Investment Newsletter April 2018
Winds of Change: Signals in the Bond Market Windmills were a very important development in the history of the Netherlands to drain the land and process the crops. But the windmill, and in particular the sails, had another very useful purpose. They sent messages.
Neal Foundly Investment Analyst
Equilibrium Investment Management
By positioning the sails at various angles, millers could quickly send messages across long distances. There were standard settings to announce events such as celebrations or deaths but in World War II they were used to send messages to the Resistance. For example, when British and American pilots were shot down over the Netherlands, local millers signaled the airmen’s location which allowed many to be successfully rescued.
The Answer is Blowing in the Wind The signal can often be as important as the source and this is very much the case in markets. Like the windmill, this is incredibly important for the (now global) economy but the market also sends signals which are important to stand back and read. In a steadily growing economy, the interest rates on loans (or yields on bonds) will be lower for shorter periods. In theory, the longer the period the greater the risk of default or inflation (the enemy of bonds is inflation which eats away the value of the fixed income). Thus, the ‘yield curve’ as it is known, is normally upward sloping as shown on the left of Graph 1 (over the page).
Equilibrium Asset Management LLP (OC316532) and Equilibrium Investment Management LLP (OC390700) are authorised and regulated by the Financial Conduct Authority and are entered on the financial services register under references 452261 and 776977 respectively. Registered Offices: Brooke Court, Lower Meadow Road, Handforth Dean, Wilmslow, Cheshire SK9 3ND. Both companies are registered in England and Wales.
Investment Newsletter April 2018
Graph 1:
Source:Xxx
However, as the economic cycle develops, growth picks up and builds in momentum. This eventually tips into overheating when demand outstrips supply in many areas such as employment (leading to higher wages) and the demand for equipment which causes shortages and higher prices. Central banks have a mandate to control inflation and will use monetary policy to raise short term interest rates as these price rises start to appear. In addition, as short term interest rates rise, often the markets will see this as a sign that longer term inflation and growth will be lower. This is reflected in lower yields for longer maturities. You end up with a curve on the right in Graph 1, known as an “inverted yield curve” where shorter term yields are higher than the long term. These inverted yield curves are important signals. If you look at Graph 2, below, this shows the world’s largest bond market (in the US) since 1982. The blue
line represents the difference between the yield on the long term (in this case 10 year Treasury) bond minus the yield on the short term (3 month Treasury) bond. When the blue line is above the horizontal zero line, it is a “normal” yield curve and when it dips below the zero line, is when it becomes “inverted”. Why is this important? Because when the yield curve becomes inverted, this is often the signal a recession is around the corner. On Graph 2, the grey shaded areas indicate a recession and they invariably follow dips below the line. So, what is the bond market signalling to us now? Is there danger ahead? On the right of the Graph 2 you will see that since the depths of the Credit Crisis in 2009 the yield curve has been slowly - but persistently – flattening.
Graph 2: 10 year treasury constant maturity minus 3 month treasury constant maturity
Source:Federal Reserve Bank of St Louis
Equilibrium Asset Management LLP (OC316532) and Equilibrium Investment Management LLP (OC390700) are authorised and regulated by the Financial Conduct Authority and are entered on the financial services register under references 452261 and 776977 respectively. Registered Offices: Brooke Court, Lower Meadow Road, Handforth Dean, Wilmslow, Cheshire SK9 3ND. Both companies are registered in England and Wales.
Investment Newsletter April 2018
General synopsis: southeasterly, veering south later; visibility poor
John Authers from the Financial Times recently wrote about the current level, quoting from Jim Paulsen, Chief Investment Strategist of the Leuthold Group: “Currently, even though the slope of the yield curve has declined to 1.1%, close to the flattest of this
recovery, it is only in the 5th (middle) decile of history suggesting the probability of a recession in the next year is only 4.1%” *
There are plenty of reasons to believe that the downward trend will continue for the curve in Graph 2. Several major central banks have started to raise short term interest rates from their historically low levels in response to the uptick in inflation over the past year. For example in the US short term interest rates are forecast to rise from 1.75% to 2.25% by the end of this year.
Why would the yield curve stop this trend towards inversion?
The bond swap market is indicating that this is expected to continue for at least the next two years. However, after that interest rates are expected to start dropping again which may revert to a more ‘normal’ curve.
