higher than government bonds, then maybe risk aversion must be high.

I don't buy the Japan story

It is probably an element of all three factors. However, whatever the reason, if US, German and UK government bond markets are right and there is good value in 10-year government bond yields relative to other asset classes then we must also buy that we are at the start of some kind of Japanese ‘lost decade’ – or two. Japan experienced busted asset bubbles and broken banks 20 years ago and they have been in a prolonged deflationary trap ever since with 10-year government bonds falling below 1% and a 20-year equity bear market – so why not in the West?

I do not fall for this siren call for fundamental and structural reasons. In the near term, in Europe and the US the personal and public sectors along with the banks need to restore their finances to rebuild balance sheets, restore savings and reduce debts. It will take time and overall growth in this period will be modest. But once this is done – and it is well under way in the personal and banking sectors – then they do not have the structural factors that have been a drag on the economy and equities in Japan.

‘Made in Japan’, which fuelled the Japanese miracle from the 60s to the 80s, has been replaced by ‘Made in China’ and frankly almost anywhere in the Asian sub continent and East Asia. Unlike anywhere else in the developed world, Japan has had to deal with this move into the post-industrial stage of economic development with a declining and rapidly ageing population which has deprived it of the drivers to re-launch itself.

Japan's population is ageing faster than that of any other country in the world. The unprecedented increase in retirees relative to the size of Japan's work force is forcing Japan to shrink its famously high savings and investment rates, send more industry overseas, and reverse its proud trade surplus. This in turn explains the stubbornly high budget deficit and debt to GDP ratios, and general deflation – the GDP deflator, the broadest measure of price trends, was minus 1.8% in Q2 this year following minus 2.8% in the previous quarter. Japan’s primary growth asset is now innovation.

Why we are not turning Japanese

These trends are in sharp contrast with the rest of the world, even the developed regions. Annual population growth is close to 1% in the US, over 1% p.a. in Asia outside Japan and is even growing in western Europe, helped by net migration. As for ageing, the contrast is even more severe. The ageing process is so fast in Japan that the proportion of people aged 65 or over relative to the working population reached 35% in 2010, the highest in the world and compared to 11% globally, 19% in the US, 25% in Europe and less than 10% in the rest of Asia. By 2020 this ratio is forecast by the UN to reach 48% in Japan compared to 14% globally, 25% in the US, 29% in Europe and 12% in the rest of Asia. Japan’s population time bomb is getting worse and fast.

Data for large parts of the developed West is consistent with the moderate growth outlook. There are pockets of recession (heavily indebted southern Europe) and pockets of good growth (China, India, Australia). But remember – this lower, corporate sector led growth is part of the adjustment to large fiscal deficits and the deleveraging of the public, banking and personal sectors. As this proceeds, imbalances will repair and the massive monetary stimulus will begin to find outlets with a real risk of inflation later down the road. The best sector is the private corporate sector. This is the least damaged financially and is the driver of growth. Equities and corporate debt, boosted by relative valuations with government bonds, are the most attractive areas of investment in western developed economies. And then there are the number of emerging market countries which do not have the financial or public sector sclerosis of the developed West.

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8 comments so far. Why not have your say?

Rob, the long length of your piece summarises succinctly the weakness of your arguement.

If we have a double dip equities will prove a poor choice no matter how well chosen so stick close to the monthly price trends and keep your powder dry. There is a massive buy side industry for equities and none for bonds- make up your own mind on the evidence.

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Rob, thank you very much for this excellent article. As usual, you present a cogent and balanced POV.

Ben - are you really highlighting to Rob that there is a large buy side industry? If so, you might want to look at his CV...

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An interesting and thorough analysis, which has highlighted the important part which demographics play in determining economics.

I admire the author's positive attitude to investment, however I am already retired, with somewhat different priorities to him.

First and foremost is that I probably do not have enough years of life left to recover from a capital loss if we have to endure a double dip recession.

Secondly, rightly or wrongly, I am of the opinion that a period of deflation will precede inflation.

