Have markets ‘run out of road’?

19 August 2016

The past week has been as quiet as one would expect for the middle of August. Focal points were better than expected UK economic data flow figures since the Brexit vote. With unemployment at a more than 10-year low of 4.9% and strong July retail sales, there are no signs of Brexit impact on the UK consumer.

Elsewhere, the minutes of the last US central bank’s rate setting committee meeting (FOMC of the US Fed), assured those still at their trading desks, that a further rate rise coming imminently as was the case this time last year. The minutes’ language suggested that the next 0.25% rise is now not likely to happen before the December meeting.

The oil price also recovered back towards the psychologically important $50/bbl. level, after recently beginning to slide towards $40/bbl. on over capacity reports.

Together, all the above could have been further fuel for the ‘Goldilocks’ market environment of late, where nearly all investments have risen to all-year highs. As it happened, markets did not rise further, but rather consolidated around their fairly high levels. At Tatton we were somewhat relieved about this development, as further rises increase the possibility of a sharp sell-off in the near term, should anything unexpected disturb the positive mood of this summer of 2016.

Clearly then, thus far the old investors’ adage of ‘Sell in May and go away’ (until the end of the summer) is not holding true for 2016 and indeed, the bulk of all investment returns have materialised over the summer. The double digit return levels that most of our investment portfolio types have reached by now for 2016, naturally makes investors a little apprehensive, given that only 2 months ago they were told that a Brexit vote would have very negative economic and market consequences for the UK.

So, is it worth taking profits and being satisfied with having achieved a very respectable return for the year? I do understand the temptation to cling to the calendar year perspective and call it a day for 2016. The problem is that prudent investing doesn’t quite work that way – the leading principle that leads to long term return success is ‘time in the markets, not timing the markets’. That is, unless there is truly something on the horizon that would make positive returns over the medium term a very low probability.

On the basis of our analysis this is currently not the case, or more specifically there is currently no higher probability of a lasting capital market route than there always is. Admittedly, the UK’s immediate and medium term economic future has become somewhat less predictable than before the referendum, but the latest indicators point more towards a benign and short term slow down, but with plenty of counter-measures from both monetary policy through the central bank and fiscal stimulus through the government. Besides, the rest of the global economy seems to have shrugged off the Brexit uncertainty risk and plods in the same direction as before, which is up and improved versus the first half of the year.

With our discretionary portfolio management approach we are not tied to investing in the UK and should the Brexit uncertainty issue morph into something worse than it appears at the moment then we will take necessary steps to avoid an isolated UK downturn through more overseas focused investment.

Therefore, anybody cashing in now, with a view of only coming back at the beginning of 2017 may be missing out on more upside between now and the end of the year. Markets also have a tendency to price in positive developments in the economy ahead of time. This last happened in 2013/2014, when stock markets rallied in 2013, but then traded sideways in 2014, when the actual economic progress occurred. A repeat is entirely possible and that is why trying to time markets is so fraught with the risk of undermining the long term return potential of a well-structured investment plan.

This leaves another issue which is increasingly getting more attention from investors, the question: What is the point of investing in government bonds, when the yield curve across all maturity bands is telling us that the likely returns will be lower than the Bank of England’s long term inflation target? This is the question the 2 charts in this article relate to. At the top, how even long term investment periods of up to 15 years are only providing a yield of no more than 1% - and below, how well the same government bond investments have done in the recent past and indeed outperformed the far more volatile equity markets.

This is where the term ‘run out of road’ is perhaps more applicable. This is because the source of the extraordinary government bond investment returns of the past decade (and indeed 35 years in total!) have not been the result of income from high yields, but rather the boost that capital values of bonds experience when general yield levels fall. Over the past 35 years they have come down from 15% while over the past 10 years their 5% decline was what made the 6.78% return possible (above chart). However, now that we are closing in on the 0% line, bond return potential has literally run out of further yield reduction ‘fuel/road’. Yes, they can fall to 0% and even marginally below, but that is it – investors tend to put their cash into vaults, rather than being charged for lending it out!

Does that mean government bonds are now riskier investments that equities? Well, this depends on one’s definition of risk. Investors who experience fluctuation in their invested capital as the highest risk, then the answer is probably No – at least over the next 12 months or so. However, for those who see risk as the possibility of not making a positive return, or at least a return in excess of inflation, then the answer is getting all the closer to Yes, as we are getting closer to the 0% line across all maturities.

Why?  Well, at Tatton – and indeed across much of the markets – the fact that central banks have just pledged to continue to buy more government bonds through increased QE monetary easing programs tells us that there is little risk that there will be more sellers than buyers in the short term. “Don’t fight the Fed” is another useful investor adage that comes to mind here. At the same time, equity markets will continue to experience their ups and downs, and whenever stocks sell off, government bonds are pushed up by the resulting demand for ‘safe-haven’ assets. In risk targeted/profiled portfolios, government bonds will therefore continue to fulfill their ‘shock-absorber’ function to dampen the impact of the more volatile equity markets on overall portfolio value fluctuations.

On the return potential side, however, we have for a while now said and warned not to expect much if anything from portfolios’ bond allocations. At best, they will preserve value as, over the coming decade, yields slowly rise away from the 0% line (as per is our expectation). At worst, stronger growth and inflation will return and bonds will lose a little of their face value year after year. This is what happened to US bond investors between 1945 and 1980, when yields gradually rose from low single digits to 15% and average 10 year US treasury returns average -1% per annum.

Even once the central banks stop their QE buying programs, it is unlikely that yields will jolt back to levels of 2.5 or 3.5%, because so many financial institutions have to hold government bonds for reasons of capital reserves and central banks continue to hold on to what they have already bought. However, a sudden loss of the bond gains of the last 12 months would then be probable, which is why we are watching the situation very closely and will not shy away from taking decisive steps to avoid capital losses from government bonds, just as we did in 2013.

Those investors who have the luxury to be able to determine the asset allocation of their portfolios through their appetite for risk, rather than their capacity for risk (I.e. they need access to their funds in the near to medium future with a reasonable certainty of outcomes), might want to use the summer quiet to review their current positioning against what I have written above. ‘Past performance is no guide for future returns’ has not been more true for government bonds since the end of WWII!

Over the coming weeks we endeavour to run a few insight pieces on fixed interest bonds and how to get one’s head around their sometimes quite counter-intuitive dynamics.