Markets are rattled once more. Sovereign debt issues are reverberating around Europe; the effects of financial reform are being anticipated in the US. And then one of the more astute global asset allocation strategist, Tim Bond of Barclays Capital, comes out with this: a note to clients entitled "Dancing by Volcano".
Bond is a man to watch (or at least read). A little under a year ago, in the face of almost universal bearishness, he called the turn in both equity and bond markets, understanding better than many of his peers that the process of quantitative easing would inevitably lead to a sustained rally in asset prices as freshly printed money from central banks washed through the system. He referred at the time to equities climbing the steepest wall of worry, but his mood has become increasingly bearish over the past three months and now Bond is saying this: "Fiscal dynamics point towards higher government bond yields in many economies, including the UK and US. We examine the historical relationship between yields and budget deficits, broadening the analysis to consider equity valuations. History is unequivocal in linking fiscal deterioration to higher yields. This point is clearly becoming recognised by investors. As a result, a contagious process has started, during which risk premia in bonds, equities and currencies adjust higher to reflect the fiscal situation. This process is unlikely to remain confined to southern Europe, but will eventually embrace all those economies with sizeable budget deficits."
We've heard this before, of course. But Bond's special quality has proved to be his timing in investment decisions, and so the fact that his is making this stark observation now should be taken as a bold warning.
As Bond himself says, one of the trickiest things to get right as an investor is to judge the balance of risks between a short-run bullish opportunity and longer run, more threatening conditions.
So, it was right to pile into equities at the end of the first quarter of last year on the basis that extremely low short-term interest rates married with relatively easy credit conditions would push the price of relatively riskier assets higher.
But that was always going to be a temporary state of affairs. And, as we move into the "medium term" post the Great Recession, the focus has to be on monetary and fiscal policy risks faced by investors. It's not a pretty sight: "The broad picture is that many, if not most, G20 economies are in a fiscal mess. This is not a problem merely confined to the southern European nations. The aggregate advanced economy G20 government debt/GDP ratio is projected [by the IMF] to reach 118 per cent of GDP by 2014. The first point we can make is that such ratios are high enough to provide a significant impediment to growth."
The BarCap man cites a recent paper by Carmen Reinhart and Kenneth Rogoff – two economists who have a fast growing fan club right now – called "Growth in a Time of Debt". They demonstrate, quite clearly, that if history is any guide countries with a government debt/GDP ratio above 90 per cent tend to experience sharply lower growth.
Another aspect to take account of is that among G20 nations the simple fact that populations are ageing again affects the fiscal outlook. As the boom generation retires there are fewer people working and paying taxes.
On top of this we have to factor in the reality that as governments seek to rein in their spending, that in itself represents a drag on economic growth. Says Bond: "Both the cure and the disease itself will slow growth, the former by significantly less than the latter. This outlook needs to be considered as a critical factor for strategic asset allocation, particularly as growth differentials between the high and low-debt economies are concerned.
"Average growth in economies with low debt ratios, such as China, Brazil, Australia and Norway, is going to be much stronger than average growth in the high debt economies, such as Japan, the US, Spain, Greece and the UK. This point has obvious implications for geographical and sector equity exposures."
Something else that history teaches us: fiscal crises tend to lead to a hike in market interest rates. It sounds like common sense, since fiscal problems for a country signal greater risk, yet at present it is only Greece, with its well-aired problems, that shows a typical bond market reaction.
That is while so many market participants are now watching the likes of Portugal and Spain so closely. Bond observes: "The question that begs to be asked is why other fiscal casualties have not experienced a similar rise in bond yields. In our view, the placid behaviour of some of the larger US and UK bond markets is primarily attributable to private sector de-leveraging. With businesses and households paying off debt at a rapid clip, the total net demands on bond markets have declined… this environment tends to be associated with low real yields. Similarly, the negligible level of short-term rates is driving investors out of cash instruments and into bonds, again a factor that helps keep real yields low. Equally, changing regulations and rapidly shrinking loan books have increased the banking system's appetite for high grade bonds. It is reasonable to suppose that the QE programmes will also have served to dampen the US and UK bond markets' reaction to the fiscal deterioration."
Summary: it's only a matter of time before the UK and the US get hit.
At some stage, the various dampening factors currently weighing down bond yields in the largest fixed income markets will start to evaporate. The risk is that temporary pressures are obscuring the real picture in terms of market risk.
In Bonds words, higher market interest rates is not so much a risk as an absolute inevitability: "Contagion is therefore the current watchword".
- The writer is an Associate Editor with the Financial Times
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