Low inflation, central bank asset purchases and the flight to safety following Britain’s decision to leave the European Union (known as Brexit) have all resulted in a further drop in bond yields. A significant proportion of sovereign bonds offer negative yields, or in other words, guaranteed losses for investors holding to maturity.
Investors have responded with an ever-desperate hunt for yield, the continuation of a theme that has been in evidence since 2012. While we see shares as broadly fairly valued on an absolute basis, they appear particularly cheap in comparison to unsustainably expensive bonds.
There is a risk that clients who would typically not accept equity risk are being drawn to the asset class on the promise of higher returns than they might achieve in cash or bonds. Troubles might occur for these investors over the next few years as bond yields gradually increase with modestly rising inflation and the cessation of extraordinary monetary stimulus programs.
Conditions have improved from earlier in the year
Rebounded energy prices and a more moderate US dollar have helped conditions improve from the slowdown earlier this year. We anticipate further modest expansion, led by increasing consumption in the US and China and continued meek revival in Europe. We expect the globe to avoid a deep recession in the next couple of years that would derail the equities rally.
Industrial activity and services in the world’s largest economy are expanding again. A lift in manufacturing new orders indicates positive momentum for the remainder of the year.
US wages growth is now around typical historic growth rates and will build further as the labour market tightens. The labour market continues to grow, though monthly average job creation has slowed to around 172,000 per month so far this year, compared to 223,000 per month in 2015. A number of states will raise minimum wages this year, which will contribute modestly to wages growth but also restrict job growth somewhat.
Brexit uncertainty to remain for some time
Brexit proceedings and related uncertainties are likely to prevail for a number of years. The paths Britain and the European Union take could lead in a variety of directions. British Prime Minister Theresa May will seek the best possible access to the single trade market while also seeking greater control over the numbers of people entering Britain, a critical issue that influenced the Brexit outcome.
Brexit could well be a game changer for the EU and may ignite real reform. The European Council statement soon after Britain’s referendum result indicated there is greater willingness to listen to the dissatisfaction among many people within EU and a readiness to have greater reflection that could give rise to further reforms.
The EU has major incentivises to keeping the remaining twenty-seven members together by finding ways to enhance the benefits of membership. Germany, likely to be the European leader in negotiations with Britain, is probably the most motivated to making sure the EU and eurozone continue to exist. Germany has become increasingly reliant on exports which would be hurt if members leave the eurozone and experience depreciations in their currencies. German exports now represent 46 per cent of GDP compared to 32 per cent when the euro commenced in 2000.
Concessions on the free movement of labour could reopen opportunities for Britain to remain in the EU after all. Such moves may also help reduce the drive for other Brexit-style referendums while suppressing the rise of populist parties like Germany’s Alternative, Spain’s Podemos, Italy’s Five Star Movement and France’s National Front.
Fiscal expansion might be another way to help contain the rise in populism. Increased infrastructure investment could create employment within construction and related sectors, and boost potential economic growth. The EU could also allow Italy to use public funds to recapitalise Italian banks which have under-provisioned for their non-performing loans worth 360 million euros. This could diffuse the rise of the Five Star party which is threatening to pull Italy out of the eurozone and EU. Such an event would have far greater implications for the future of those institutions than Britain leaving the EU.
Eventual rise in yields could destabilise share prices
The rally in bonds has gone too far. Yields have already started to rebound as the initial Brexit shock dissipates. We expect a further gradual rise in yields in the months ahead. With time will come greater clarity over new arrangements within the EU. There will be greater certainty that economic consequences for both the UK and Europe will be relatively modest. Major catastrophes are likely to be avoided.
We think the market is underpricing the likely mild pickup in inflation over the next year or two, particularly in the US. Bond yields should steadily rise as inflation reverts to target levels and official interest rates increase. Rebounding oil prices and rising wages, especially in the US, will have a meaningful impact over the next year. The rise in populism may also be modestly inflationary over time through the influence on governments to use fiscal measures to help address the growing concerns over income inequality.
The US Federal Reserve has paused its rate rise cycle in the face of weak international developments, but continued evidence of an ongoing US recovery will encourage further hikes from later this year. This will also help to counter the various forces weighing down yields globally. We expect at least three US rate rises next year while the market is projecting one at best.
There is a limit as to how far monetary policy can go and there may be more of a push toward fiscal actions. Ultra-low interest rates are providing a stimulatory benefit, but there are also costs. Very low interest rates favour borrowers over savers, especially hurting older people living on fixed pensions. Negative interest rates hurt the ability of banks to generate profits as effectively the lender is paying a fee to the borrower. Corporates have taken the opportunity to refinance debt at lower rates, but they have been more inclined to buy back their own shares than to undertake growth investments contributing to the weak revenue growth outlook.
High public debt levels and fiscal imbalances mean that a coordinated fiscal campaign is unlikely unless there is a major downturn. Some regional expansionary programs are under way however, most notably in China, Japan and Canada.
Where to invest
Share prices are full but not excessive given the modest growth environment. Investors should have a neutral weighting to equities, the exact amount dependent on their unique goals and risk tolerance. It is wise to carry additional cash in order to readily take advantage of intermittent market sell-offs to buy high-quality assets more cheaply.
Within Australian equities, investors should be distrustful of overly popular and now expensive bond proxies, especially infrastructure owners and real estate investment trusts. Dividends are still likely to provide a high proportion of total returns given full market prices and modest economic growth. However, the best performing companies will be those delivering enduring growth in earnings through unique assets or skills and strong cash flow that supports a rising dividend stream.
Housing, consumption and liquid nitrogen gas (LNG) exports will help Australia grow faster than most developed economies in the next few years. Each of these areas are well-represented in our portfolios.
It still makes sense to own fixed interest securities, but at a far lower than typical weighting given unsustainably low yields. Bonds play a critical diversification role in long-term portfolios. Bonds help hedge portfolio values against market disappointments that can significantly hurt growth asset returns.
As always, patience and a focus on a tried and tested investment approach are vital.
Andrew Doherty, director, AssureInvest