Thirdly, I have been keeping an eye on the gold price. The London "fix" is exactly that. It's the price the controlling banks would like the PM to be bought/sold at. However trading in forward contracts on the NYMEX suggests to me that they are finding it increasingly difficult to resist upward pressure.

Fourthly, China's stratospheric growth has in part been due to its currency being pegged to the dollar. If this state of affairs continues it will give the Chinese a pecuniary advantage. I don't believe America will stand for it much longer and will issue an ultimatum. Either revalue the renminbi or face quotas and tarrifs on your exports.

It is for these reasons that I am holding 90% cash, 10% junior gold mining shares.

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An interesting article that raises some good points to think about, but it certainly wasn't 'thorough'. Equities may look cheap but austerity measures across Europe and the UK have barely begun. I'm also concerned that Asia will struggle should US and Europe tip back into recession or grow at a flaccid 1-2% (I'm sceptical about the Chinese domestic consumption story) . IMHO if you happen to be sitting on a large pile of cash, it's worth waiting for several more data points before deciding where to deploy it. My money remains allocated to deflation now, inflation later thesis (with a modest amount of cash available to take advantage of crashes/slumps/mini-rallies).

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There is an additional important element to the argument, which is not clearly alluded to here and that is of the US structural debt e.g. social welfare and medicaid - the demographic timebomb.

These off balance sheet items push the US debt/GDP figure to between 500%-1000% (depending on the assumptions). (See BIS working paper March 2010 on future debt projections of developed economies)

The financial crisis is only the cyclical part of the deficit. The real fun is yet to come.

So the US options are to delever and save more - except that governments and consumers cannot do this at the same time; competitively devalue except that this has political consequences and everybody is trying to do this too at the same time; protectionism; try to achieve inflation; massively cut welfare payments to the elderly; increase immigration to pick up the slump in tax revenues.

Given what we know about the US economy and its policymakers, the global political landscape where surplus countries refuse to give back stolen growth - more QE is inevitable - therefore we will see a UST bubble prior to a ratings downgrade - at which point gold will be left. They'll likely try and impose a tax on that too....

The view regarding the spread between equities and govt bonds must also be taken in context. Firstly, one must use real yields and not nominal. One must also take in to account the fact that quoted P/Es use operating earnings and not reported earnings (which are much lower) and the last ten years (schiller adjusted P/E timescale) have been artificially inflated by cheap credit...

An equity trading range is the best we can hope for. Definitely elevated macro risks at the moment...just look at the PIGS bond spread in the past month and the movement of the Yen. The Greeks also seem to be moving out and dumping in swiss francs (which is a liquidity trap for the banks)

If one agrees that this is a secular bear market, then we could look for an entry point for equities 2015-2018

90% cash is a bit extreme IMO - atleast consider decent global bond funds such as Old Mutual Global Strategic Bond, Templeton Global Bond (they can go long/short)

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Nothing like a personal perspective that actually ends with a stated outcome.

thanks rob

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Could you all highly intelligent gentlemen advise me if NOW is the time to switc h some equity funds into bonds please?

Many thanks

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Mr Blue

Sep 15, 2010 at 13:10

It depends...on your risk profile..current portfolio...age...investment horizon..frequency of trading, which equity funds you have etc.

That said..a basic answer is that equity markets look toppy..so it might not be a bad time to transfer.

If you are approaching retirement, wealth preservation is the name of the game. Big global imbalances remain, and we will undoubtedly see further blow ups in the years ahead.

So you can dance whilst the music is playing for potentially higher returns, or you can build in a level of protection.

Global bonds only form part of this - you also need to look at gold and absolute return and currency funds, those funds which operate in deeply liquid markets. You could consider Standard Life GARS and Investec for the Gold and currency options (these are just a handful of options)

With regards to global bonds - we will see further lurches between optimism and pessimism. Current expectations are for further US stimulus late this year, or early 2011 in the form of money printing - this will likely favour stocks for a while and not bonds, although this will likely reverse as they will get less growth this time round.

To paraphrase the conditions still look supportive for credit going in to 2011. Beyond that it's likely you will need to be more careful.

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