Bond Markets: There Will Be More Blood
March 5, 2021
Ask Forstrong: What’s happening with rising bond yields? Should investors be worried?
For 40 years bonds provided positive returns when stock markets struggled.
That relationship has changed recently: bonds are failing to deliver protection during stock market declines.
Looking ahead, investors are witnessing the beginning of the end of the disinflationary era. Bonds will face chronic headwinds for years to come.
Markets are nowhere close to pricing in this outlook. Investors need to look beyond bonds for income and safe haven assets.
It is now clear that 2020 was a hinge moment in history. Nearly a year ago this week, Italy abruptly quarantined 11 towns and more than 50,000 people to limit the outbreak of a then-mysterious virus. That sent a clear message that a pandemic was a serious, global threat. By March, the simmering unease would turn into a full blown, nostril-flared financial meltdown.
A year into this crisis, everything has changed. And most have seemingly forgotten their pre-pandemic lives — a three-dimensional world complete with water cooler gossip, regular haircuts and spring break in Cabo. A world where the amusement of interrupting kids and pets on Zoom calls had not run its course as a comedic genre. Clearly, quarantine existence has shredded all convention.
What is less clear is what all this means for the period ahead. That question that has detained many fine minds — and invited much hyperbole. Obituarists have been particularly busy. Malls are apparently dead. The business traveler is an anachronism. China and US relations are now in a permanent deep freeze. And, globalization is receding (doubtful, but a topic for another time).
Yet, for financial markets, the most obvious — and most telling — casualty of coronavirus has been the bond market. For 40 years bonds provided positive returns when stock markets struggled. That was manifestly not the case throughout 2020. Initially, bonds did rally as COVID-19 made its way into the public consciousness. Yet by mid-March, bonds sold off along with stocks. Then, when equities tanked again in September and October 2020, bonds promptly sold off again.
This is a crucial development. Nearly all diversified portfolios run by pension funds and big institutional money are constructed on the assumption that bonds will provide refuge during crisis. Admittedly, this is a far easier proposition when bonds have positive real yields (often as high as 4% over the last 4 decades). It is a very different proposition when real yields are deeply negative as they are today.
Most investors have no living memory of bonds underperforming during inclement environments. Yet there is precedent. During the 1960s and 1970s, US bonds provided persistently horrific returns (earning the title “certificates of confiscation”).
Now, it could be said that rising yields last year were an anomaly given the enormity of stimulus directed at resuscitating global economies. Or, that rising yields this year are simply recognizing the growing prospect of a return to normal economic activity, courtesy of mass inoculation (of course, this is dependent on the efficacy of vaccines — watch Israel’s highly organized rollout here for signs of success). After all, the OECD’s leading indicators are forecasting full-throttled economic growth ahead. The IMF also expects the strongest year of global growth since the early 1980s and this could be too conservative if encouraging signs of vaccination programs continue.
All fair points. But, looking ahead, everything hinges on the nemesis of bonds: inflation. In the short run, US core inflation is likely to exceed the 2% target in the March/April period due to the annual base effect. The issue is what happens after. The big surprise will be that inflation remains higher than the past decade.
Coming To America: Inflation?
The global policy response to COVID-19 has set in motion dynamics that mark the beginning of the end of the disinflationary era. Note that we are not calling for rampant 1970s style inflation. Rather, a gradual uptick in overall inflation will play out glacially over many years.
This shift is now being strongly endorsed (whether they know it or not) by a wide-ranging cast — central bankers, fiscal policymakers and even consumers. It should be quite the spectacle. Most central banks remain clearly focused on the last battle, assuming a long, plodding recovery like the post-2008 period with a complete lack of inflationary pressures. The Fed has now made major modifications to its monetary policy framework, shifting to an “average inflation targeting” approach (allowing inflation to run hot to make up for past undershoots). Fed Chair Jay Powell has even recently suggested that they would delay tightening policy if unemployment rates for minorities and low-wage workers were too high. Clearly, the Fed no longer sees its main job as stabilizing prices but rather creating a “full employment economy”. This is a massive ideological shift.
In the world of fiscal policymaking, the pandemic has been a moment of revolutionary break. Fiscal stimulus arrived fast and furiously. But plans for additional fiscal spending are still widespread, ranging from tax cuts to infrastructure projects to initiatives that move the world further away from its carbon intensity. Underpinning all of this is Modern Monetary Theory (for more on this topic, click here). Importantly, a consensus amongst policymakers has emerged: the risks of doing too little greatly exceed the risks of doing too much. Deficit shaming and austerity are now dead.
Lastly, consumers will contribute to inflationary trends. This is entirely behavioral. Many now wonder if the post-pandemic world will roar as it did in the 1920s. How could it not? Taken together, the 2008 crash, the pandemic and the populism that reached it ugly climax in Washington earlier this year add up to a period of relentless distress. It would be strange if, coming out the other side, consumers did not roar.
Not that it was needed, but research is now emerging showing that pandemics have long lasting effects on behavior. The 1920s were possible because all authority — political, economic, cultural — stood discredited after civilization’s near demise. It was a time of reduced inhibition and deep experimentation. The world is not working with such a naked canvas today. But the concept remains the same: the lower the trust in public institutions, the higher the desire to indulge (YOLO!). Who knows what is coming next? (pro tip: Buenos Aires, a city that has habitual hyperinflation and currency crises, is a wonderful city to explore and indulge this theory).
What are the risks to the above? Historically, rising yields have been problematic for stocks when they have increased in response to hawkish central bank action. This is not the case today. Higher yields reflect improving economic fundamentals. Yet, at some point, higher rates can choke off recoveries. The US 10-year Treasury yield has tripled since last summer. It would not be surprising to see bonds stage a short counter-trend rally from here. Investors will have to continue monitoring the yield curve, investor positioning and economically sensitive prices like copper to determine if yields have risen too far and too fast.
Still, the bigger story, is the peaking out of a 40-year period of disinflation. Losing investments will be those that have been bid up on the “lower forever” inflation thesis. This includes high-duration growth stocks (which thrive on low discount rates) and, of course, Western government bonds. Winners include bank stocks (which have become well-capitalized and are natural beneficiaries of a steepening yield curve), commodities (which have largely completed their secular downturn), industrials (and other cyclically-oriented sectors that can pass through rising costs) and the Chinese bond market (the only major economy in the world that offers positive real interest rates). Markets are nowhere close to pricing any of this in.