A lot of mixed signals in the markets. How long before we see the downturn???

An interesting item on the world today.....  Aivars Lode

Article written by Alan Kohler, Editor of the Eureka Report in Australia: 

Two weeks ago I wrote here in my Saturday Briefing “Bonds: it’s a bubble”. Since then the yield on the Australian 10-year bond has bubbled from 1.23% to 0.9425% yesterday, having dipped below 1% for the first time on Tuesday.

Yesterday’s new low was prompted by the RBA basically giving up on inflation and unemployment, forecasting that unemployment will rise by 2021 and that inflation won’t hit the target range (2%) until mid-2021. Unsurprisingly, given that, Governor Phil Lowe is muttering about zero interest rates and quantitative easing. And unsurprisingly the bond bubble had another bubble.

What the hell? 

It has been an extraordinary couple of weeks in the global bond market:

• On top of the Aussie 10-year yield going below 1%, the US 10-year bond yield fell below 2% last week and is now 1.699%, approaching the all-time low of 1.36% in July 2016;
• The stock of global bonds trading on negative yields broke through $15 trillion;
• Every single German government bond, from one month to 30 years, now trades on negative yields;
• The Austrian 100-year bond, face value 100 euros, now sells for 185 euros, 68% higher than in December – easily outperforming the Nasdaq (up 29%).
• Countries totalling 30% of the world’s GDP currently have an inverted yield curve;
• 16 central banks have now cut interest rates this year by a total of 1060 basis points, the latest being New Zealand, India, and Thailand this week.

There are basically two schools of thought about all this: mine – that it’s a bubble – and the also common, more pessimistic view that the bond market is heralding a global recession. As Gluskin Sheff’s resident pessimist Dave Rosenberg wrote on Thursday: “At this stage, it’s a question of when, not if.”

On the other hand John Authers, writing in Bloomberg, thinks this might be the bond market’s equivalent of the Nasdaq in early 2000 … its dot com moment.

If you’re wondering which scenario would be worse for investors in equities, there’s no doubt about that: global recession of course. 

Let’s have a look at history (this chart was put together by Dave Rosenberg’s staff from a few different sources):

GLOBAL BOND YIELDS

As you can see global yields have been this low only twice before – in the late 1500s and the 1930s.

Deflation was pretty common before the 20th century, usually because of huge bursts of new supply and/or productivity. That’s what happened in the 16th century, after the Portugese explorer Vasco de Gamma first linked Europe and Asia by sea and kicked off the age of Asian colonialism, with huge increases in the supply of all sorts of products.

The Spaniard Francisco Pizarro then arrived in South America in 1502 and did the same thing there. Also Francis Drake and his cousin John Hawkins kicked off the African slave trade in 1563, which had a big impact on labour costs.

This is generally called “good” deflation because it involves increased supply – of goods and labour (not so good for the conquered nations and the slaves).

That sort of thing continued periodically through the 17th  and 18th centuries, culminating in the Industrial revolution producing periodic “good” deflation in the 19th century through dramatic improvements in productivity.

The deflation and super low yields of the 1930s, on the other hand, were due to a deficiency of demand caused by the Great Depression, which is, of course, “bad” deflation.

Did the yield curve predict the Great Depression? Well, yes: the difference between the 10-year bond and 3-month Treasury notes fell from positive 2% in 1924 to minus 1.45% in May 1929, five months before the Great Crash.

By the way, it also predicted the 1921 depression, inverting in June 1920.

The period 1921 to 1946 is regarded as the first great bond bull market, although as you can see there were a few earlier ones, with the US 10-year yield falling from 5.67% to a low of 1.55, due first the Great Depression and then the manipulation of yields during WW2. 

So here we again, minus both depression and war. It’s hard to get one’s head around what’s going on, but I’ll have a crack.

First, let’s acknowledge that I could be wrong, and the bond market really is predicting a stock market crash and global recession. After all, when the US yield first inverted in December 1927, the Dow Jones was around 200. It sailed on oblivious to the danger to peak at 381.17 on September 3, 1929, before bottoming at 40 two years later. It took a generation to regain that 1929 peak.

But things are far more complicated now than in the past, and it is no longer a simple question of whether bonds or equities are “right”. They are probably both wrong – that is, there’ll be no recession/depression and no inflation.

One of the most respected bond traders in the market, Joachim Fels of Pimco, wrote a blog post on Tuesday in which he discussed the “deeper fundamental drivers” behind low and negative interest rates.

“The two most important secular drivers are demographics and technology. Rising life expectancy increases desired saving while new technologies are capital-saving and are becoming cheaper – and thus reduce ex-ante demand for investment. The resulting savings glut tends to push the “natural” rate of interest lower and lower”.

