The first quarter of 2016 has been marked by additional monetary easing by major central banks venturing further into negative interest rates and direct credit easing in response to a weakening global economy. It is a symptom of the ongoing global debt default that to support the current market valuations (and avoid a crisis of confidence), interest rates have to be lowered. This was also the case in Q1 2015.
In our opinion, future returns in all asset classes have now been reduced to sufficiently low levels where active management has to change more drastically especially given the increased volatility and illiquidity of the markets. Here is our read of what lies ahead for fixed-income portfolios.
The economics of debt
The ballooning of global indebtedness and low interest rates worked hand in hand to lever up global economic growth and provide better returns in financial assets. Graph 1 shows the total (government, non-financial corporates and households) level of debt-to-GDP in major economies on the horizontal axis as well as the change on that metric since the Global Financial Crisis (GFC).
Graph 1 – Progression of debt-to-GDP ratios in major economies
Despite the widespread recognition that the root cause of the GFC was global imbalances (and indebtedness), global debt-to-GDP has increased since 2008 as the above graph shows. The major difference is that, post-crisis, a portion of the debt has been transferred from household to government and corporate balance sheets as a stabilization mechanism.
At the same time, organic nominal economic growth that is required to pay off the debt (organically) has been absent as global nominal GDP halved since the GFC as shown in Table 1. This is in the face of unprecedented monetary accommodation in the last seven years which implies that absent easy money policies, the potential nominal growth must be even lower.
Table 1 – Global nominal GDP pre and post crisis
What the economics of global indebtedness implies is that the global debt default, not de-leveraging (which commonly is mischaracterized), is currently underway as borrowers are unable to survive the debt burden without acquiring additional debt – given the lack of organic nominal growth.
Underestimating the debt dynamics in relation to interest burden has been the main reason why mainstream economists have consistently got the direction of interest rates wrong. The current dynamic of high debt and low nominal growth requires even lower nominal rates to sustain and smooth out the ongoing global debt default. Unless the global policy mix and recipe changes meaningfully (a decent chance of that happening especially post the next economic downturn) to deal with the global debt problem, the path of least resistance is to lower interest rates.
The golden age of central bankers
To facilitate the global debt default and avoid a disorderly financial and real economic outcome, global central banks have taken center stage since the GFC to engineer what we call a “controlled default”. Graph 2 shows the size of public debt and the amount that has been absorbed through the quantitative easing (QE) programs since the GFC. Recently, QE has absorbed almost all of the government debt globally.
Graph 2 – Quantitative easing absorbing public debt issuance
Graph 3 – Yield curves in the U.S., Germany and Japan
The global debt default is so severe that interest rates in Japan and Germany, up to seven and 10 years are negative. Although negative real rates (interest rates adjusted for the rate of inflation) have been in place since the GFC, negative nominal interest rates are an explicit capital confiscation or a taxation of lenders and a clear form of borrower default. It is also fascinating that as the graph shows global interest rates have plunged since the U.S. Federal Reserve’s (Fed) historic 0.25% rate hike in December 2015 which is the clear signal that the Fed made a policy mistake and does not fully appreciate the extent of the global debt crisis.
Looking forward, central bankers are emboldened more than ever to manage the global “controlled default”. The following is what Peter Praet, member of the executive board at the European Central Bank (ECB) had to say. This interview was conducted shortly after the ECB unleashed one of the largest monetary easing programs in March which included a deposit rate cut (to -0.4%), free loans to the banking system for four years, an increased QE program and buying of investment grade corporate debt.
“Q: But do you think the market is right to believe there will not be more cuts?
A: In the introductory statement we said very clearly that we expect the key ECB interest rates to remain at present or lower levels for an extended period of time, and well past the horizon of our net asset purchases.
Q: So you haven't reached the lower bound?
A: No, we haven't. As other central banks have demonstrated, we have not reached the physical lower bound. This re-composition of the toolbox does not mean that we have thrown away any of our tools. If new negative shocks should worsen the outlook or if financing conditions should not adjust in the direction and to the extent that is necessary to boost the economy and inflation, a rate reduction remains in our armory.”
