From the desk of the Investment Committee

Articles 29/11/2019

Life in financial markets is never dull.

 

With the Australian share market currently hitting record highs, many would believe economic conditions couldn't be better. Yet global government bond markets (including Australia) appear to suggest something different.

What is going on?

The state of global bond markets today is quite extraordinary. Current 10 year government bond yields are a measly 1.8% in the US and 1.1% in Australia however spare a thought for Germany and Japan where their  bonds trade at -0.4% and -0.1% respectively. The table below outlines the current pricing of government bond yields across key markets and maturities.

 

 

1M

3M

1Y

2Y

3Y

5Y

7Y

10Y

15Y

30Y

USA

1.59

1.59

1.56

1.64

1.63

1.64

1.73

1.79

-

2.23

Euro

-0.54

-0.59

-0.63

-0.63

-0.66

-0.60

-0.52

-0.35

-0.21

0.14

Japan

-0.10

-0.20

-0.17

-0.18

-0.19

-0.19

-0.19

-0.08

0.12

0.44

UK

0.77

0.76

0.65

0.53

0.48

0.50

0.49

0.70

0.98

1.27

France

-0.65

-0.60

-0.54

-0.61

-0.59

-0.43

-0.28

-0.04

0.23

0.76

Canada

1.66

1.65

1.69

1.59

1.58

1.52

1.51

1.49

-

1.60

Australia

-

-

0.83

0.79

0.74

0.79

0.93

1.10

1.22

1.70

China

-

-

2.69

2.79

2.81

2.99

3.17

3.20

3.52

3.80

As at 25 November 2019

All else being equal, negative yields mean investors buying those bonds today are locking in a capital loss over the remaining term of the bond! Ordinarily this would suggest bond investors are incredibly worried about the future economic environment however, today's prices owe more to the actions of global central banks and politicians than it does to the health of the global economy.

 

The recent slowdown in global activity has centred on trade and manufacturing while actual economic growth and employment has proven somewhat resilient in most regions. However, ongoing US/China trade tensions, Brexit uncertainty (complicated by a UK general election) and general softness in the Chinese economy are potential headwinds for business activity and confidence. While we hope to receive clarity over the next 3 months, constant delays to the resolution of these issues has increased the risk that the global slowdown will broaden. It is these geopolitical risks which have captivated global central banks and resulted in the wave of interest rate reductions delivered over 2019.

 

One potential silver lining of record low bond yields, is the access governments have to very cheap capital. With monetary policy appearing to have limited impact on economic growth we believe fiscal policy needs to come to the fore. For governments with relatively low debt levels such as Australia, we feel consideration should be given to borrowing prudent levels of capital for investment into 'congestion busting, growth-enabling' infrastructure.

 

We view the recent behaviour of central banks as a little unusual and a source of potential financial risk. Not only are their actions inflating asset prices but they are leaving themselves little room to support the economy should real activity fail to respond to the latest rounds of stimulus. In the depths of the GFC, prompt central bank action was critical in cauterizing the downturn and sowing the seeds for the subsequent recovery. Today though, central bank policy is kicking into the wind. We believe it better for central banks to respond to tangible macro weakness (should it eventuate) than attempt to move pre-emptively and fail to prevent a downturn.

 

For global equity and credit markets however, this reality seems to be overlooked. Markets have gleefully devoured central banks' policies, with reduced interest rates feeding into higher asset prices and richer valuations. Unfortunately, this exuberance could evaporate should a genuine downturn occur in the global economy. We view the current buoyancy in equity markets as a product of the unusual generosity of central bankers combined with overly optimistic corporate earnings forecasts for 2020. We believe equity markets are at risk of disappointment: only in a deteriorating macro environment will ongoing global rate cuts be delivered. Yet in such a scenario, corporate earnings are much more likely to be below current expectations.

What are we doing?

We continue to believe the global economy (including Australia) remains in reasonable shape. While resolution of a number of geopolitical concerns around the new year would assist, current valuations and earnings expectations suggest this scenario is already factored into equity markets. In light of this, we suspect there is less upside to be had investing significant capital into equities today relative to the potential downside should a broader downturn emerge. We therefore feel a degree of caution is warranted with respect to portfolio management: focussing stringently on the preservation of capital and retention of liquidity. This has seen us continue to take profits on a number of equity exposures, reinvesting into appropriate priced (and highly liquid) defensive assets while also holding greater levels of cash. Such positioning will afford us the opportunity to participate in equity markets when valuations become more attractive.

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