He didn’t talk in detail about technology, but you know what he means.

To that he added three cyclical factors at work:

• The slowdown in the global and U.S. manufacturing sector has started to spill over into the U.S. labor market. …Six-month average net monthly payroll gains have now slowed to 140,000 from 225,000 last year and, more importantly, aggregate hours worked for production and non-supervisory workers are now contracting on a six-month annualized basis
• President Trump’s surprise announcement to introduce a 10% tariff on the remaining $300 billion or so of imports from China effective September 1, and China allowing its currency to depreciate against the dollar and possibly penalising U.S. agricultural products, raises uncertainty and is likely to induce companies to postpone or slash investment spending (and hiring) further, thus reducing the demand for investible funds.
• With the natural rate of interest likely falling fast due to all of these developments, the Federal Reserve risks lagging behind, thus effectively tightening the monetary policy stance (measured by actual rates minus the natural rate) rather than easing it.

He concludes that the fed will now cut rates back to zero and start quantitative easing again, with US bonds going into negative yield.

And then Adrian Orr, the governor of the Reserve Bank of New Zealand, shocked the markets by not only cutting the cash rate there by 50 basis points, but also raising the prospect of negative policy rates.

I have long thought that a big part of the problem is the failure of central bankers to adjust their thinking for the modern world, in which secular, non-economic factors are bearing down on inflation, as mentioned above by Joachim Fels. They are stuck in the Milton Friedman mindset, that inflation is always and everywhere a monetary phenomenon. That was a mistake.

Technology and globalisation are not transitory side-effects, they are fundamental exogenous shocks, a bit like the oil shocks of the 1970s except the other way.

And just as Paul Volcker took the Fed funds rate to 20% in June 1981 to crush inflation, sparking another great bond bull market, central banks are belatedly trying to crush disinflation (not deflation – there isn’t any of that).

The problem, as I see it, is that all of these economic and market developments are coinciding with unsettling geopolitical and social events.

It feels a bit like 1968, with a rising tide of protest and popular revolts. An (anonymous) Macquarie strategist wrote the other day: “The world regularly loses its mind due to economic and generational causes, but ultimately sanity prevails.”

It took a while for sanity to prevail after the late 60s, though, and in the meantime we got terrorism (IRA, Baader-Meinhof etc) and finally the oil shocks and recessions of the 1970s. This time we have Donald Trump and Boris Johnson, not to mention Orban, Salvini, and Duterte all asserting a populist mandate, and the rise of white supremacy terrorism.

The result of all this is uncertainty, and therefore lower investment and consumption, and higher savings. Growth is also being held down by “zombie companies” – non-viable businesses kept alive by low debt servicing costs.

For good businesses, the lower cost of capital is not sufficient to offset the resulting lower growth.

The challenge facing investors is to keep your head while all those around you are losing theirs. 

Every day we read about rising tensions in Hong Kong and the Persian Gulf, North Korea letting off missiles, no-deal Brexit threatening trade dislocation and return of the Irish Troubles, mass shootings in the US, rising inequality due to the declining marginal pricing power of labour, negative interest rates and apparently panicking central banks and overlaying it all the obvious rising threat of climate change.

What should investors do? How to react?

Well, certainly not by shifting all your money into gold bullion and stocking the wine cellar with cans of baked beans.

It is a time to focus on core themes of investing in scarcity and defence (which doesn’t mean fixed interest or the military – it means businesses that have a defensive moat).

The cost of capital is going to zero, and in some cases negative (some corporate bonds already trade at negative yields and, as discussed, US$15 trillion worth of global bonds are in negative yield already). 

Only businesses with an -opoly after their description (monopoly, duopoly, oligopoly) will have pricing power, no matter what business they are in. 

Borders in the west will remain porous and populations will continue to expand. Someone said the other day that there are 450 million people in Africa who want to go to Europe and hundreds of millions in central America who want to go to the US. They will be harder and harder to keep out. Australia’s population is going to keep growing at the present rate.

Also the ageing of the population is inexorable, although immigration is distorting the average demographic picture.

It means infrastructure and healthcare must remain sound investments. It’s not a time for cyclicals, and value investing (low PEs) will remain challenging because low interest rates have changed the rules.

In general, you should buy “anti-fragile” assets and avoid leverage and cash-burn, which is to say financials and tech start-ups that will need to raise more cash. That probably does mean investing in some gold, short-dated Australian government bonds as well as infrastructure and property.

Eventually the world will come to its senses, but the moment the world has gone mad.  

The best strategy is to not go mad yourself.