A menu of bad options – asset management under siege
The intervention of central bankers in capital markets has been the most obvious in the sovereign bond markets as rate cuts and QE have lowered interest rates across the maturity spectrum globally. However, after seven years of monetary easing the impact has spread to all asset classes. As the bedrock of financial markets, interest rates provide the base risk-free yield for all other assets which in turn earn a premium on top of the risk-free rate.
In Graph 4, we compare the 10-Year U.S. Treasury bond yield to the valuation for U.S. equities over the next 10 years. With a cyclically-adjusted price-to-earnings ratio of about 25, the expected return in U.S. equities hovers around 4-5% which is about 2-3% above 10-Year U.S. Treasury yield. The unlevered expected returns of all other financial assets are between U.S. Treasuries and U.S. equities as shown in Table 2 resulting in what we call the “menu of bad options.”
Graph 4 – Comparing U.S. equity valuations with U.S. Treasury bonds
Table 2 – The menu of bad options facing investors (savers)
No easy option for fixed income – higher returns are not risk-free
Faced with low interest rates, fixed-income investors have taken refuge in higher yielding assets or assumed different types of risk (e.g. equity or currency risk) in their fixed-income portfolios. These higher returns come with additional risks. The sad news is that there is no free lunch in capital markets and some investors have invested in products that are not really fixed income but sound like fixed income.
Graph 5 shows the time series of total returns in a broad high yield corporate cash index and long Japanese government bonds as an extreme example of why higher yield does not necessarily mean higher total return before the maturity of bonds.
Graph 5 – Yield of a bond (or a bond portfolio) is an incomplete measure of total return
Yield of a bond is only an indication of total return if the bond is held to maturity, absent borrower default. As the above graph shows, the total return of a bond from the point of investing to maturity ebbs and flows as expectations of future interest rates and risk premiums (e.g. default and liquidity premium) evolve and have little to do with the yield.
This does not argue that investors should shun higher yielding assets and buy Japanese government bonds. Instead it shows that both instruments play a role in managing the total return of a fixed income portfolio and that is independent of the yield of the instrument. Toggling between risk-free asset and risky assets required active management and fixed income expertise. Focusing only on the yield of a bond or a bond portfolio when investing in a product leaves out significant amount of detail and opportunity, as it is the most simplistic (incomplete) measure of return.
The need for innovation in fixed income investing is greater than ever
The return expectations of unlevered portfolios are trapped between 0-5% as shown in Table 4. The volatility of financial markets, on the other hand, is abnormally high due to the divergent monetary policy (mainly the U.S. Federal Reserve’s policy mistake in raising rates in late 2015), reduced liquidity of financial markets as a result of post-crisis regulations and the historical amount of monetary liquidity (cash capital) in the system that is constantly looking for a home (returns). The combination of low returns and higher volatility is toxic for traditional portfolios.
Graph 6 – The active suppression of volatility ended with the Fed’s (misguided) tightening campaign starting since the Fed QE taper
I am convinced that fixed-income active management in the traditional Canadian DEX-type investing will not survive if the current environment persists for the next few years. Some of the long lasting investment wisdoms that alpha portfolio managers have used are not as relevant in the new low-income world for three main reasons: the emergence of efficient passive strategies, the policy-driven environment and the large amount of liquidity (cash capital) desperately looking for returns.
In our opinion, the ability to tactically allocate within different sleeves of fixed income has the best potential to add value in the current policy-driven environment where investors are faced with the menu of bad options and violent market moves.
The spectrum of available returns is compressed between 0-5% but there is lots of cash capital and liquidity and volatility is ever more present. This means that when risk premiums (e.g. equity risk premium or credit spreads) widen, the corrections are violent and fixed-income portfolios that are able to allocate tactically between rates, credit and foreign exchange have a chance to outperform and survive the current environment. There are no easy answers and active fixed-income managers are called upon more than ever to employ skill and sophistication to justify their value. This is the rationale behind Signature’s Tactical Bond Pool. Graph 7 shows our tactical decisions in fixed income since 2015.
Graph 7 – A snapshot of Signature’s asset allocation decisions in fixed income