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Getting old when yields are zero
Mark McFarland (CIO WEEKLY REVIEW) / 29 July 2012
Perhaps the most important development last week wasn’t the failure of markets to move higher or the revelation that up to seven regional governments in Spain are now in need of funding.
CalPERs, the California public-sector pension fund, notified the markets that its annual investment returns to June 30 were far below expectations, in part because all-time low long-term bond yields make it virtually impossible for their asset managers to deliver returns in line with projections. The yield of 1.5 per cent on US 10-year bonds is rather a lot less than the 5-9 per cent enjoyed by asset managers not long ago. And there hasn’t been a noticeable decline in the cost of living to make the adjustment easier on baby-boomer wallets.
To more seasoned investors this should sound familiar, particularly those who have followed Japan for the last twenty years. Over the next ten years it is going to be a challenge for traditional investment plans to earn the kinds of returns their sponsors were projecting, unless extra duration risk is taken on board or unless extra credit risk is entertained through the medium of lower ratings or moving from secured to unsecured assets. (Equities in the G-7 are now starting to reflect this by offering dividend yields in excess to bond yields).
In fact, from an investment perspective, the results from CalPERs are a wake-up call for all since they are symptomatic of the ill effects of quantitative easing — the depression of inflation-adjusted long-term yields to (somehow) stimulate long-term growth and keep zombie borrowers in the game. In Japan in the late 1990s, the effects of severe risk aversion at the national level meant that long-term bond yields fell below 100bps and as economic malaise progressed solvency ratios on life insurance portfolios deteriorated steadily to the point where the minimum ratios were relaxed to stave off potentially systemic bankruptcies.
Contracts requiring cashflows to match liabilities based on previous history were unfundable because the traditional asset-matching instruments no longer brought in yield. Europe’s LTRO programme has simply added to the malignancy by adding default risk to the mix. A G-7 world with low yields and ageing populations is looking at a prolonged period of financial and social adjustment unless there is clarity on how to escape without a massive burst of inflation. Clearly, this is an opportunity for asset allocation specialists to offer risk-adjusted liability-matching programmes to help clients meet their regular obligations.
Aside from the usual demographic arguments, it is for this reason that our long-term view is heavily skewed towards Emerging Markets, where debt levels are low, markets are being freed from government intervention and where investment flows can find yields much higher than in developed nations. Simply because potential growth rates are higher.
Looking at markets, though, it is perplexing to see so much gravity and such low levels of concern about the future. S&P volatility is back below 17 per cent and earnings revisions in the MSCI World index are negative. Yet few want to touch equities, even though volatility is low. Forex volatility has dropped materially since the end of Q2, despite the fall in euro to its lowest level in 11 years. Euro-yen (EURJPY) is near an all-time low — implying risk aversion. Meanwhile, the US dollar shows no sign of succumbing to default risk fears — even though we are now less than six months away from another hike in the federal borrowing limit.
Despite the strength of dollar, agricultural and energy prices have forged ahead since mid-June. In Emerging Markets, fixed income is gradually extending duration risk as yields on short-term hard currency bonds are squeezed on limited supply. Yet growth rates in Brics have slowed and we are now starting to see the beginnings of deflation in the eurozone to accompany a decline in capital expenditure. Structured products offering capital protection and enhanced yield, to compensate for low money market yields, are enjoying an under-writing bull market. Yet the end of super-cheap libor-based funding is possibly upon us and rising commodity prices are the last thing central banks need now.
Much of what we are seeing in world markets makes sense if you believe that market participants are now less fearful of cross-correlation risk that they used to be, probably because perceived levels of leverage have declined since the Lehman Brothers bankruptcy. The belief that rates will remain low for a long time and that much of what is known about Europe’s problems is already in the price leaves markets vulnerable from macro-political risk perspective and much of that is as difficult to foresee.
So from a tactical perspective, we continue to see a need for diversification and the avoidance of market-sensitive risk through either low beta equity exposure or short-duration bets in fixed income. We prefer that exposure to Emerging Markets continue to be expressed through US dollar or low-beta means. Last Friday’s market reversals on the S&P500 and the 600-point follow up plunge on the Hang Seng are evidence that rallies end quickly, and rather abruptly. South Africa’s decision to cut rates just ahead of renewed weakness resulted in a 1.5 per cent drop in ZAR and a lower JSE.
Lastly, it is encouraging to see markets working for the long-term benefit of investors. After seeing the Indian rupee (INR) fall from 44 per US dollar to a low of 57 at the end of June, and ratings agencies Fitch/S&P putting India’s local currency debt on downgrade watch, the authorities in Delhi have announced increased permitted foreign access to India’s corporate and government bond markets. Long-term INR debt is BBB-, one notch above investment grade.
It’s unlikely that this is the point at which India’s asset markets become attractive, but the downside risks to INR are being mitigated by grown up policy moves from Delhi. The rise in Brent back above $105 per barrel is not good news for an RBI grappling with slow growth and sticky core inflation. Nevertheless, these new initiatives compliment further liberalisation of trade financing for exporters and projected changes to the country’s fuel subsidy policies. These will allow for increased diesel prices in exchange for long-term investment in export-orientated infrastructure.
The writer is chief investment strategist at Emirates NBD. Views expressed by the author are his own and do not reflect the newspaper’s policy
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