Fixed Income

2019 has been unusual in that both equity and bond markets have rallied strongly against a backdrop of solid economic growth. Commentators have repeatedly cited the supportive stance of Central Banks as the catalyst for the extension of this extraordinary long economic cycle. The hallmark of this extra Central Bank stimulus is the lack of widespread inflationary pressures despite universally strong/full labour markets and cheap access to credit for most borrowers. As discussed previously there are several structural factors constraining inflation, most notably rapid technological change and industry disruption.

However, in our assessment, the Phillips Curve still exists, and this cycle has taken significantly longer for the unemployment and inflation impact to connect to the real economy. This cycle came from a major global banking crisis which was deflationary (as it also was in the 1930s) and required deleveraging over multiple years to correct asset pricing.

As the chart shows, the number of global government bonds with negative yields will reach new record highs in 2019. The big question is whether this make sense when unemployment rates are so low, inflation is tracking between 1– 2% for the countries within the G20, global growth is ok (in particular consumption spending is solid), company earnings are high and surprising mostly to the upside, and risk markets are at or near record highs.

Our research suggests that current bond prices are unjustifiably high and that a bubble has formed in the government bond market. Who would have thought that investors in the current economic environment would be happy to accept such low or (in some markets) negative yields as the stable choice to protect capital? Is this rational or is the world really moving into “Japanification” of long-term deflation? 

The case study into Germany clearly shows that inflation has been stable to slightly rising, and consistently tracking above bond yields since 2014. Defying economic gravity, bond yields are not only less than inflation, but they are now outright negative–i.e. investors are investing in a zero-coupon bond and willing to accept a reduction in capital upon maturity. This is a total doomsday scenario as investors fear the future or are totally irrational - hence a bubble.

The big story for Australia in 2019 has been the large re-rating of the equity market and risk premium following the May election outcome. As has been well documented the ASX 200 has had a stellar run. Yet at the same time, the bond market has rallied hard – in part due to the RBA rate cut (with more expected) but also due to investors’ assessment of fear and hence the desire for “safety” regardless of the yield. As the chart shows, inflation is now above the 10-year bond yield in times of growth and equity market buoyancy.

Care is warranted here. Most investors are looking for where the risks lie and the first place they look is the equity market. We discussed this in a prior article and concluded that there could be a mild bubble in tech but we are far from a re-run of the late 1990s. The biggest risk increasingly looks to be in the bond market, where logic is being defied and irrationality is becoming more widespread. This includes the Australian bond market and (unlike Germany and Japan) Australia has both favourable demographics and large resource inventory.

Now is not the time to be chasing government bonds, as a bubble has formed and fundamentals are being defied. We are not invested in this market segment as the risk/returns are far from attractive. Rather, we are seeking the superior risk-reward and lower volatility of Australian private debt which is currently an underserviced niche segment of the market due to bank deleveraging and will be largely immune to any major bond market sell-off. 





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