Since its inception, we have not incorporated any bond asset class categories in our Top Down Portfolio.
This is simply because the “Top Down Portfolio” is designed to replicate the asset allocation of a diversified macro hedge fund and is therefore well suited for the most aggressive section of any active investor’s portfolio. Considering our preference for momentum strategies, we have seen many equity markets (especially emerging markets) and some currency exchange rates (i.e. AUD/JPY and NOK/SEK) offering a better risk/rewards profile compared to bond markets, while Gold and Silver provide stronger protection against the potentially increasing risk premiums on the international financial markets.
However, we are well aware that bonds are usually the main asset class category in investment portfolios, going unaltered even through the steep yield decline over the past few years. Nevertheless, according to the latest US data gathered by Michael Belkin, author of “The Belkin Report”, only USD24bn had gone into various kinds of equity funds over the entire recovery rally starting in March ’09, versus USD178bn into bond funds.
Accordingly, this week’s “Global Strategy Weekly” will be analyzing bond market perspectives in both the US and Euro Zone, though we shall not be altering the 10 asset class categories in our “Top Down Portfolio”.
In the “Global Strategy Weekly” published on 18 January entitled “What is the yield spread telling us?” (look here for an exerpt), we underscored that very steep yield curves (the spread between 3m US T-Bills and 10y T-bonds is still well above 300bp) are usually followed by a decrease in long term rates and an increase in short term rates. We are of the opinion that a flattening yield curve in both the US and Euro Zone (we consider the German bond market as a benchmark) is the most likely scenario in the medium term.With short-term Government Bond yields close to historical lows in both the US and Euro Zone, we see very few reasons to invest in them now. Thus, investing in short-term Government Bonds would make sense solely in the event of fresh financial turmoil, or should deflationary pressures resume.
More uncertainties surround the outlook of long-term Government Bond yields. On the one hand, we are skeptical insofar as the decline of long-term rates in the next few months, as the steepness of the yield curve would indicate. Indeed, despite huge advances since its lowest level, posted in December 2008 (at 2.42% in the US and at 2.95% in Germany), long-term yields still remain low, especially considering the global economic recovery. On the other hand, we cannot agree with the general belief that yield may climb much further in the next few quarters (the economists in December’s Livingston survey conducted by the Federal Reserve Bank of Philadelphia predicted that rates may rise to 4.1% in the US by the end of 2010, and to 4.64% by the end of 2011).
Further, we estimate that economic growth in the US and Euro Zone over the next few years is likely to be subdued, since the potential growth rate has declined following the past two years in crisis. Moreover, the deleveraging process that would take place in major developed countries (i.e. total Debt as % of GDP is at 296% in the USA and at 285% in Germany) should eventually take its toll on economic growth.
Two other factors will play a positive role in lowering long-term yield in the next few quarters. US long-term Government yield will continue to benefit from foreign purchasing of US bonds. According to the paper “International Capital Flow and US interest rate”, the Federal Reserve’s economists Francis Warnock and Veronica Warnock demonstrate that foreign flows have an economically large and statistically significant impact on long term interest rates. While a slowdown of foreign buying is possible, the prospects of international investors completely abandoning the US market in the months ahead are unlikely. For this reason, foreign acquisition of US bonds should likely continue benefiting the US economy.
In the Euro Zone, difficulties surrounding the outlook of peripheral countries are likely to have a positive effect on German Bonds, which should continue to be seen as a safe heaven.
Our main scenario is that long-term Government Bond yields in the US and Euro Zone should rise in the short term (especially in the US), which is in line with economic recovery gathering momentum in early 2010, and then decline when the respective Central Banks begin increasing rates in H2 ’10, with investors setting off to discount more moderate economic growth and lower inflationary pressures. While we are not recommending investing in long-term government bonds now, we do see the potential for long-term Government bonds to gain positive returns in the next few months. We believe that the best choice for bond investors is to have their portfolios buttressed to last as long as possible.
Notwithstanding the above, a sudden increase in inflation is the main risk to our projection. In the working paper “Inflation Hedging for Long-Term Investors”, published in April 2009, IMF’s economists Alexander Attiè and Shaun Roache verified that “long-term treasury bonds are the worst performing asset class in the immediate aftermath of an inflation shock as yield increase”. However, the two economists also noted that “after about 3 years the return dynamics begin to work in favor of long-term treasuries, albeit gradually.”
Nonetheless, we believe that the prospects of a big spike in inflation are slim due to slack capacity utilization and the effects of deleveraging process on consumer spending, which we have emphasized previously. We substantially concur with the economists’ consensus in the Livingston Survey, in that consumer price should rise by 2.2% in 2010, and by 1.8% in 2011. The break-even inflation rate for the next 10 years (implicit in the TIPS) is at 2.27%.
Should inflation rise well above current expectations, bond investors should switch to inflation-linked bonds.