Asset Allocation

Bond markets look like they are pricing disaster, while equity markets are pricing an extended boom. But maybe there is a more nuanced message in there, the same one central bankers the world over are also asking politicians. 

I’m going to use Germany as a more extreme example, but the story is similar pretty much all over the developed world.

Lessons from Germany

In Germany, the yield on a 19-year government bond was negative this week. To put that into perspective, you can give the German government 100 Euros today and the German government will give you back less than 100 Euros while keeping your money for the next 19 years.

It is desperate a cry for help from markets, whether they know it or not.

For most of the early 2000s, for the German government to borrow (for ten years) to expand the German economy it cost around 4-5%.

Then the financial crisis happened, and markets offered the German government a 50% discount from the usual borrowing rate as an incentive to borrow – yields fell to 2.5%. The German government was too concerned with austerity to accept the offer.

By 2012 as it was clear Europe was stagnating and Greece would need yet another bailout, the market rate for the German government to borrow fell to 1.5% – markets were now offering 75% off the usual borrowing rate in an effort to get the German government to borrow and expand the economy. The German government, fresh from lecturing its southern neighbours on the benefits of austerity, declined the offer.

As growth slowed once again in 2016, markets changed their offer. If the German government would just borrow some money to expand the economy, they could have it for free – please just take it off the market’s hands. Yields hit 0% for the first time. The German government declined the offer.

Now, markets (and central banks) are offering to pay the German government to borrow money. Begging, pleading, imploring for economic help. In response, the German finance minister this week was threatening Italy with billions of dollars of fines because Italy wanted to run larger deficits to spark economic growth. So, I’m going to take that as declining to borrow on the behalf of the German government once again.

Lessons from Japan

Japan, in particular, is a vision of what will happen if Europe continues down the current path. The Bank of Japan has been struggling with an over-indebted economy and moribund consumer for more than twenty years now.

The Bank of Japan has expanded its balance far beyond what conventional wisdom thought possible. The Bank of Japan effectively “ran out” of debt to buy and expanded its asset buying to buy shares through exchange-traded funds (often called ETFs). It now owns around 80% of all exchange-traded funds in Japan. It is a top ten shareholder in close to half of all listed Japanese companies.

There is still no sign of growth or inflation.

It is not an inviting future.

But Europe seems to be determined to follow a more austere policy path while somehow expecting higher inflation. 

Lessons for Australia

It is the same story in a lot of the rest of the developed world.

In Australia, the Federal government could, if it chose to, borrow at 1.3% for ten years as of Friday. The market is begging for fiscal stimulus – a generational chance to invest in the future at an interest rate that is 1% below the inflation rate target. 

All the government needs to find are projects that have higher than a -1% real return. The current government doesn’t seem to think that rate of return is achievable and feels the need to strive to pay down debt instead.

I'm not expecting the Reserve Bank of Australia to be leading the way on innovative monetary policy, based on the responses to date. I'm not expecting the Australian government to "get out in front" of the problem by using fiscal policy.  

And ten-year bond rates of 1.3% suggests the bond market agrees. 

Asset allocation

In 2018 with a slowing Australian economy, stagnant wage growth and ten-year government bond yields of 2.8% I felt being overweight bonds was an easy decision (investors make money on bonds when yields fall). At the time there were very few voices expecting rate cuts in Australia. 

While we were expecting Australian ten-year bond yields to fall to current levels (1.3%), I was expecting it to take years – the last few months have been a capitulation.

I am of the view that stagnant economic growth and inflation is going to be on the investment menu globally until we see governments (rather than central banks) spend significant amounts of money. And probably “helicopter” money created by central banks. 

Given the current state of economics, that will probably take some sort of reasonably large economic crisis to challenge the current policy. Until then I expect more of the same – slow economies, punctuated by occasional spurts of growth before grinding lower again.

The low bond yields present an asset allocation quandary. I was hoping that by this stage we would have seen equity prices that were more reasonable, giving us the opportunity to switch out of our bonds and into equities. But globally equities are looking expensive. Not irrationally expensive (although I can mount a good argument against buying Australian stocks), but certainly more expensive than I would have thought given the uncertain and low growth outlook. 

So, taking some profits on bonds to hold more cash seems to be appropriate while waiting for the next opportunity.



Comments

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P Malone

clearest analysis I have seen in years

John Dakin

Succinct and convincing. Thanks, Damien