Reasons Why I'm Not Ready to Diversify Out of Bonds
You know the day destroys the night,
Night divides the day,
Tried to run —
Tried to hide —
Break on through to the other side!
“Break on Through (To the Other Side)”, The Doors, 1967.
There is a lot of buzz lately about bonds entering a bear market. If that proves correct, it marks a major paradigm shift.
A bond bear market likely means a sustained rise in inflation, which means we are finally breaking through—achieving economic ‘escape velocity’. Daybreak in the form of reflation. It means the long, cold night we so feared at the beginning of the cycle—deflation—is no longer a threat.
Are we really on the other side of the deflation risk, though? Or, might a levitating stock market be creating detachment from economic reality—like psychedelic illusions that once transfixed the mind of The Doors front man, Jim Morrison?
Here are three reasons I’m not yet ready to sell all my clients’ bonds, and bid adieu to the risk of deflation.
Reason #1: Bond yields have not decisively broken out
Subjective opinions are like air in markets—they’re all around us. Price action consolidates these opinions, and acts as the arbiter of truth.
Lately, inflation hasn’t been too hot or too cold. Markets like that setup. Don’t interpret inflation as being static in nature, though. Prices are always rising or falling.
Bonds are very sensitive to inflation’s trajectory. If the reflation theme is real, bond prices should fall, pushing yields higher.
Below is a chart of 30-year bond yields. Does this look like a bull market to you?
For me, yields on the long end of the curve must convincingly break above the trend line and form a solid base (i.e. higher high and higher low) for the bond bear thesis to resonate.
Reason #2: The economic recovery remains a ‘show me story’
Enthusiasm is percolating across the financial landscape.
At 4.1%, unemployment is at the lowest level in 17 years. Meanwhile, consumer confidence and manufacturing surveys are near cycle highs. Economists are nudging GDP forecasts higher. Profit estimates for firms in the S&P 500 Index surged 3.5% over the last four weeks; the biggest jump in six years according to Bloomberg.
Present trends are encouraging. There’s no denying that.
Yet, it’s also important to take a step back and remember what cycle we’re talking about. This cycle is like the tall, skinny kid on a basketball team who needs to hit the weight room. At 34 quarters and counting, it’s long, but it’s not very strong. The annualized growth rate of 2.0% is the weakest since WWII.
Of course, past is not always prologue. Throughout most of this cycle, businesses have been reluctant to make long-term investments. That’s changing though. Surveys indicate CEOs are feeling better about the current policy approach in Washington, and business prospects abroad. Capital spending rose at an annualized rate of 6.2% through Q3 last year, and recent tax cuts may provide additional ammo for capital reinvestment.
Such positive momentum indicates recession is not likely near-term.
However, whether the pace of growth ultimately matches investors’ expectations matters as well. Citi’s Economic Surprise Index reached a five-year high in December and has since peaked. I wrote a column early last month profiling the index and its mean reverting tendency. There have only been five times since 2003 when the index peaked above 75, as it recently did. From those prior peaks to the next corresponding troughs, 10-year bond yields fell on average by 1.1% over the next seven months (source: Canaccord Research).
Thus far, bonds have not reacted much. If data continues to disappoint that may soon change.
Reason #3: Monetary policy uncertainty
Investors are feeling very comfortable about monetary policy.
The Monetary Policy Uncertainty index uses news articles to measure angst pertaining to the Fed’s moves. There have only been four other times when the public was this confident in Fed policy. When a base forms, usually not much lower than the present level, equity market volatility often rises in tandem.
The current level of complacency regarding Fed policy strikes me as odd. There are a lot of unknowns to contemplate about the period ahead.
What happens when central banks inject $14 trillion of liquidity into the global fixed income market, and then start to withdraw it?
The truth is, no one really knows. Not Bill Gross, Ray Dalio, Ben Bernanke, Janet Yellen, or the new Fed Chair—Jerome Powell.
A grand monetary policy experiment transpired via the QE programs. The final chapters of this story are not yet written.
There is a lot of evidence suggesting QE has impacted markets. Too what extent is debatable. But history says negative interest rates on bonds, like we’ve seen this cycle, are not normal. Nor is it normal to see European corporate bonds trade at an equivalent yield to U.S. treasuries.
Risk assets across the board have been influenced by central banks policies. One example is reflected in the graph below, courtesy of Fidelity. It shows the projected path of the G4 Central Banks combined balance sheet in rate of change terms (blue line), overlaid against emerging market stocks and bonds (green line). If the correlation holds, it implies EM assets may face a bumpier ride.
Bottom-line: Many investors are using conventional cycle playbooks to navigate what has been an unconventional cycle, born from unconventional policies. If the cycle began in a unique fashion, might it end similarly? If you think the answer may be yes, you ought to consider adding some deflation protection to your portfolio. This type of insurance is relatively cheap right now.