Well, by that point, the exceptionally low interest rates would have largely returned to long term norms and inflationary pressures are expected to have abated. Graph 3 is taken from the futures market and shows what the yield of the 10-year US Treasury bond is expected to be in 10 years’ time. Whilst it is important to remember that future performance can never be guaranteed, the graph shows that the expectation for that bond’s yield a decade from now is just above 3%, not too far away from the 2.83% at present.
Graph 3: 10 year-10 year treasury yield expectations
Source:Bloomberg
Signal and manoeuvre
Bond markets are dynamic and subject to change at any time – the eventual outcomes are likely to be different from these expectations. It must be remembered that the inversion of the yield curve does not cause a recession but is simply a signal which is right about three quarters of the time. That said, we clearly will be watching for signs of change for both opportunity and impending danger. As it stands today, our outlook for fixed interest securities have fallen over the last 12 months and our current “best guess” for returns for this asset class is around 3.5-4% over the next 12 months. Remember
as bond yields rise, as we expect over the next year at least, the price correspondingly falls. *Financial Times, 17 April,”Authers’ Note: The Beginning and the End” Disclaimer: The content contained in this newsletter represents the opinions of Equilibrium Investment Management. The commentary in this newsletter in no way constitutes a solicitation of investment advice. It should not be relied upon in making investment decisions and is intended solely for the entertainment of the reader.
Equilibrium Asset Management LLP (OC316532) and Equilibrium Investment Management LLP (OC390700) are authorised and regulated by the Financial Conduct Authority and are entered on the financial services register under references 452261 and 776977 respectively. Registered Offices: Brooke Court, Lower Meadow Road, Handforth Dean, Wilmslow, Cheshire SK9 3ND. Both companies are registered in England and Wales.
Investment Newsletter April 2018
General Economic Overview A number of leading indicators point to good but a slowing pace of growth in the major developed economies. The pick-up in demand growth over the last year has resulted in higher prices driven by greater wage pressures and commodity price rises. As 2018 progresses, the year-on-year pace of inflation is expected to moderate but central banks, especially in the UK and US, are likely to raise interest rates to avoid potential overheating in the respective economies. The Brexit uncertainty hangs over many investment decisions in the UK. Recent advances in the negotiations have resulted in a strengthening of sterling which will serve to reduce the costs of imported goods although less good news for exporters of goods and services to overseas markets. Asset class key + positive - negative = neutral (normal behaviour)
+5 strongly positive -5 strongly negative
Asset Class
Score
Equity Markets Stock market volatility has resulted most markets looking a little less overvalued with the UK indicated as better value than most (albeit with the Brexit uncertainty). We continue to see more value in Asia including China and Japan, and smaller companies within the UK.
-3
Fixed Interest Interest rates are expected to continue rise in the UK and US this year. This will put a squeeze on companies as the cost of financing rises and may raise the prospect of more indebted companies failing. With little prospect of positive surprise and growing risks, we remain cautious.
-4
Commercial Property With the retail sector struggling against online competition and uncertainties in City offices, the returns this year from UK commercial property will be modest, and likely to be even lower next year. In particular in the office sector, we are avoiding London and prefer holdings in the major regional cities. The score has fallen from -3 last month to -4.
Cash With interest rates remaining at record lows, returns on cash will remain below average for the foreseeable future.
-4 -5
Balanced Asset Allocation For a typical balanced portfolio we are underweight fixed interest, property and equity. This is balanced by additional holdings in defined returns, alternative equity and tactical cash.
A neutral score (=) means we expect the asset class to move in line with our long term assumptions: 10% pa for equity, 7% for property, 6% for fixed interest, 5% for residential property, and 3% for cash. A +5 score means we think the asset class could outperform by 50% or more. A -5% means we think it could underperform by 50%. A negative score does not necessarily mean we think the asset class will fall.
These represent EIM’s collective views. The value of your investments can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested. We usually recommend holding at least some funds in all asset classes at all times and adjust weightings to reflect the above views. These are not personal recommendations so please do not take action without speaking to your adviser. Equilibrium Asset Management LLP (OC316532) and Equilibrium Investment Management LLP (OC390700) are authorised and regulated by the Financial Conduct Authority and are entered on the financial services register under references 452261 and 776977 respectively. Registered Offices: Brooke Court, Lower Meadow Road, Handforth Dean, Wilmslow, Cheshire SK9 3ND. Both companies are registered in England and Wales.