No Greenshoots for Bond Investors
Greenshoots or not, there has been a profound change in the Australian and US equity markets since March this year, vindicating the actions of global central bankers to stem the systemic problems of the GFC. The resulting stock market rallies can best be explained as a direct result of those regulatory efforts and the likelihood that they have allowed us to avoid a complete global melt down. In Australia rising share prices in quality stocks have brought the market back to where it might have been at the bottom of a “normal” recession and bear market. Further Australian sharemarket gains will depend on GDP growth and resulting earnings improvements – which if Ken Henry is correct will start to be seen perhaps as early as the end of this year, growing strongly in 2010 and 2011. For now, with many shares seeming to be fully priced, investors have started to look again at bonds as a way to generate good returns with relatively low risk. That is likely to be a fool’s paradise, with the looming profound risks in the US and global interest rate markets.
For investors looking to protect their capital – as well as accessing good prospects for income and growth – in 2009/2010, we advocate:
- Good quality Australian “blue chip” shares, with a focus on defensive stocks like the banks and quality resource and energy stocks: these assets will benefit from Australian GDP growth and the renewed demand for commodities as global and Asian economies continue their recovery.
- Careful investment into growth economies such as the “BRIC” (Brazil, Russia, India, China), (either alone or in combination).
- Assets that provide a hedge against the prospect of rising inflation, such as gold.
- Exposure to commodities directly, through investment funds that are linked to the performance of those commodities.
China can rely on its huge cash reserves to fund its recovery programs but the US has to rely on massive increases in government debt. US government bond issues have increased dramatically in the last 12 months and will continue to ramp up as the GFC response packages are fully implemented. In a country that nearly collapsed as a result of its unsustainably high public and private debt levels, further debt issuance can only be achieved by paying higher and higher interest rates – and that is the source of the problem for investors in bonds and bond funds. In a rising interest rate environment, previously issued bonds that pay lower returns will suffer from falling capital value. Unless you can buy bonds directly and hold till maturity, you will lose capital by being exposed to bonds.
It’s not just the skeptics like Marc Faber that are predicting problems for bond investors. Mainstream portfolio advisers like William Keenan from Lonsec are making the argument to their clients, albeit in more moderate terms than Faber and think alikes such as Peter Schiff.
Keenan told me recently that “I think the rise in bond yields has the potential to turn nasty.” His assessment is that US bond rates will rise soon, and significantly:
“My belief is that the Chinese, Japanese and Russians are wary of buying anything longer than 5 years. Yes they are buying US treasuries but only short-term paper where they can be sure of getting their money back and limit any potential losses from falling USD and rising bond yields. Investors are becoming wary of 5, 10 and 30 year paper. Would you invest in US 30 year bonds at 4.6%? Do you think that is a good return for a Country that has public debt approaching 100% of GDP?”
The consequence of rising US bond issuance isn’t just that rates on new bond issues will rise. Look how enmeshed this is with other key parts of the financial markets:
- US property mortgage rates are linked to US government bond rates. Keenan notes: “If these yields continue to rise because no-one wants the paper, then mortgages will rise also”.
- The US Fed is managing interest rates by a process known as “quantitative easing” which means that it stands in the market to buy bonds at prices above par (implying a lower or even negative yield). To finance this, the US Fed prints money, increasing the money supply and devaluing existing money on issue. As Keenan notes: “If the Fed has to do this on a large scale to keep bond yields down then the US$ will weaken due to the large currency debasement that is going on by the US Fed monetising US Govt debt.”
- The impact of a falling US$ flows into commodity prices, which are already starting to rise as stockpiles fall and economic growth resumes (see the article in this week’s Eureka Report on rising commodity prices). A falling US$ drives commodity prices higher, leading to higher inflation and even less demand for US$ denominated assets especially bonds. Keenan again: “Hence bond yields rise because of less demand AND fuel prices rise in the US. Very nasty.”
Keenan’s view is that the US inevitably will have to take some very harsh medicine – which does seem to be factored into the US political psyche with discussions this week in the US financial media that President Obama’s healthcare reforms will be shelved this year. As Keenan prophetically comments:
“The only way out of this dilemma is for the US Govt to face up to the fact that it cannot afford to keep racking up debt when it already has $10 trillion against an economy worth $14 trillion. It must reduce spending and /or increase taxes at some point soon. Both of which are unpleasant for the US economy and US consumers. This is why I do not expect a V shaped recovery (in the US) but a long L shaped flat period.”
Avoiding the risks of investing in the US, or in the bond markets that will suffer from collateral damage as the US rebuilds its economy, will be key to preserving and growing your wealth in 2009/10.
© Alpha Structured Investments
